Media comment has focused on the risks but the nationalisation of Northern Rock could prove extraordinarily profitable for UK taxpayers – assuming the government can avoid making a significant compensation payment to equity and subordinated debt holders.

Despite Treasury guarantees, Northern Rock has been forced to offer high interest rates to retain its retail deposit base, with savers concerned that their accounts would be frozen in the event of the bank going into administration. (Including a temporary loyalty bonus, Rock’s tracker online account currently pays a 6.99% AER.) Nationalisation removes this liquidity risk and should allow the bank to reduce its retail funding costs significantly.

European Union state aid requirements imply the Bank of England will continue to charge a penal interest rate on its loan but this now represents a transfer within the public sector.

On the assets side, the aim will be to shrink the mortgage book to allow early repayment of the Bank of England’s loan. New lending will be negligible and mortgage rates will be raised to encourage existing borrowers to refinance elsewhere. Assuming they stay, this will add to the boost to profitability from lower funding costs. Job losses are also inevitable, reducing the bank's cost base.

The key concern is that housing market weakness coupled with possible adverse incentive effects from public ownership will lead to significant default losses. Northern Rock had £97 billion of customer loans at 30 June 2007 but credit risk on £46 billion of the total had been partially transferred to holders of securitised notes.

In the housing recession of the early 1990s repossessions nationally reached a peak of 0.77% of outstanding mortgages in 1991. Assume Northern Rock is forced to foreclose on 1% of its loans each year for three years and achieves a recovery rate of only 70%. Based on a £97 billion book, this would imply a loss of £850-900 million, of which about £150 million might fall on holders of securitised notes. Northern Rock’s shareholder funds stood at £2.3 billion at 30 June 2007. Even assuming significant erosion since, the remaining equity in the business should easily absorb any losses barring an Armageddon scenario for the housing market.