DBRS Confirms Northern Rock plc Commercial Paper at R-1 (middle)

Dominion Bond Rating Service (“DBRS”) has today confirmed the ratings of Northern Rock plc (“Northern Rock” or the “Bank”) at current levels.

Northern Rock is a mid-sized U.K. bank specializing in residential mortgages, which account for 89% of its loan book on a managed basis. Despite its relatively small size, Northern Rock became the largest net mortgage lender in the U.K. in 2005, with a 14.5% share. In the wake of a very buoyant housing market in the U.K. in recent years, Northern Rock has increased its share of the outstanding stock of mortgage loans to 6.5%, up from 3.5% in 2000. The Bank’s sustainable competitive advantage is inherent in its relatively simple business strategy: high quality asset growth of 20%-25% [average index loan-to-value (LTV) is 58%], a very low cost base (cost/income ratio of just 31.6%), and advantageous funding costs through the use of securitization, all of which give rise to the ability to offer attractively priced loan products and services in an increasingly competitive market while meeting return targets of 19%-22% return on equity (ROE).

Financial leverage appears substantial (assets/equity is close to 50 times). The Bank funds most of its asset growth in the wholesale markets, including aggressive use of off-balance sheet securitization, which represents 40% of total funding, up from 18% in 2001. On a risk-adjusted basis, leverage is more conservative, with a Tier 1 capital ratio of 7.7%, above the Bank’s target of 7.5%. With the adoption of Basle II in early 2007, Northern Rock is expected to enjoy some additional capital relief with a lower risk weighting attaching to its conservative residential mortgage assets, though the timing of this adoption will be subject the Financial Services Authority. In late 2005, the Bank obtained additional capital relief by selling some of its residual, first loss exposure under securitization structures. DBRS expects the Bank to continue to sell down these residual risk exposures in order to achieve maximum capital efficiency.

DBRS is mindful that Northern Rock has grown rapidly in an especially buoyant U.K. housing market, having taken substantial market share from larger, more established lenders. In order to maintain spread, the Bank has been targeting unsecured personal lending and higher LTV mortgages. Even though DBRS considers residential mortgages to be a conservative asset class, the Bank is singularly exposed to a house price correction as well as a deterioration in unsecured personal credit.