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Rating Action:

Moody's downgrades Northern Rock's senior debt and deposit ratings to A2, preference shares downgraded to C

20 Feb 2008
Moody's downgrades Northern Rock's senior debt and deposit ratings to A2, preference shares downgraded to C

Changes outlook on the E+ BFSR, subordinated debt, RCIs and TONs to developing from negative

London, 20 February 2008 -- Moody's Investors Service announced today that it had downgraded to A2, with a developing outlook, the long-term bank deposits and senior unsecured debt of Northern Rock plc (Northern Rock) following the announcement by HM Treasury on February 17 that the government will enact legislation to take the bank into temporary public ownership. The bank's preference shares were downgraded to C from B3. The Bank Financial Strength Rating (BFSR) remains E+ (mapping to a baseline credit assessment of B1), the outlook is changed to developing from negative. The outlook on the dated subordinated debt (currently rated B1), on the undated subordinated debt (currently rated B3) and on the Reserve Capital Instruments (RCIs) and Tier One Notes (TONs) (currently rated B3) was also changed to developing from negative. The short-term rating is affirmed at Prime-1. The rating of the covered bonds remains Aaa, on review for possible downgrade, and the Granite Master Trust ratings remain unchanged.

Moody's said that the key considerations for this rating action within the context of a nationalised entity are a) the fact that the bank will be in temporary government ownership and thus the final intent is to privatise or sell the bank, b) a very high assumption of support throughout the restructuring process, c) the fact that any significant improvement in the intrinsic strength of the bank is likely to be a slow process, d) the legal status of the preference shares vis-a-vis other Tier-1 instruments, and e) the uncertainty around the government guarantee and other government support post privatisation. Overall, Moody's assessment is that the decision to nationalise the bank provides greater security to senior debt holders and depositors of Northern Rock, provides the necessary timeframe to potentially develop a market based solution but does not improve immediately the intrinsic credit profile of the bank.

Moody's said that the fact that the bank's E+ BFSR (mapping to a B1 baseline credit assessment) which remained unchanged, albeit with a developing outlook, reflects the rating agency's view that it will take some time to effect long lasting changes in the bank's overall franchise and financial fundamentals. Nationalising the bank on its own neither has an immediate positive impact on the bank's financial fundamentals nor on its franchise strength, thus maintaining the BFSR at E+. Moody's commented that the BFSR remains unchanged at E+ due to the continued weak liquidity position of the bank on a stand-alone basis (i.e. absent parental or other external support) and due to the fact that the bank still faces significant hurdles in rebuilding its franchise. The change in outlook to developing reflects the uncertainty of nationalisation on the bank's ability to compete in the mortgage and savings market in the UK within the confines of EU State Aid regulations. A likely outcome for the bank is that it is significantly scaled down and this is likely to have a substantial effect on profitability and cost ratios. However to enable the bank to be sold or privatised in the future the franchise of the bank does need to be stabilised and strengthened. Moody's also noted that, although unlikely, the possibility remains that the bank may be placed into a run-off situation. Moody's also noted that the majority of rated mid-sized mortgage lenders in the UK have a BFSR in the range of C- (mapping to a baseline credit assessment of Baa1) to C+ (mapping to a baseline credit assessment of A2), and that if Northern Rock is able to successfully rebuild its franchise and stabilise its financial situation, it could possibly move gradually towards this rating range. The speed at which the bank's BFSR potentially converges to the above stated range depends on the degree of success of and the pace at which the bank's management can effect this positive change within the confines of adhering to EU State Aid regulations.

Moody's said that the nationalisation of Northern Rock has clarified the ownership issue for the time being and has allowed the rating agency to conclude the review initiated on September 17, 2007. Commenting on the rationale behind the downgrade of the Aa3 (on review for downgrade) debt and deposit ratings, Moody's noted that the starting point is the E+ BFSR which when combined with a fully supported probability of systemic support leads to a rating of A2 for senior debt and bank deposits. However the degree of support is limited by the fact that the bank will be in temporary public ownership, pending final approval of the bill through Parliament which is expected in the coming days. The developing outlook on the A2 rating reflects the uncertainties in the longer term around an eventual sale or privatisation of the bank and the implications that this could have on the rating. It also takes into account the possibility that depending on the funding structure of the bank going forward certain instruments may be explicitly backed by the government or that debt issued under a guarantee from the government may be grandfathered.

