Northern Rock Sold To Virgin Money, But 'Bad' Bank Remains

Analysis: 'Bad' Bank Remains Despite Virgin Money Purchase
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Virgin Money is to pay £747m up front for the nationalised lender Northern Rock, in a deal that could rise to close to £1bn over the next five years. What the group is buying bears little resemblance to the fast-growing, risk-taking high street champion that imploded spectacularly four years ago.

"What they're buying is an extremely conservative retail bank, because the former Northern Rock was scrubbed of most of its toxic assets, which were run off under the government's aegis," Jason Karaian, financial services analyst at the Economist Intelligence Unit said. "What they are actually buying is a deposit-heavy mortgage lender."

The run on Northern Rock in September 2007 that led to the bank's nationalisation the following February is seen by many as a turning point in the financial crisis - the moment when the turmoil in international money markets claimed a high street casualty. The previous month the European money markets had become locked after the major French bank, BNP Paribas, froze withdrawals for funds that were being hit by the subprime carnage in the US.

Interbank lending suffered, and for Northern Rock, which had fuelled its aggressive expansion in the UK's mortgage and high street banking market through cheap credit, it was a disaster waiting to happen.

On September 14, the Bank of England agreed to support the lender, seen as an acknowledgement that it was suffering from an acute liquidity problem. Shares slumped and the following day customers queued up to withdraw their money, prompting the government to guarantee deposits.

After various other attempts to bring the bank's financial troubles under control, the government took Northern Rock under public ownership in February 2008.

In October 2009, a plan to break the bank into two sections - a 'bad' bank incorporating its toxic debts, which the government would hold onto; and a 'good' bank, which would be sold.

Virgin Money emerged early on as a frontrunner to acquire the good half of the company, making an offer that was not contingent on any other deals - such as the NBNK consortium, which wanted to combine Northern Rock with 632 Lloyds branches that are being spun off as part of an agreement with the government. The Co-operative Bank was also in the running.

The price, about 75% of the bank's book value, is "a fairly full one", Karaian said, and goes some way towards paying back the equity stake the government took to support the bank.

For Virgin Money, it represents a solid starting point to build a new banking franchise. Most of the risk has been stripped out of the bank, meaning that the new lender will be able to leverage a strong, deposit-funded balance sheet for growth.

"[Northern Rock] have a tier one ratio that's basically off the charts as far as most banks go," Karaian said. "They're almost totally funded by deposits, which is pretty rare these days, and it's run by design increasingly conservatively. In fact, there's scope for refashioning the balance sheet now, heeding the lessons of the past. I would very seriously doubt that the new owners would thus wrap up the wholesale funding and go back into some of the racier parts of the mortgage market that Northern Rock was previously involved in. Starting where Northern Rock is now, there is a lot of scope for quite quick growth."

Virgin Money CEO Jayne-Anne Gadhia told Reuters that the company will look to float on the stock market "in between two and five years time."

The government has stated that it is keen to increase the amount of competition in the high street banking market, and alongside the relatively high price of the sale, bringing a popular brand with a reputation for innovation into the deal made it an attractive one for the Treasury.

"The deal has been on the cards for a while and now that it has been finalised it will increase competition within the banking space, which can only be a good thing. Virgin Money is an innovative brand that will now have a real high street presence, and any deal that enables consumers to have more options when it comes to choosing how they bank should be welcomed," Kevin Mountford, the head of banking at MoneySupermarket.com, said.

David Kuo, director of the investment analysis company The Motley Fool, said: "There are only three logical reasons why anyone would sell an investment, The first is if there is if there something materially wrong with the investment that would put your money at unacceptable risk, The second is if you have found an investment that could generate better returns. The third reason is if you need the money desperately.

"I think we can safely say that there is nothing seriously wrong with the high street bank, otherwise, why on Earth would Richard Branson buy it. Britain’s best known entrepreneur may well own an airline, which is reason enough for anyone to be certified, but he is nevertheless a shrewd businessman and he is unlikely to buy a pig in a poke."

The real reason, Kuo said, is number three - the government needs the money.

However, selling Northern Rock, analysts noted, is just the start. The government still has in excess of £20bn of bad debts on its balance sheet through Northern Rock Asset Management, the 'bad' half of the bank, and is a long way from recouping its investments in the high street giants Lloyds and RBS, which it holds 40% and 83% of, respectively. Shares in those banks have slumped on continuing growth concerns in the UK and on the sovereign debt crisis in the eurozone, massively devaluing the value of the taxpayers' stake.