February 2008 was a bad month to buy a bank, even if the purchase price was zero and you had £27bn of loans to protect. Given the slump in the housing market, the government's "investment" in Northern Rock, the mortgage lender it had to nationalise after a depositor run last summer, has performed as well as could be expected. The priority must still be to shrink Northern Rock's balance sheet as fast as possible and reduce risk to taxpayers, rather than slow the decline in the hope that it will mean lower losses.

Northern Rock's results for the first half of 2008 show a loss of £585m, leaving the bank with too little capital to support its balance sheet. With further losses expected, the Treasury will have to buy up to £3.4bn of new shares, Brussels permitting. That should be no surprise. A recapitalisation was certain, no matter who took the Rock over.

The question is whether those public funds - part of the £17.5bn of Bank of England loans still outstanding - will be safely recovered. One way to answer is to look at the three sources of Northern Rock's loss. First there is an operating loss, because Northern Rock is doing little new business and paying a high interest rate on its debts. The management team must build a profitable business so the bank can eventually be sold, but that was never going to be possible at the same time as reducing the balance sheet.

The second source of losses is the one-off cost of redundancies and write-offs. Those too are inevitable.

Of greater concern is the third source of losses: a £238m charge for bad debts on Northern Rock's mortgages and consumer loans. The charge is due to the weakness of the housing market, but the deterioration of Northern Rock's assets has been rapid and, as creditworthy customers are encouraged to take their business elsewhere, bad debts will only get worse. Mortgage defaults are the true threat to the taxpayers' investment in Northern Rock.

The losses highlight a dilemma: shrink Northern Rock quickly to recover public money, and operating losses will be high while credit quality suffers; or go slow and minimise losses, but risk more public money for longer. There can be only one choice: Northern Rock must be rapidly scaled back to reduce the total public funds at risk.

Nationalisation was never perfect but it was the only sensible option, and progress to date bears that out. The Bank of England loans exposed taxpayers to Northern Rock's bad debtors; nationalisation just means the Treasury can also benefit if the Rock is sold in the future. The mistake now would be to take fright at losses and slow restructuring down.

Source: Financial Times