Moody's also noted that the government will need to ensure that the nationalisation of the bank and the structure and strategy while in public ownership is in accordance with EU state aid rules: a detailed plan needs to be lodged with the EU Commission by March 17, 2008. While the bank is in public ownership the rating agency noted that it does not expect the long-term bank deposit and senior unsecured debt ratings to fall below A2 given the support of the UK government, even if the explicit state guarantee were to be removed.

Looking forward if the bank was to be sold to an institution where Moody's would impute a low probability of parental support or a low ability of the acquirer to support the bank, it is likely that the rating could fall to as low as non-investment grade unless the bank's stand-alone creditworthiness has improved markedly to a BFSR level of D+ or above. It is important to note that, given the existence of rating triggers on the covered bonds and Granite's RMBS programme, Moody's would not expect a privatisation of the bank unless an A2 rating or better can be achieved for the bank post privatisation either on a stand-alone basis or as a result of parental support. This view, however, may change over time if the importance of covered bonds and the RMBS structure to Northern Rock were to reduce.

The downgrade of the bank's GBP400 million non-cumulative preference shares to C (stable outlook) from B3 (negative outlook) follows the decision of the UK government to nationalise these instruments, in addition to the common equity. It is Moody's understanding that under UK Corporate Law there are certain circumstances where the preference shareholders can become minority shareholders and this is why these instruments are also being taken into public ownership. Any compensation to holders of the preference shares is expected to be calculated assuming that all financial assistance provided by the Bank of England or the Treasury had been withdrawn and that no further public financial assistance would be provided. Therefore, in Moody's view, it is highly likely that the preference share holders will experience a substantial loss.

The change in outlook on the subordinated debt, RCIs and TONs to developing from negative is in line with the change in the outlook on the bank's BFSR. In line with Moody's notching guidelines the ratings of junior securities for a bank with a BFSR in the E category would be close to that of the BFSR implied rating. Moody's further added that coupon deferrals on these instruments, although unlikely, cannot be ruled out given that the government is likely to impose losses on the preference share holders and has specifically said that these instruments will continue to absorb losses before any other creditors. The RCIs and TONs have a different legal status under UK Corporate Law as they are debt instruments of the bank and not preference shares and therefore there are no circumstances under which holders of these instruments could become minority shareholders of the bank.

The Granite Master Trust and other RMBS ratings of Northern Rock remain unchanged. Collateral performance remains the driver for the ratings on these transactions, and this continues to perform in line with Moody's expectations.

Northern Rock's covered bond ratings remain on review for possible downgrade. The review of the covered bond ratings will assess Northern Rock's commitment to hold sufficient over-collateralisation to maintain the Aaa ratings.

The ratings of Northern Rock are as follows:

Bank Financial Strength Rating: E+ (developing outlook)

Long Term Bank Deposits: A2 (developing outlook)

Short Term Bank Deposits: Prime-1

Senior Unsecured Debt: A2 (developing outlook)

Commercial Paper: Prime-1

Dated Subordinated Debt: B1 (developing outlook)

Undated Subordinated Debt: B3 (developing outlook)

Reserve Capital Instruments and Tier 1 Notes: B3 (developing outlook)

Preference Shares: C (Stable outlook)

Headquartered in Newcastle-upon-Tyne in the UK, Northern Rock had assets of GBP113 billion at the end of H1 2007.

London
Adel Satel
Managing Director
Financial Institutions Group
Moody's Investors Service Ltd.
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

London
Ross Abercromby
Vice President - Senior Analyst
Financial Institutions Group
Moody's Investors Service Ltd.
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

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