European RMBS hit a record volume in 2005, climbing 14% to $175.2 billion. With the European housing markets improving, analysts say there's more healthy activity in store for 2006. The vastness of the market is noteworthy in and of itself, but one star in the RMBS galaxy shines brighter than the others: Northern Rock's securitization of first loss position from outstanding deals.

Snatching the award for the European Deal of the Year, the GBP423 million ($730 million) Whinstone deal is the first public securitization of on-balance sheet reserve funds and by far the largest transaction of its type completed in the international markets. The deal employed an innovative structure, using a credit default swap to transfer reserve fund risk. Lehman Brothers structured the deal and was joint lead with Barclays Capital.

In the last decade, Northern Rock has transformed from a regional building society to a leading U.K. mortgage lender. Its growing appetite for funding has been partly sated by securitization via its Granite Master Trust. Through the Whinstone transaction, Northern Rock transferred around 80% of the retained risk in the master trust program to third party investors, thereby sharply strengthening its capital position.

Following the deal's announcement in October, Standard & Poor's attached a positive outlook on the company's unsecured credit rating of A'. While recognizing the funding benefits that securitization provided Northern Rock, S&P did not deem that risk had been transferred in the Granite series of deals, where Northern Rock had likely retained the expected losses. With the Whinstone deal, S&P said the company had adjusted the common equity ratio to risk weighted assets more in line with competing banks.

"Northern Rock's deal specifically securitizes the reserve funds in its master trust program and it was well placed," said one market source. "In light of Basel, it makes sense for banks to remove that first loss piece. And I think we'll see more deals of this kind although there has been some of these deals that have already been done, but privately."

Whinstone is a synthetic securitization referencing the performance of the reserve funds as credit enhancement for 13 existing Granite mortgage-backed securitization issues. At the Nov. 15 closing, Northern Rock bought credit protection via a credit default swap from Whinstone against the target balances of the issuer reserve funds. Whinstone, in turn, passed on its assumed risk to the capital markets through the issuance of a series of credit-linked notes. Simplicity is one of the structure's strengths, with the credit default swap passing, to capital market investors, the risk related to the reserve funds in all the Granite transactions up to the end of 2004. Meanwhile, the underlying Granite transactions are unaffected.

The credit linked notes issued by Whinstone were split into three classes, a sterling-only GBP9 million ($15.5 million) in class A notes rated A/A/A2' respectively by Fitch Ratings, Standard & Poor's, and Moody's Investors Service; GBP296 million ($511 million) equivalent BBB/BBB/Baa2' rated class B notes; and GBP117 million (201.96 million) BB/BB/Ba2' rated class C notes. The B and C notes were issued in dollars, sterling and euros.

Northern Rock said that following the success of this transaction it intends to repeat the deal on a regular basis. "This is...a key part of our funding armoury," said Adam Applegarth, Northern Rock chief executive in a press release. "[Whinstone] improves the capital management associated with such deals [and] puts us in an excellent position to take advantage of the benefits that Basel II will bring Northern Rock."

(c) 2006 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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