Jeremy Warner's Outlook: Darling on back foot over Northern Rock

It may still be too early to depict the Northern Rock debacle as Labour's "ERM moment", as Vince Cable, the acting leader of the Liberal Democrats, attempted to yesterday by asking the Chancellor whether he had been singing in his bath. We are not in fiddling-while-Rome-burns territory quite yet.

Even so, it is not looking good for the Treasury, where there is growing concern over the potentially calamitous losses ministers have exposed the taxpayer to in defence of this miserable little company. An entirely painless outcome is looking ever more improbable.

Mr Cable's bath reference was to Norman Lamont who as chancellor was said to have been singing in his bath with happiness at Britain's ignominious exit from the ERM. Though the ejection may ironically have been the right thing for the British economy, it shattered the Tory party's reputation for economic competence and contributed to its crushing defeat at the next election.

The Government insisted no taxpayers' money was at risk when it embarked on the Northern Rock rescue, yet the Chancellor, Alistair Darling, was able to give no such assurance in his Commons statement yesterday or in subsequent exchanges. Nor even was he able to reassure the House that the £20bn to £24bn Treasury guaranteed loan would be repaid by the end of this parliament.

He also quite plainly needs a crash course in banking, for it is obviously incorrect to insist as he did that the separate Treasury guarantee of £14.5bn of deposits is essentially risk-free because it relates to money in the bank. Would that this were true. In fact the great bulk of deposits would have been lent out and cannot easily or quickly be got back. That's what bankers do.

It may be technically correct for the Chancellor to say that he had no option given the need to maintain financial stability but to extend the loans and the guarantee to Northern Rock. But this is politics, where perceptions are everything, and, whether or not the course of actions taken were unavoidable, he's going to get the blame for them if they go wrong.

What's more, it is faintly disingenuous to claim they were unavoidable. In fact, the reason the taxpayer was forced to come to Northern Rock's rescue was because of the Government's failure to put an adequate deposit insurance scheme in place.

If this had been in existence, Northern Rock could have been allowed to go to the wall without loss to all but a small number of very large depositors. The absence of this safety net, and the hugely embarrassing and costly rescue operation the Chancellor has consequently been forced to engage in, has undermined the Government's record on economic and financial stability. Unavoidable? Only because the system which the Government is responsible for was found wanting.

What's occurred is utterly shambolic, the very antithesis of the well-regulated financial markets the Government aspires to.

So how serious is it for the Chancellor? Serious enough, it might be said, but not yet irretrievable. The back-of-the-envelope calculation of the taxpayer's exposure I engaged in last week still broadly holds true, but here's a more detailed analysis.

Northern Rock's last published balance sheets showed total assets of about £113bn, yet it is only really the loans of £97bn which are available to help defray the cost to the taxpayer. Of these, about a half have already been securitised and are therefore out of the equation. The balance is made up of £37.5bn of residential mortgages, £8.5bn of unsecured loans and a little bit of commercial lending.

Of the £20bn to £24bn of public money lent to Northern Rock, some £13bn is fully collateralised against good-quality mortgage assets. The Bank of England claims already to have taken a hair cut on these assets in accepting them as collateral, so, even if they were sold tomorrow, it would get the entire £13bn back. The balance of public money is secured only against Northern Rock and is therefore more high-risk.

The penalty element of the interest Northern Rock is paying on these public loans, equal to one and a half percentage points, is meanwhile being rolled up into subordinated loan stock which Northern Rock can count as tier- two capital. Yet even taking account of all this, plus the £14.5bn of deposits that have been guaranteed by the Treasury, the taxpayer seems to be just about covered by the available assets.

All the same, it's touch and go. If the quality of the loan book deteriorates – all too possible given a sharply slowing economy and fast-deteriorating housing market – then the assets would be worth less and the public purse could be in trouble.

In the meantime, Northern Rock is being kept alive on a drip feed of public money which the Government is conveniently able to keep off the books as far as the public finances are concerned. Until any losses are crystallised, the Government doesn't have to account for them. This is why the Treasury won't be calling in the administrators or nationalising the Rock. The last thing it wants is to pay any real money out. Indeed the best available option for the Government is to continue running the Rock as a going concern as proposed by the former Abbey National boss Luqman Arnold.

As far as I can see, all the various "bids" put forward over the past week involve some degree of risk to the public purse. Certainly none of them provide the Government with a clean exit. What's more, all of them are designed to provide what Vince Cable calls "a profit opportunity for the spivs of the City". As he rightly points out, it is embarrassing, to put it mildly, that public money should be used for this purpose.

The workout proposal put forward by Mr Arnold looks no more risky than any of the others, though he will need to give a more convinving schedule for repaying the Government's money to succeed. Mr Arnold also has the merit of commanding the support of shareholders. According to yesterday's statement by the Chancellor, the Government can accept or veto any proposal, but it cannot dictate the outcome.

The precedent of Railtrack has left ministers wary of the charge of acting as "shadow directors". The problem the Government has got is that any proposal barring nationalisation or receivership that doesn't command the backing of shareholders will struggle to succeed, and could get bogged down for months or even years.

Since all of the so-called "bids" involve either a pittance of a price or a very high degree of dilution, it is not easy to see why shareholders would accept any of them. The Government then has little option but to soldier on, subject to a new management team such as that proposed by Mr Arnold. If the board cannot be persuaded of the merits of this approach, then shareholders now led by two highly vocal hedge funds will requisition an EGM to force through the desired change.

For the Government, that ERM moment hasn't arrived quite yet, but Northern Rock certainly has the potential to become one.

Is Fred destined to shred Citigroup?

Fred the Shred to the rescue. The story that Sir Fred Goodwin, chief executive of Royal Bank of Scotland, is being considered for the top slot at the ailing Citigroup is not as improbable as it might seem.

If you had to draw up a shortlist of top bankers for the post, Sir Fred would undoubtedly be among them. What's more, he might even be available. Sir Fred has not enjoyed a good relationship with the investment community in recent years. He might reasonably think that his talents would be better appreciated on Wall Street than in the City.

Insiders insist that Sir Fred is fully committed to RBS, especially after the ABN Amro deal, where he has yet to convince a sceptical City that he can make the acquisition value creative.

Yet I wonder. Instead of having to battle the City's constant carping over his allegedly empire-building tendencies, Sir Fred would in Citigroup have a ready-made one, but one that needs to be stripped back rather than expanded. The challenge of running the world's largest bank? What banker could resist. First, however, Citigroup has to offer him the job. I doubt they've ever had a non-American run Citigroup before.

j.warner@independent.co.uk