Takeover may be Rock's only hope

By Sean Farrell, Financial Editor
Published: 15 September 2007

Northern Rock, the once-booming mortgage bank, has a choice between stagnating or being taken over – if anyone will buy it just as the housing market slows down.

Adam Applegarth, the bank's chief executive, yesterday accepted that Northern Rock's days of rapid growth were over after it was forced to ask the Bank of England for emergency funding. The Newcastle-based lender's shares fell by 31 per cent.

"The business model will have to evolve, and it will be a different form of Northern Rock afterwards," Mr Applegarth said. Whether Northern Rock is independent or bought remains to be seen, he added.

Merrill Lynch analyst John-Paul Crutchley said: "Over the longer term we think Northern Rock will struggle to fund any new growth without the backing of a larger financial partner. We see a strategic partnership or full take-out of the business as the only viable alternatives."

Northern Rock had been seen as an unlikely candidate for takeover because its cheap cost base made it difficult to slash expenses, and because the Northern Rock Foundation charity would be due 15 per cent of the bank's shares in any takeover.

Analysts said the ideal bank to buy Northern Rock would be one with excess deposits that could be used to fund Northern Rock's lending. Alex Potter at Collins Stewart said the only two UK banks in that position are HSBC and Standard Chartered, but both are concentrating on Asia and emerging markets.

With UK banks out of the picture, the most likely candidate was said to be ING, the Dutch bank, which could use its online UK deposits to fund Northern Rock and expand its UK retail business. ING also has experience of sorting out distressed banks after buying Barings for £1 in the mid-1990s.

Colin Morton, a fund manager at Rensburg, said he sold his small holding of Northern Rock shares yesterday, adding that it was by no means certain that a buyer would come in for Northern Rock because the prospects for the UK housing market look increasingly bleak. Rightmove, the property website, said yesterday that asking prices for houses have fallen 2.6 per cent in the past month.

Northern Rock expanded at breakneck pace by borrowing in the money markets to fund the growth of its mortgage business. The freezing of those money markets amid panic caused by US sub-prime defaults has blown that strategy apart.

The bank yesterday issued its second profit warning this year, cutting its estimate for full-year profit by 20 per cent. It gave no guidance for 2008, when a large number of its fixed-interest mortgages come to an end. With the bank forced to raise prices, it will struggle to retain customers.

Mr Applegarth said the financial world had changed since early August when investors panicked after years of feasting on high returns in the debt markets. He said the market would probably never be the same for the debt that Northern Rock had once sold easily, forcing the bank to go to the Bank of England with a change of strategy.

Northern Rock was a building society until it demutualised in October 1997, resulting in a payout of shares to the society's members. The company's shares fell to £4.38 yesterday, below the £4.52 price when they were first sold on the Stock Exchange.

The news caused jitters for investors in other mortgage lenders that rely on the wholesale funding markets for their growth. Alliance & Leicester, HBOS and Bradford & Bingley shares all fell heavily.