The battle for Northern Rock still isn't over, and a quick-fix solution is now nothing but a dream.

Private bidders are struggling to find funding for a takeover bid while U.K. Prime Minister Gordon Brown hinted that the embattled mortgage lender might have to be nationalized to save Britain's banking reputation. In the midst of all this, Granite, the bank's securitization platform, continues to perform, but not without trouble.

The lack of resolution on Northern Rock is a concern for Granite bond holders, Societe Generale analysts said, primarily because the spreads are, on average, 30 basis points wider at the triple-A level when compared with other similar U.K. paper, which have spreads that are more than 100 basis points higher at the triple-B level.

Last Tuesday's shareholder meeting in Newcastle, the home of Northern Rock, saw employees outside protesting a proposal by the board to sell the bank on the cheap, which would include a fire sale of assets. Inside, those who were making decisions on Northern Rock's future voted down the proposal. More than two-thirds of the investors, who have seen shares slide from above GBP10 ($19.60) last year to around GBP0.59 now, backed a motion by the hedge funds RAB Capital and SRM Global to limit the board's ability to proceed with such a sale.

A few hours later, Prime Minister Brown was on the news to say the government was reviewing all options for resolving the Northern Rock crisis, but made no distinct recommendations other than if the bank were to go national, it would be temporary. Chancellor of the Exchequer of the Treasury Alistair Darling addressed the situation in even vaguer terms in a speech on the day of the vote.

"The difficulties facing Northern Rock began on the other side of the Atlantic and are now being felt across the world," Darling said while speaking to the Royal Society for the Encouragement of Arts, Manufactures & Commerce. "As a result, we operate in far more turbulent and uncertain times than we've felt for many years."

Although Darling refrained from mentioning any specific action on the bank, the Treasury Department has recruited Ron Sandler, the former head of Lloyd's of London, to run Northern Rock in the event of nationalization. According to Deutsche Bank analysts, Sandler may be back at work soon to oversee the move. Such a development, said Deutsche, would be "positive on balance" for Granite. However, until more details become available, "it is difficult to predict how it might be done and what its effects on the RMBS would be," they said.

SocGen analysts added that all of this "talk of nationalization" is "far from ideal" for any party involved with Northern Rock and Granite. "However, shareholders refusing to accept a discounted sale price pressurizes the government to prove it has the situation under control given the amount of money it has lent Northern Rock," they added.

The situation has left Granite bond holders with two problems, the analysts said. First is the possibility that the bank's downgrade or insolvency would cause a ratings trigger. But, "we expect rating agencies would waive this trigger if the quality of mortgages is good and the Northern Rock entity continues to lend," they said. The second is extension risk should the trust have insufficient cash flows to meet payments.

Rock Downgrade

Last Wednesday, Northern Rock's ratings luck ran out, as Fitch Ratings downgraded the bank to, F' from the previous C/D'. The rating action was taken based on the assumption that Northern Rock would have defaulted without such extended financial support. Furthermore, Fitch said, "the transfer of Northern Rock into public ownership could result in losses for subordinated stakeholders should this process result in a desire or requirement to sell asset portfolios quickly."

Even more disturbing to the bond holders is the aggressive way in which Northern Rock produced mortgages. Thirty percent of the Granite pool is composed of mortgages with an LTV above 90%. Another section of borrowers who took advantage of the Rock's "fast track program," which requires an LTV below 85%, have income levels that fluctuate too much to be attractive to other lenders. Furthermore, incomes in another 45% of the Granite pool were not verified.

Despite this, Northern Rock was able to sell a portion of its mortgages to JPMorgan for GBP2.2 billion. These loans were made to elderly borrowers with no interest payments, although the property returns to the bank for reselling in the event of death.

The cash injection should reduce the funding issues the bank faces and, despite problems with Granite's other mortgages, SocGen analysts said the trust isn't necessarily going soft. "We see significant relative value buying the shorter-dated senior Granite bonds, which have earlier legal final maturity dates and hence get paid rapidly under either assumption," they said.

"For those seeking a longer-term view that the Rock will recover and its mortgages will continue to perform, CDS offers the best approach, as any extension would result in wider margins than the actual cash bonds, where discount margins rely on redemption at the call date."

There is also talk that the GBP25 billion loan owed to the Bank of England might be securitized, in what Deutsche Bank analysts see as a silver lining. However, the government is unlikely to guarantee the securitization, as some speculate such a move might not abide by EU regulations. "In our view, a third-party guarantee would be more likely," they said. Deutsche analysts added that such a deal would resemble a similar action in 1996 and 1997 when the then record Credit Lyonnais' securitization "arguably also kick-started the development of the primary European structured finance market."

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

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