Is it possible to save Rock from ruin?

Gordon Brown favours a complex last-ditch plan to get the bank - and him - out of trouble by issuing guaranteed government bonds. But, as Heather Connon and Heather Stewart report, however great the PM's desire for a private-sector rescue, the state will still end up carrying the can

Geordies are famous for braving the north-eastern cold in nothing more than a T-shirt or sleeveless frock. The distressed employees and small shareholders at last week's extraordinary general meeting of Northern Rock were, by and large, much more sensibly clad than that, but the vicissitudes of the failed bank have left them just as exposed to its financial chill. How is the Geordie bravado holding up in the face of dire economic - and footballing - circumstance?

Small investor Robin Ashby bought his shares in Northern Rock to show his support for the local economy. 'It is one of only two big quoted companies based in the north east,' he says. It is also, he adds, 'fantastically' important to the area - about 3,500 of its 6,300 employees are based in Newcastle and a further 1,500 in nearby Sunderland. Northern Rock is one of the few businesses employing significant numbers of graduate trainees - many of its senior management, including former chief executive Adam Applegarth, joined the company that way. Its charitable foundation is a 'significant player' in local projects; and, of course, its name is emblazoned on the shirts of Newcastle's football team.

Ashby's loyalty prevented him from selling out last August, when the first hints emerged that its business could be affected by the sub-prime crisis. He remained faithful even when the repercussions from bad lending in the US sent Northern Rock to the Bank of England for help and savers queued to withdraw their money.

Like the rest of the Rock's shareholders, large and small, he hopes that loyalty will be repaid with a sale of the bank to one of the two private-sector bidders. But the odds on some form of nationalisation remain significant, for all last week's assurances by Alistair Darling and Gordon Brown that a private-sector solution remains the preferred course.

The plan they have now cooked up with adviser Goldman Sachs appears to offer such a solution, although cynics might say it is a politically motivated manoeuvre designed to get Northern Rock's debts off the books. In reality the Treasury would still foot the bill if it all goes wrong.

Goldman Sachs's financiers have been working frantically against the odds for the past few weeks on putting together a financing package for bidders. They first tried to tap sovereign wealth funds - pools of money built up by countries in Asia and the Middle East - but that proved tricky because virtually all the potential candidates are already bailing out US investment banks such as Merrill, Citigroup and Bear Stearns (see box, right). Goldman and the authorities are now pinning their hopes on Plan B - a complex funding mechanism that would involve Northern Rock repackaging its Bank of England debt by issuing bonds 'wrapped' with a government guarantee. These could be used to finance a bid, either from Virgin Money or Olivant. As the bonds would have a fixed life, it would put an end-date on taxpayer involvement - and government debt would be viewed as safer than bank backing.

The scheme would be presented as an alternative to nationalisation, but critics say the taxpayer would still be on the hook for the liabilities, and it would still need state-aid clearance from Brussels.

One big advantage from Brown's and Darling's viewpoint, however, is that since the state guarantee would only be called upon if something went wrong, the debt would count as a 'contingent liability,' which means - conveniently - it would not count as government debt. A straight nationalisation would force Darling to bring an estimated £100bn of Northern Rock's debts on to the government's books, busting Brown's sustainable investment rule of keeping public-sector debt below 40 per cent of GDP.

Shareholders are still hoping against hope for a sale, as they made clear at last week's meeting in Newcastle. Hedge funds RAB Capital and SRM Global - which together account for about 18 per cent of the bank's shares, and which called last week's meeting in an unsuccessful bid to boost their ability to influence the decision - said they were willing to do all they could to support a deal. Olivant is their preferred bidder and they are 'prepared to put in large amounts of equity capital if required'.

The government hopes, if the Goldman scheme can be made to fly and a sale pushed through, that shareholders will indeed stump up significant sums of new equity. That, and the government-backed funding, would finance the Rock through a hoped-for recovery, and shore it up until the credit markets recover.

