Bill Jamieson - Why Northern Rock annual report is a collectors' item

IN THE great global credit crisis of 2007-8 some artefacts are set to become collectors' items. Prominent among these, I suspect, will be the Northern Rock 2006-7 annual report. It was presented to the group's 108,000 shareholders less than a year ago.

Key features in the report were a 19 per cent rise in underlying attributable profits to a new record; a 24 per cent growth in underlying assets to 100.5 billion; a record 22.7 per cent rise in gross lending to 33bn; "robust" credit quality, with mortgage arrears less than half the industry average; and a 20.3 per cent rise in dividends.

It should serve as a textbook model for management and business schools on how an annual report, compliant in all respects and bristling with figures to reassure shareholders – including the "virtuous circle" chart below – cannot be taken as a guide to a business model or its resilience.

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It will be studied for three reasons in particular. First, it is a graphic illustration of how a representation of a company at a particular point can be a misleading depiction of its strengths and weaknesses.

Second, it shows how Northern Rock, just months before entering a terminal crisis, was fully confident of its business model, its financial health and its prospects for the year ahead.

And third, it is an example of how a company can have its corporate governance gleaming like a Rolls-Royce but have the satnav set on a course for disaster.

I do not believe that Northern Rock was in irresponsible hands. Still less was it greedily run, as some companies are, for the private benefit of the board. But that is what makes this report, with the benefit of hindsight, such a chilling document.

Neither the real nature of the business model, nor the risks taken by virtue of that model, are evident from a document whose format is disconcertingly similar to the thousands presented to investors each year.

Here are some highlights from the report and accounts endorsed by the shareholders just ten months ago and signed off by the auditors PricewaterhouseCoopers as a "true and fair" view.

From chairman Dr Matt Ridley:

• It has been another excellent year for Northern Rock. Our strategy of using growth, cost efficiency and credit quality to reward both shareholders and customers continues to run well.

• We expect house price inflation to moderate and we continue to see little prospect of a severe house price correction, given that mortgages remain comparatively affordable.

From chief executive Adam Applegarth:

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• Three-month-plus arrears numbers (fell] in the second half of the year to 0.42 per cent. The proportion of "together" lending, our highest risk product, fell from 35 per cent in the first six months of the year to 26 per cent in the second half and the proportion of lending over 90 per cent of loan-to-value from 30 per cent to 22 per cent."

• We now have established funding programmes in most major international capital and debt markets. Within these markets we have established a strong profile, which meant that around 25 per cent of the total was raised in the private placement medium term note market. We see plenty of scope to increase our funding in these markets to support our business growth.

Following the chief executive's report came a section that most investors glaze over – a five-page corporate governance report.

This section details the work of the audit committee, risk committee and internal control committee. The risk committee, which met four times, reviewed "the key risks inherent in the business". Internal control is a board responsibility and it concluded: "Northern Rock is a well-controlled, risk-averse business that continues to adopt a prudent stance in the management of risk."

So Northern Rock was not lax in its procedures. It just missed the fundamental flaw in its business model. Were investors dumb in failing to spot it on the basis of this annual report? No more, I would say, than the auditors, or the tripartite supervisory regime of the Financial Services Authority, the government and the Bank of England, or the non-executive directors. None of this supervisory great and good uttered a squeak.

So it is perhaps not just the flawed business model, but also the regulatory and governance models, that failed spectacularly.