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Last Updated: Thursday, 21 February 2008, 11:06 GMT
Q&A: Northern Rock and Granite
Northern Rock branch

Opposition parties have attacked the government over its handling of the body that owns many of Northern Rock's loans. But what is Granite, and does its ownership structure matter?

What is Granite?

Granite is a special-purpose financing vehicle set up to allow the Northern Rock to sell off large parts of its mortgage book to bondholders.

It was this financing model which got Northern Rock in trouble when the market for such mortgage-backed bonds dried up in August.

Northern Rock financed 60% of its lending through activities like this on the wholesale money markets, rather than relying on money from depositors - a key reason for its rapid expansion.

Does Northern Rock own Granite?

According to Granite's accounts, Granite is legal vehicle ultimately controlled by Northern Rock but registered as a trust in Jersey.

The accounts say that "although Northern Rock does not own directly or indirectly more than half of the voting power, the company is obliged to follow the policies and procedures prescribed by Northern Rock".

Such legal entities are common among US and UK banks that want to finance additional mortgage lending off-balance sheet.

By creating a separate legal entity, they avoid the obligation of having to raise extra capital to back their additional liabilities.

Why doesn't the government want to say it owns Granite?

The government has made it clear that it does not want to take the liabilities of Granite into public ownership - and, in particular, says "it has not provided any guarantee arrangement to Granite bondholders".

This seems a wise precaution in view of the credit crunch, which has called the viability of all mortgage-backed bonds into question.

If the government were to guarantee mortgage bondholders around the world, this would amount to a far greater liability than merely guaranteeing that the depositors of Northern Rock will not lose their money.

And it would also expose the government to claims for help from other UK banks whose earnings have been hit by bad debts from their mortgage-backed bonds.

Are all the best Northern Rock mortgages in Granite?

The opposition has alleged that the best mortgages were put into Granite, in order to make it easier to sell their bonds on the open market.

But this may not be true. Granite has been used to finance the recent rapid expansion of Northern Rock's activities, and its loans tended to be bigger than those advanced to the average Northern Rock customer, with a higher risk in terms of loan-to-value.

The average mortgage in Granite's book was valued at 117,000 and the average size of the loan was 77% of the value of the property, compared with 60% for Northern Rock loans overall.

What will happen to Granite now?

The new boss of Northern Rock, Ron Sandler, has made it clear that he wants to run down the size of the Northern Rock mortgage book.

As a result, Northern Rock is not offering attractive rates on new mortgages, or to those customers who are coming off its fixed-rate deals.

Therefore, its use of Granite as a financing vehicle is likely to shrink and perhaps disappear.

If credit markets do recover, however, and if Northern Rock is returned to the private sector, it might consider reviving the use of Granite to finish future expansion.

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