Virgin's Richard Branson is confident that Goldman will come up with a financing package allowing him to do the deal and is making last-minute improvements to his bid. These included beefing up the management team - something the banking regulators had wanted - with the appointment of the former Alliance & Leicester managing director Peter McNamara. He would also allow existing investors to put in some capital, which may make them more enthusiastic about the Virgin offer. But all that remains to be seen.

If Goldman's bond idea falls down, however, there does not seem to be another workable scheme to refinance the £55bn or so with which the taxpayer is supporting Northern Rock through the Bank of England.

Royal Bank of Scotland, Merrill Lynch and Deutsche Bank - which have separately been working to help buyers raise the finance for their proposed deals - have far too many financial problems of their own to risk any liabilities ending up on their own balance sheets. And without credible financing, neither Virgin Money nor Olivant can get off the ground. Goldman's plan, it seems, is the only way of squaring the circle.

A growing number of Rock employees seem to feel that there is no secure solution. The number voting with their feet and leaving has risen sharply over the past month - including the commercial director, who has gone to Nationwide, a somewhat safer building society. Those remaining are incensed by the retention bonuses being paid to a handful of staff, and worried about the safety of their pension scheme

'The retention bonuses have gone down very badly,' says one employee. 'They have been given to just 170 people out of the 6,300 staff - a small group, but with a very big impact on morale.'

These 'key' employees, including communications director Brian Giles and Derek Robinson, the head of credit investments, have been told they will receive a quarter of their salary, capped at £25,000, every three months.

Trade union Unite has been trying to talk to Virgin Money and has had discussions with Luqman Arnold, who is heading Olivant's bid. However, both bidders envisage Northern Rock's size should be closer to the 5.5 per cent share of the mortgage market it had in 2004 than the 19 per cent share of new loans it took in the first half of 2007 - meaning some redundancies look inevitable.

Under nationalisation - still a significant possibility - employees' prospects would still be uncomfortable, unless the government balks at sacking thousands of people in England's poorest region, a Labour parliamentary stronghold.

The government has lined up Ron Sandler, saviour of the Lloyd's of London insurance market, to run the bank if it is nationalised, but he is unlikely to have a remit to expand. He is more likely to seek to maximise the price paid by a bidder when the markets recover enough to make financing a deal viable again. Paul Thompson, former boss of insurer Resolution Life, has joined the board of Northern Rock and is tipped as a possible chief executive under Sandler. A finance director is also believed to have been lined up.

The Rock drama is, of course, playing out against the background of a rapidly deteriorating economic outlook that is already affecting the UK housing market. If it is nationalised, the government could face the terrifying prospect of repossessing the homes of defaulting Rock borrowers - so it is hardly surprising that Chancellor Darling and Prime Minister Brown are still pressing for a private-sector deal. 'Maybe they're just hoping and hoping and hoping that something turns up,' says Vince Cable, Liberal Democrat Treasury spokesman, who has long argued that nationalisation is the only viable way out.

However, a state rescue would prolong the government's involvement, leaving it exposed to criticism over Northern Rock's every future decision. 'It would be seen to be damaging to them politically,' says Cable. 'Gordon is obviously terrified of being portrayed as old Labour.'

For Darling and his boss at Number 10, the political stakes are extremely high, and the Treasury's hard-won reputation for deft economic management has been sorely tested since the summer.

Brown has invited European heads of state to London on 29 January to discuss ways of preventing future market crises; Darling has stuck firmly to the line that, as he put it in a speech last week, 'the difficulties facing Northern Rock began on the other side of the Atlantic and are now being felt across the world'. But it can hardly have escaped Brown's notice that he is the only leader who has overseen a very visible bank run and been forced to make vast public funds available to a stricken lender.

The 'tripartite' system of financial regulation he devised, in which the Bank of England, Treasury and Financial Service Authority (FSA) have joint responsibility, was stretched by the crisis. There has been a whiff of acrimony between the Treasury and the Bank of England about how each handled the situation, and both have blamed the FSA for failing to spot Northern Rock's fragility earlier.

