As rumors of takeover bids continue to swirl, the ability of Northern Rock to continue operating at its current capacity for the foreseeable future is increasingly doubtful.

Meanwhile, Fitch Ratings is quick to clarify that it believes the troubles surrounding the U.K.'s fifth-largest mortgage lender are isolated and will not bleed into the broader market.

After receiving an unprecedented number of calls from investors, subscribers and the press, the rating agency arranged a teleconference entitled: "Northern Rock - No Contagion to the U.K. Mortgage Sector," said Gordon Scott, managing director in Fitch's financial institutions group. The title reflects the conclusion Fitch reached after discussions with all of the rated mortgage lenders in Britain. But despite vouching for the sector in general, the rating agency said that the future of Northern Rock is still unclear.

Essentially, the bank is faced with three options at this point, according to Fitch. The first would be to change the business model to reflect a larger retail business and a lower rate of loan growth, an unlikely scenario considering the damage to the firm's reputation after the recent bank run. Furthermore, Northern Rock's business model isn't intrinsically flawed: Thousands of global financial institutions successfully run similar wholesale businesses, with low retail funding-type banking methods. As an example, Fitch said similar institutions, such as Bradford & Bingley and Alliance & Leicester, are performing relatively well.

The second choice is to begin a total winddown to minimize the negative impact on its investors. This option is considered even more unlikely than the first. The final way out, which is becoming more and more favored, is a takeover.

The City is brimming with takeover buzz, which the bank denies, even as its shares rose in anticipation of a purchase agreement. "Northern Rock is not in discussion with any other party at the present time," the bank said in a statement. "However, the Board is aware of its fiduciary duty and is actively considering all strategic options in the interests of shareholders, customers and other stakeholders."

In the event of a takeover, it is unlikely that one party will come forward to acquire all of Northern Rock, as few banks are willing, or perhaps able, to fund such a substantial asset base, Fitch said. Instead, suitors are believed to be lining up to pick the bank apart. However, a source from Deutsche Bank questioned the viability of this option since the covered pools in Northern Rock's covered bonds cannot be separated. A covered bond analyst at Fitch responded that it is, in fact, legally possible to do so. The analyst added that the covered pools could be sold in portions, and in all likelihood will be.

Royal Bank of Scotland analysts said that in the event of a breakup of the bank, the master trust program would be difficult to manage and could lead to a nonasset trigger unless the bidder for the mortgage portfolio could continue to feed loans into the trust under the Northern Rock name.

"However, Granite master trust's funding would be difficult to replace in current markets; therefore, a portfolio acquirer would need to manage the trust carefully to prevent a trigger," Royal Bank of Scotland analysts said. "Should the emergency facility be used up by funding deposits, little cash would remain available to continue to ramp up mortgages. If assets in the trust fall below their minimums, a nonasset trigger occurs."

Another question that Northern Rock's master trust faces at the moment is whether it can continue to fund itself on a stand-alone basis. Royal Bank of Scotland analysts are concerned that a mark to market of the entire balance sheet might challenge the view that the bank is solvent, and insolvency would prompt a nonasset trigger.

Northern Rock has already announced its intention to issue a new series under the Granite master trust. RBS analysts said that more collateral would need to be added to the trust to prevent early amortization through a nonasset trigger. It is unclear if the funding arrangement procured with the Bank of England extends to providing Northern Rock the ability to continue originating mortgage collateral at a level large enough to support the mortgage lender's master trust program.

"A drop below the minimum seller share may provide the impetus to a nonasset trigger and accelerate the maturity profile," said Royal Bank of Scotland analysts. "We believe that this transaction will be retained by Northern Rock to act as collateral for the Bank of England's emergency funding arrangements."

One of the more interesting questions Fitch fielded was from Daniel Turner of ING, one of the banks believed to have its eye on Northern Rock. Turner was concerned about what would happen to Granite, the bank's platform, should it be further downgraded, which is likely in the event of a nonasset trigger. Should this happen, a Fitch analyst said, new issuance would stop and principal would be reallocated away from the bank in order to repay note holders. But, Fitch added, that is not a likely outcome.

(c) 2007 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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