Northern Rock could be in a position to repay most its loan from the Bank of England by early next year. Here’s how.

First, consider the Granite securitisation vehicle. According to documentation on Rock’s website, on 31 March 2007 Granite held £16 billion worth of fixed-rate mortgages with resets occurring in 2008. Rock is offering unattractive rates to refinance, while its standard variable rate is a high 7.59%. Any borrowers able to switch to other mortgage lenders are likely to do so. Let’s assume £13 billion of Granite mortgages are repaid in 2008.

Granite expects to repay principal of £9 billion on its outstanding notes in 2008. If £13 billion flows back from mortgages, this leaves a surplus of £4 billion. My understanding is that Northern Rock is able to extract this surplus by injecting mortgages from its own book into the Granite pool.

Rock’s non-Granite mortgages totalled £38 billion on 30 June 2007 so there would seem to be no obstacle to extracting surplus cash from Granite, even if new mortgage business is negligible, as seems likely. Moreover, a portion of these non-Granite mortgages will also be repaid this year. Assuming the same profile as for the Granite pool, £11 billion could be fixed-rate deals resetting in 2008. Let’s say £9 billion of non-Granite mortgages are repaid this year. Adding this to the £4 billion Granite surplus gives a total inflow of £13 billion.

Now consider funding. Rock had £24 billion of retail deposits on 30 June 2007 but at least half left the bank after it was forced to seek emergency funding from the Bank of England. Post-nationalisation, savings are returning in response to high interest rates and the unlimited government guarantee. (Savers were previously deterred by the risk of accounts being frozen if the bank entered administration.) Even after a recent cut, Rock’s tracker online and silver savings accounts offer a highly competitive 6.25%. If this edge is maintained, retail inflows of £10 billion or more look possible this year. (Landsbanki’s ICESAVE attracted £5 billion in the 15 months to 31 December 2007 from a standing start and without the benefit of a government guarantee.)

Adding a £10 billion deposit inflow to mortgage repayments of £13 billion would leave Rock only £2 billion short of the estimated £25 billion Bank of England loan.

What could go wrong with this scenario? One risk is that other lenders will be unable to accommodate borrowers switching from Rock given the current difficult funding environment. Perhaps this partly explains government measures announced last week designed to restart the market for mortgage securities.

Similarly, concerns about unfair competition or the stability of other institutions relying on retail funding may force Rock to cut its deposit rates, implying a smaller savings inflow.

Rock could also decide not to pay the Bank of England back so soon, even if it has the resources. It may wish to continue to generate new mortgage business, albeit on a much smaller scale than in recent years, in order to maximise its attraction to an eventual purchaser. Also, the Bank loan represents cheap funding, at least when considered from the perspective of the public sector as a whole. The Bank of England effectively pays Bank rate on the money it creates to lend to Rock. At 5.25%, this is a full percentage point below the rates Rock currently offers on its leading savings products.