The U.K. government has changed its direction for nationalized Northern Rock's portfolio.

It initially intended to shrink the lender's balance sheet, but under the several schemes for further financial intervention announced at the beginning of the year, one possibility was to increase volume for the U.K. mortgage lender's portfolio.

Northern Rock was nationalized in February 2008. Since its nationalization, the bank has focused on the contraction of its balance sheet to repay its borrowing from the government and establish stand-alone capital and funding positions. The bank said it has primarily achieved this by encouraging mortgage customers to refinance with other lenders when their fixed or discounted interest period expires.

The government is now looking to inject up to £10 billion ($14.25 billion) into Northern Rock and might start hiring new employees in order to use the lender to ramp up new mortgage lending.

"The decision to shrink the mortgage portfolio indirectly impacted some RMBS structures last year," Unicredit analysts said. "The fact that not enough assets were filled into the Granite Master Trust generated a decline in the minimum seller share and an irreversible breach of a non-asset trigger, making the structure static."

In a statement to the House of Commons earlier this month, U.K. Chancellor Alistair Darling said, "In order to maintain some of the capacity being lost in the mortgage market, I have decided that Northern Rock will no longer pursue a policy of rapidly reducing its mortgage book."

Darling said that once the housing market recovered, Northern Rock could support lending to creditworthy customers that can only afford deposits of less than 25%.

Northern Rock confirmed in a separate statement that it will reduce the rate of mortgage redemptions and therefore repay the government loan over a longer period. This means that more mortgage customers will be able to stay with Northern Rock.

Standard & Poor's analysts said that a likely consequence of this decision is that Northern Rock will require more capital than the £3 billion common equity injection previously proposed by the government.

Merrill Lynch research highlighted that the reversal of the government policy toward Northern Rock may come a few months too late. The non-asset trigger breach, following nationalization of the bank, forced the unwinding of the master trust. This breach, Merrill said, "had profound negative consequences on the MBS investor base, especially when we can say it was totally unnecessary and avoidable."

Fitch Ratings said that Northern Rock's decision to slow redemptions would slow the speed at which future credit enhancement for tranches in Whinstone Capital's Whinstone 1 and Whinstone 2 deals accrues. Analysts expect a slowdown in the Granite prepayment rate as a result from the latest move on behalf of the bank.

As a result, Fitch downgraded both Whinstone deals and also changed the Outlook on the notes to Negative. These transactions are synthetic securitizations which reference the reserve funds acting as credit enhancement for the notes issued from the Granite master trust, which is backed by residential mortgage loans originated by Northern Rock.

Fitch said that the reserve funds providing credit enhancement for Granite Mortgages 04-2 plc, Granite Mortgages 04-3 plc and GMI were required to be increased following the occurrence of an arrears step-up trigger event. These stepped-up amounts provide additional support for the Whinstone transactions to the extent that the required increase is met by the trapping of excess spread.

The current level of credit enhancement available to the Whinstone notes is not sufficient to prevent rating migration in the event of sustained housing market deterioration.

(c) 2009 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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