Northern Rock: is time starting to run out?

The N word loomed larger for Northern Rock this week. After three months of trying to find a "private sector solution" for the stricken bank's crisis, the pros-pect of nationalisation has now become a more serious option for the Government to make sure its gets its 25bn of loans back.

Mervyn King, Governor of the Bank of England, is known to be punctilious in his use of language. His comments about nationalisation at the House of Commons Treasury Committee therefore seemed to indicate a new gloom in the authorities' thinking.

Asked if nationalisation was now inevitable, Mr King said: "I don't think anything is inevitable. You can't rule out the possibility that a management team will be able to obtain the degree of financing the preferred bidder and for that to lead to a successful bid."

In previous public utterances from the Government and its regulators, the door was left open for nationalisation but a sale or change of management was pushed as the leading option. There is no doubt that a sale or change of management is still the Government's preferred choice. To nationalise Northern Rock would be seen as a major climbdown after leaving the bank ailing for months. The state taking control of a bank would be legally messy and could further diminish the UK's international reputation in financial services.

But the mood emanating from the authorities is that the chances of the bank being nationalised have increased over the last couple of weeks because of fears that neither bidder will be able to secure the funding necessary to get a deal done.

Northern Rock is working with two potential bidders: Sir Rich-ard Branson's Virgin Money consortium and Olivant, headed by the former Abbey National chief executive Luqman Arnold.

The key to a successful bid is securing the funding to repay a big chunk of the Bank of England's loans to Northern Rock. The Governor told the committee that tightening conditions in the fin-ancial markets had made it more difficult for the banks lined up to fund a solution to lend. Northern Rock has said it will decide which bid to recommend to the authorities by the end of January.

The financial crisis that brought Northern Rock close to collapse is also making it harder to achieve a deal. With the bank's business drifting, fears increasing about the housing market, and financing banks apparently strapped for cash, now is a bad time to try to sell a mortgage lender.

Some commentators believe some form of nationalisation is just around the corner. Howard Wheeldon, senior strategist at BGC Partners, said: "We suspect that an announcement that the Government deems nationalisation as the best option to protect its investment is imminent. We also believe that the plans are fully drawn up and will have tripartite support when a Bill is presented to the House of Commons."

The Conservatives insist they have not been consulted on nat-ionalisation. David Cameron, the Tory leader, has said nationalisation would be a disaster but the opposition has not ruled out supporting a Bill if asked to do so by the Government.

So what would nationalisation look like?

The nightmare scenario for the Government is Railtrack, the privatised rail operator that was taken back into public ownership in 2001 after a series of train crashes shattered public confidence in the country's railways. The Government faced litigation and a campaign from angry shareholders that kept the story in the headlines for many months.

But others say there is a simpler model for nationalisation in the form of Rolls-Royce, which Edward Heath's Conservative government took over in 1971. This is the route favoured by Vince Cable, the Liberal Democrats' Treasury spokesman, who has taken the lead in calling for nationalisation. With Rolls-Royce on the verge of bankruptcy, the Heath government used a one-line Bill to put it into administration and seize control.

But Nick Wood, a corporate recovery partner at Grant Thornton, says the Government will want to avoid administration because without special provision for bank depositors it would have to honour its guarantee to depositors, who would come after other creditors in the pecking order.

But Mr Wheeldon does not think administration would be necessary. He believes the Government could simply place a nominal value on the company's shares and take over the bank.

Nationalisation would not necessarily mean years of ownership by the Government. Instead, it could be used to stabilise the bank until the financial markets return to normal. Chris Saunders, the Lib Dems' Treasury adviser said: "In nine or 12 months' time, if the inter-bank borrowing is back to its normal rate and the housing market has had a soft landing, the Government could sell it off quicker and for a better price."

Another option would be to sell off the bank in pieces to interested parties such as Bradford & Bingley, which has told Northern Rock it would like to buy some of its mortgages.

The chief losers under nationalisation would be the bank's shareholders, who would be offered little or nothing for their stakes. Few would have sympathy for the hedge funds that bought into Northern Rock after its share price collapsed in the hope of making money. True, the bank has about 180,000 small shareholders but many of them received the shares for free when the former building society demutualised 10 years ago and have received healthy dividends in that time.

Rolls-Royce shareholders were paid 1p a share because the company would not have existed without the taxpayer's backing. The same would be true of Northern Rock, the Lib Dems argue.

But is nationalisation really the only option? There are smart brains involved in both bids for Northern Rock. Are they really working day and night on deals that have no chance of getting funded? Luqman Arnold, the head of Olivant, insisted when he put in his detailed offer that when a bidder was selected the banks would be happy to lend against Northern Rock's assets.

Citigroup is the main funding bank and is said to have agreed in principle to lend up to 10bn. It is true that the US bank's woes have increased since it first became an adviser on Northern Rock, but it has since become the lead bank for the $70bn financing of BHP Billiton's bid for Rio Tinto. Some close to the sale process believe nationalisation is being used as a stick to beat Northern Rock's board, the bank's shareholders and the bidders into agreeing to a deal as soon as possible.

There remain other options for deals. Lurking in the wings is JC Flowers, the private equity firm that made the early running in the bidding process. It has told the Government it will not improve its proposal to offer more than a nominal price to shareholders. But it is said to have 15bn of agreed funding and is ready to return to the fold if the authorities agree to its terms.

Mr Wood of Grant Thornton says an option for the Government is to part-nationalise the bank by taking a "golden share" to safeguard the loans from the Bank of England and the Treasury. Mr Wood says: "Whether it is nationalised or it goes to a third party purchaser, the Government is going to have to leave a big chunk of money in there. Politically, I can't see them wanting to nationalise the bank."

Who's still in the running to buy the Rock?

The main bidders for Northern Rock are Sir Richard Branson's Virgin Money and Olivant, a private investment company headed by Luqman Arnold, former chief executive of Abbey National.

Virgin was made preferred bidderby Northern Rock three weeks ago, but Mr Arnold has muscled his way in so that he gets equal treatment with Virgin.

Virgin wants to inject 1.3bn of equity plus its small Virgin Money business into Northern Rock, take up to 55 per cent of the company and retain its listing. The bank would be rebranded as Virgin. Sir Richard's ability to graft a household name on to Northern Rock's business was one of the main reasons he was favoured early on.

Mr Arnold wants to add up to 800m to Northern Rock's equity through a rights issue that would see his firm get up to 15 per cent of the company as well as "high-value warrants" that would work like share options. Mr Arnold would take over as executive chairman and run the bank without a change of control. He says he is ready to start straight away and that speed is of the essence to save the business.

The question for the Government is: when does it get its money back? Virgin proposes to pay 11bn immediately and the rest by the end of 2010. Olivant has offered to repay at least 10bn upfront with the rest in 2009.

Another group, the Tyne consortium, dropped out early this month but is said to be considering a fresh proposal.

Northern Rock has lined up three commercial banks Citigroup, Royal Bank of Scotland and Deutsche Bank to fund its chosen bidder. In straitened times for banks, there are concerns that they will have difficulty coming up with the funding.

JC Flowers, a private equity firm headed by the former Goldman Sachs partner Christopher Flowers, is said to have secured 15bn of funding from some of its regular financers, including Credit Suisse. But it told the Government that it was not willing to sweeten the terms of its proposal to give shareholders more than a nominal sum.