Darling has suggested he could take more control in future crises, by chairing a 'Cobra-style' committee like the one used by the Prime Minister to handle national emergencies. But the Treasury has yet to publish detailed proposals on this, and MPs on the cross-party Treasury select committee are still carrying out their own investigation into the events of the summer.

In the end, Northern Rock's problems boil down to two facts. First, it borrowed unwisely, getting most of the finance for its aggressive mortgage lending from the wholesale markets - banks and other large investment institutions - rather than from its savers and depositors. It failed to anticipate that a wobble in the financial markets could make that finance more expensive - or impossible - to obtain.

The fact that this wholesale funding was, until last summer, much less expensive than paying interest on fresh deposits from savers meant it could build its businesses by being the cheapest lender around. That has now compounded its problems; the yield on its mortgage portfolio, at an average of 6 per cent, is so low that it will be difficult, even when the market settles, to raise finance cheaply enough to provide a decent margin.

For the government, nationalisation would have the advantage of getting shareholders out of the picture, as happened when it brought Railtrack back under public control. The tripartite authorities are believed to have already discussed the price they should offer shareholders. Nick Wood, partner in Grant Thornton's recovery and reorganisation practice, says that such a valuation is usually decided by independent experts, such as accountants or investment bankers, and ratified by the courts. But, he adds: 'The hedge funds are likely to appoint their own experts and the judge will have to make a decision about who is right.'

SRM Global's Jon Wood has already told Darling that the price should be 400p, which may be around a third of the peak level for the shares but it is still well above last week's share price of 64.5p and at least twice what even optimistic analysts, not to mention buyers such as Olivant and Virgin, think the bank is worth. However, Wood has pointed out that it is illegal under the Human Rights Act for the government to expropriate assets for less than what they are worth, so we can expect a hard-fought battle.

Before Christmas, nudging Northern Rock into administration was being talked about as a possibility; but that would mean the government losing control of the process and simply becoming one creditor (albeit the largest one) fighting for its share of the bank's remaining assets. Given that it could be months before the cumbersome process of administration would give savers back their cash, the Treasury would also be likely to have to fill the gap by making good on its promise to guarantee deposits. So, unsurprisingly, Brown dismissed the idea of administration in Parliament last Wednesday, describing it as a cut-price 'fire sale'. Even if the only viable option proves to be running down Northern Rock's mortgage book - making no new loans, and waiting for homeowners to repay existing ones - the government would rather control that process itself.

There is nothing to prevent the government running a bank. Girobank, established by Harold Wilson in 1968, remained in state ownership until 1989, when it was swallowed up by Alliance & Leicester. Under European state aid rules, Brussels has no objection to public ownership; it simply wants to make sure that no company is unfairly propped up by taxpayers. European governments are even allowed to take a business under their wing, and spend cash on 'restructuring' it, so long as it emerges as a smaller, viable enterprise. The Treasury has been discussing the various proposals with Brussels to ensure that they would not be rejected. So the Treasury can nationalise it - but it will do everything in its power to avoid that.

It is now more than four months since Northern Rock sought support. After that initial shock, the affair created considerable excitement as potential bidders entered the fray. Four months on, the euphoria has gone and it is clear that the Rock is a problem that cannot be solved quickly, easily, or perhaps at all. Any solution this or next week can only be, to borrow from Churchill, the end of the beginning of a long and bloody engagement.

Nationalisation: A short history

The media may be portraying the idea of nationalising any private enterprise, or taking it into state ownership, as an astonishing and disastrous solution to a problem, but it was not always seen to be so, nor was nationalisation the prerogative of Labour governments.

In 1916 David Lloyd George, as Secretary for War in the Liberal-dominated coalition, nationalised the breweries and pubs in Carlisle, Gretna, Cromarty Firth and Enfield to protect munitions production from the workers' 'excessive drunkenness'. The Carlisle brewery was denationalised by act of Parliament only in 1971, finally being sold to Yorkshire brewer Theakston.

In the inter-war years, a Conservative government nationalised the British Broadcasting Company (which became the Corporation) in 1927 and the National Government created the London Passenger Transport Board in 1933 with a virtual public-sector monopoly over bus, Tube and tram services across an area far wider than the then boundaries of the London County Council.

