Accountability in action on Rock

The occasion is the publication of the National Audit Office report into the Treasury's handling of the collapse and nationalisation of Northern Rock. What is remarkable about this document is not just the comments and criticisms made, but the fact they are made at all.

The conduct of the most powerful Government department when it was taking its most controversial decision in decades has been subjected to an objective audit and a rigorous forensic analysis, which just would not happen in a lot of countries. There is a lot of loose talk about accountability. This is it in action.

Mind you, it is still Whitehall, which means the casual reader might need a decoder.

Take, for example, the comment that the Treasury, in bailing out Northern Rock, lacked the capacity fully to understand the risks it was taking on.

The background is that it agreed with the old Northern Rock board that the latter would restrict its new mortgage lending.

This the board did, but only up to a point. The Treasury failed to spot that Northern Rock was still offering new 125% mortgages even as the property world crumbled about it.

Suffice to say that now the bust is upon us, such mortgages represent 30% of Northern Rock's loan book, 50% of its arrears and 75% of its repossessions.

This same streak of naivety was present after the formal nationalisation early in 2008 when the Treasury approved the business plan for the rescued company.

In fairness, the civil servants were under acute time pressure, but it still seems astonishing Whitehall accepted a plan from the bank that was based on a projection that house prices would fall by only 5% in 2008, and be flat this year, at a time when most other market predictions were already much more pessimistic.

Nor is this a semantic point. Because it so misread the market, Northern Rock lost £548 million in the six months to June 2008.

This was fully £300 million more than the board had predicted just three months previously, and worse than its worst-case scenario.

That loss rather puts the row about Sir Fred Goodwin's pension into perspective. It also raises the question of who was advising the Treasury at this time, given that it could scarcely expect to have all the necessary expertise in-house. The answer, of course, was Goldman Sachs.

It is not the NAO's job to ask what problem the Government could possibly have that is so bad Goldman Sachs could be the answer, though others may care to.

It is, nevertheless, odd that an investment bank that had been at the epicentre of the excess which led to the banking bust should find immediate favour as an adviser on solutions.

Even more alarming is the fact the Treasury allowed Goldman to push it around. The contract under which Goldman was employed promised the bank a success fee of £4 million.

The fatal flaw in this arrangement from the taxpayers' perspective - though not from that of Goldman Sachs - was not the quantum, though that might be thought to be rather high, but something more fundamental. The contract failed to define what was meant by success.

Interestingly though, the sum was never paid. We are not told why.

The arrogance of Goldman Sachs comes through in other ways too.

It was being paid to advise to the Treasury but refused to provide its client with copies of or access to the models it was using, and on which the advice was based.

This meant the Treasury was being pushed into a bailout of the bank - and a commitment that could rise to £50 billion - without being allowed by its adviser to do its own crunching of the numbers.

Goldman was asked repeatedly to provide the model, but always refused. It seems a far from a healthy relationship.

One reason the Treasury was so dependent on Goldman was, of course, that it lacked in-house expertise, but there is a lesson to be learned here too.

Apparently, Goldman, the Bank of England and the Financial Services Authority did one of their occasional disaster stress tests in 2004, and this highlighted the fact the Treasury lacked expertise in dealing with bank failure and the associated financial stability issues.

The point of stress-testing is that you do something about the weaknesses that come to light.

However - and this speaks volumes about attitudes in the department at the time - remedying this shortcoming was not considered a priority "because of the benign market conditions".

One final point. The Treasury, even after it had agreed to pump in all the money, was excessively concerned about keeping Northern Rock at arm's length. The reason was apparently that it was worried about being classed as a shadow director.

Bank of England Governor Mervyn King has been ridiculed for invoking moral hazard as a reason for not rescuing Rock earlier.

The Treasury being worried about being a shadow director when there was £50 billion at stake seems similarly out of touch with reality, however intellectually sound it might be.