The Granite bondholders can only look to the mortgages in Granite as a source of their repayment, not to the assets of Northern Rock. Because the Government has not guaranteed the Granite bonds, it will not be liable to investors. Granite has two modes of operation.
Granite in normal operation
In its normal mode, regular payments of principal and interest from the mortgages are paid to both the bondholders and Northern Rock. If a mortgage is redeemed and the capital element repaid, the payment will be received by Granite which will pay an amount to the bondholders and an amount to Northern Rock, with any excess cash over and above what is needed to pay bondholders being distributed to Northern Rock.
A worked example is provided below:
■ Initial value of mortgages sold to Granite is £1000. The initial share is £100 (10 per cent) for Northern Rock (the seller's share) and the bondholders' share is £900 (90 per cent). On the next payment date for bondholders, say £60 is due to be paid, and on that date assume that Granite has received £100 in payments of interest and principal from the underlying mortgages;
■ The bondholders are paid £60. Northern Rock is paid its share of the distribution (10 per cent or £10). The remainder (£30) is then paid to Northern Rock as a further distribution of its share of Granite;
■ After the distribution, the value of Granite is now £900 (£1,000 less £100). The seller's share is £60 (£100 less £40) and the bondholders' share is £840 (£900 less £60).
In the above example, if the amount required to pay bondholders was £120, not £60, bondholders would only be paid £100 and Northern Rock would not receive a payment. The bondholders would not have recourse against Northern Rock for the remaining £20 they are owed, but could receive this amount in subsequent collections of principal repayments from the underlying mortgages.
Granite in "pass through" mode
As in the above example, the seller's share can fall on each distribution date. If Northern Rock's share of the trust falls below a threshold level (the minimum seller's share), the Granite structure starts to operate in "pass-through" mode. The effect on Northern Rock would be that it would not receive repayments according to its share of Granite until the bondholders' share had reduced to zero.
In pass through mode, the bondholders still bear the risk that there are insufficient funds in Granite to repay them. Therefore, Northern Rock's share of Granite is preserved but deferred. Taking the example above:
■ Value of assets in Granite is £1000, Northern Rock has a 10 per cent share (£100) and bondholders have a 90 per cent share (£900);
■ In pass through mode, Northern Rock will not receive any share of principal receipts from the mortgages until the bondholders have been fully repaid from the assets in the pool up to their 90 per cent share;
■ However, the bondholders will only receive £900 if there are no defaults on the underlying mortgages. If defaults occur, the mortgage pool will reduce (for example, if there are losses of £200 the pool would reduce from £1,000 to £800 and bondholders will only receive 90 per cent of £800 (£720), notwithstanding they are owed £900;
■ Ten per cent of the now £800 pool will go to Northern Rock as well as surplus monies once the bondholders have been paid their 90 per cent share. Northern Rock's 10 per cent share does not go to make up the shortfall for bondholders when the pool value goes down from £900 to £800.