Northern Rock's Granite Master Trust breached its non-asset trigger, because the current-seller share fell below the minimum on two consecutive distribution dates. The breach is the result of a strategic decision by Northern Rock's management.

Adding new loans to the trust "was not in the best interest of taxpayers given one of our prime objectives under the current business plan is the repayment of a government loan," a Northern Rock spokesman said. Granite bonds are excluded from governmental support and not guaranteed by the Treasury.

"The structure requires the breach of minimum seller share to be observed on two consecutive dates before a non-asset trigger breach is declared," explained a Merrill Lynch research report. "This was designed to give the seller time to remedy the situation by, for example, adding new loans. It was expected that Northern Rock would do so upon breach of the minimum seller share, to maintain the trust running as normal and to avoid the non-asset trigger diverting principal cashflows away from the seller. The bank had both the ability and the time to do so. Clearly, a decision had been made not to add new loans but instead to facilitate a speedier unwind of the trust than would have otherwise been the case."

The master trust is now in run-off as a result, and existing notes are being redeemed as cash flows are collected, according to a modified waterfall. Analysts said that senior bonds with short legal final maturities and a relatively long weighted average life can be expected to be repaid the quickest, but a significant number of bonds will face extension risk.

"Most bonds outstanding are rated triple-A," Unicredit analysts said. "Within this bucket of senior bonds outstanding, the majority also belong to issues featuring the longest legal final maturity of 2054, which is clearly a disadvantage from a senior investor's perspective in terms of extension risk."

Higher quality loans will be used to pay down the senior notes, which are then exposed the remaining pool's performance deterioration. Fitch Ratings has warned that, as a result, the lower-rated Granite tranches might be subject to downgrades. The rating agency said that the arrears performance of Granite Trust's underlying mortgage collateral has already deteriorated significantly. In 2008, 90+ day delinquencies were reported at 2.07% of the current balance, using September 2008 numbers, compared to 0.52% at the end of December 2007.

The program has also breached an arrear trigger event, as the principal balance of mortgages in arrears for more than 90 days divided by the outstanding principal balance of all mortgages within the trust exceeded 2%. This triggered reserve fund building via excess spread.

"In our view, this event is another one of the unprecedented negative headlines that have threatened the securitization market throughout this year," Unicredit analysts said. "Given the size of the program and the importance of the U.K. prime RMBS market, the event is clearly supporting once more the bearish mood in securitization markets."

Unicredit added that now that the government has turned away from its commitment to the Northern Rock master trust, it could mean that it will proceed in the same fashion with the other state-owned banks that have master trusts. "The U.K. government may not only no longer support the Bradford and Bingley, Aire Valley trusts going forward, but also investors have once more been deterred by uncertainty related to a former flagship securitization product in Europe," the analysts added.

(c) 2008 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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