Evaluation of final bids

2.37  The private sector proposals were considered against the objectives set out in the statement of principles of 19 November 2007, including the Tripartite Authorities' expressed preference for a private sector deal over public ownership and public ownership over administration.

2.38  Goldman Sachs conducted a financial analysis of the Virgin and Northern Rock management bids, comparing them with each other and with public ownership. It compared the fees offered by the bidders in return for each element of public support with market rates for financial instruments with a similar level of risk. These estimates of the gross subsidy were then adjusted to give a net subsidy under each option:

■  for the private sector proposals, by deducting the estimated share offered to the Treasury when the buyer sold the business on;

■  for public ownership, by deducting an estimate of the potential sale proceeds from a sale of the company after three years.

2.39  Both the private sector proposals required substantial and ongoing public subsidy, leaving the taxpayer exposed to significant risks. Figure 10 shows the cashflows to the taxpayer of either Virgin or the Northern Rock management team buying the company compared with its transfer into public ownership and later sale back into the private sector, across three business scenarios. The scenarios were based on a set of stress tests provided by the Financial Services

Authority and key assumptions made by the Northern Rock management team in putting together its bid. The downside scenario was modelled on the recession and collapse in house prices experienced in the early 1990s. The base case assumed a five per cent fall in house prices during 2008 while the upside assumed no change in house prices during the period 2008 to 2011.

2.40  The estimated net public subsidy under both private sector proposals and under public ownership was substantial, ranging from £500 million if market conditions improved to as much as £2.8 billion in a recession scenario. The Treasury was involved in the development of appropriate assumptions and received presentations setting out the detailed outputs, which were discussed with Treasury officials.

2.41  We examined the assumptions on which the financial analysis was based, but have not had access to the detailed calculations underlying the figures shown above. Under the terms of its contract with the Treasury, the calculations remain the intellectual property of Goldman Sachs. The Treasury itself did not have the detailed calculations. At our request the Treasury asked Goldman Sachs to provide these details. Goldman Sachs declined this request. Our analysis of the assumptions shows that:

■  The gross subsidy, in the form of continued lending to the company and the arrangements to guarantee liabilities, under each option was the cost of providing such support based on the indicative costs of funding a private sector bid, as put forward by potential financiers earlier in the bidding process. These costs were then reduced by the fees offered by Virgin and the Northern Rock management team for the support. The assumptions used appear reasonable. The level of subsidy under each option and across the business scenarios was fairly uniform with a slight increase to reflect a higher level of support under the downside scenario;

■  When calculating the net subsidy under public ownership, the Treasury assumed that Northern Rock would be less successfully managed in public ownership and therefore sold on at a lower price than a private sector owner might achieve. The assumed price was set at a multiple of 0.75 of the company's estimated book value in 2011, at the lower end of historical trading multiples for the company and comparable mortgage lenders. Such an estimate will always be uncertain, however, given its dependence on changes in the housing market as demonstrated by the much higher net public subsidy under the downside scenario. The sale price would also be dependent on potential buyers' perceived confidence in the Northern Rock brand.

2.42  Although the financial analysis of the bids suggested that public ownership was likely to cost less than choosing one of the private sector bids, the uncertainties surrounding the estimates meant that a decision on what would offer the best value for money needed to take into consideration a range of other factors.

2.43  Ernst & Young provided regular reports to the Bank, which were copied to the other Tripartite Authorities, on changes to Northern Rock's assets and liabilities and such matters were also subject to oversight by the Financial Services Authority as the company's regulator. The Bank, as lender, conducted an appraisal of those assets directly securing its original loan, made in September 2007. Whilst the private bidders had undertaken due diligence on Northern Rock as part of the bidding process, the Treasury did not commission further due diligence work of its own on Northern Rock's assets and liabilities. The Treasury's appraisals of the options available and the likely net costs of public ownership were based on information provided by Northern Rock management throughout the bidding process. The contract with Goldman Sachs excluded any validation work on the information it received and the Treasury did not put in place its own arrangements to validate the information supplied.