Many industries were taken into state ownership during the 'total war' of 1939-45 and the landslide victory of the Labour party thereafter confirmed the population's acceptance of state ownership as part of the cradle-to-grave protection of a welfare state. The National Coal Board, the Central Electricity Generating Board, British Gas and the British Transport Commission all originated under the Attlee premiership, and the private shareholders of the Bank of England were bought out by the state. Cable and Wireless became part of the General Post Office and, perhaps most momentously, a mix of commercial, charitable and local authority medical provision became the National Health Service. Even the British sugar industry only narrowly avoided being sucked into the state sector.

Many of these nationalisations remained unchallenged until the Thatcher government of the 1980s, but the iron and steel industry was always the subject of an ongoing battle, reprivatised by the Tories in the 1950s and then returned to the public sector as British Steel in 1967 by the next Labour administration.

The need to save failing parts of UK industry that either had strategic importance or were significant employers motivated the Labour government of 1976-9, which oversaw the last gasp of nationalisation. British Shipbuilders merged Cammell Laird, Govan, Swan Hunter and Yarrow with partial success - there is still shipbuilding on the Clyde under the auspices of BAE.

But the most significant undertaking was the creation of British Leyland, which brought distinguished car marques Austin, Morris, Triumph, Rover and Jaguar under one umbrella. At the time it employed 128,000 and held 40 per cent of the UK car market. It returned to the private sector, as Rover Group, in 1988. We all know the unfortunate outcome.
Andy Beven

Sovereign wealth funds: Friends or foe?

Funny thing, globalisation. A popular view is that it's a wheeze to allow western multinationals to take over the world. That's what made last week look so odd. American investment banks being bailed out by funds controlled by dictatorially inclined regimes that hold sway in Asia and the oil-rich nations of the Middle East.

The latest infusion of overseas capital is designed to prop up the balance sheets of banks that have lost billions by investing in sub-prime mortgages. It's the US version of the Northern Rock debacle.

Citigroup and Merrill Lynch reported write-downs last week of $18bn and $14bn respectively. But Singaporean government-controlled GIC agency and Kuwait Investment Authority bought stakes in Citigroup worth $10bn. That's on top of the $7.5bn invested in Citigroup by the Abu Dhabi Investment Authority last November. Merrill is getting $6bn extra from Kuwait, Korea and Japan. In 2007, Morgan Stanley sold 9.9 per cent of the bank to a Chinese-run fund.

The rescue of the banks by sovereign wealth funds, controlled by arms of Asian and Arab governments, raises knotty political and corporate governance issues. Richard Portes, economics professor at the London Business School, says: 'Let's be clear: SWFs are foreign government appendages. They should exert economic, not political, influence.'

But SWF holdings in western banks are relatively small and experts warn of the west becoming unduly protectionist.

Some countries cause more concern than others. Philip Hammond, the Tory treasury spokesman, says: 'I am not that bothered about the Chinese buying small stakes in banks. But if the Russians bought our gas distribution network, that would be different. We know that the Kremlin is prepared to use its economic interests to achieve political ends.'

Gavyn Davies, economist and former Treasury adviser, says: 'We should be pleased the SWFs can rescue western banks. If they could not, the global economic situation would be much worse.'

If nothing else, recent events illustrate the sharp imbalance of global trade. America and Britain are running massive trade deficits, with consumers borrowing to buy in cheap goods from Asia and, as a consequence, China is sitting on foreign currency reserves of nearly $1.5trillion. The Gulf states have money to burn, thanks to the sky-high oil price.

Portes asks: 'Why shouldn't these countries diversify their foreign holdings? Buying into the investment banks could produce good returns.' But Doug McWilliams, head of the UK-based Centre for Economics and Business Research, says: 'It's only a matter of time before the Chinese buy a "crown jewel" company.'

Analysts warn resistance to foreign government holdings will grow if SWFs become too powerful. The funds know this, which is why their investments have been relatively modest. But for how long?
Richard Wachman