LLOYDS TSB was asked by Northern Rock to mount an eleventh-hour rescue takeover of the troubled Newcastle-based mortgage lender. The two banks held detailed talks, but the Lloyds deal was ultimately blocked by the Bank of England and the Financial Services Authority.

There were concerns among Bank officials that a takeover would cause greater consternation in financial markets. Once the decision to stop the rescue was made, Northern Rock had no choice but to ask the Bank for an injection of funds.

Northern Rock was also approached by Sir Fred Goodwin, chief executive of Royal Bank of Scotland. But it is thought Goodwin’s move was more opportunistic.

Northern Rock would be a bite-size deal for them. After the collapse in its share price, it now has a stock-market value of £1.8 billion – but does have 800,000 mortgage customers, 1.5m savers, and 76 branches.

In a highly unusual move, the Bank of England agreed to provide emergency funding for Northern Rock on Thursday night.

The deal, which was agreed with the Financial Services Authority and approved by the chancellor, Alistair Darling, came after Northern Rock’s board decided it would not be able to meet funding demands due in the next few weeks. Northern Rock is due to refinance £2.7 billion in securitisation vehicles in the next six months.

Northern Rock has been squeezed by the liquidity crisis in the credit markets. The UK’s fifth-biggest mortgage lender has been particularly vulnerable because it raises 75% of its funds to finance new lending from the credit markets.

Under the deal with the Bank, Northern Rock can borrow funds at a rate thought to be at least one percentage point above Bank rate using its mortgage book as collateral.

The agreement was designed to reassure customers and draw attention to the fact that Northern Rock is solvent. However, customers scrambled to withdraw more than £1 billion in savings, about 5% of retail funds, from the bank on Friday. The shares plunged by 32% on Friday to close at 438p. Since February the price has fallen from £12.58.

Though Northern Rock is aiming to continue offering loans, the punitive rate charged by the Bank is likely to lead to a huge drop in new lending. “If the market stays like it is, then we will effectively be pulling out of the market,” chief executive Adam Applegarth told The Sunday Times last week.

The lender has now in effect raised the For Sale sign. However, the Bank wants it to stabi-lise its business before finding a buyer. Sources said Northern Rock’s board was expected to decide on a sale by the year end.

Another option could be for banks to try to buy parts of Northern Rock’s mortgage book rather than the company outright.

Even if the turmoil in the credit markets eases, analysts believe that Northern Rock is unlikely to remain independent. “The simple answer is that the bank has been damaged. Its model of relying on the wholesale markets needs to be radically altered. A strategic partnership or a takeover are the only realistic options,” said one.

It is an open secret within banking circles that Northern Rock has made approaches in recent weeks to larger rivals. However, most want to wait until its year-end to see if the bank will have to make any provisions against its exposure to highly leveraged products such as structured investment vehicles (SIVs).

Several overseas bidders are watching events closely, including Credit Agricole and Citi.

Applegarth said: “Certainly the fall in our share price has made us more vulnerable. Northern Rock is likely to emerge a slower-growth, higher-margin business. Whether we have our independence is not for me to say at this stage. For us the world changed on August 9 when banks suddenly stopped lending to each other.”

Until earlier this year, Northern Rock had been growing its lending aggressively. In the first half of this year it grabbed a 19% share of net lending, leap-frogging market-leader HBOS. Northern Rock now expects this year’s profits to dive from earlier forecasts of £647m to between £500m and £540m.

It is also likely to find it difficult to hold on to customers when their mortgages mature. The bank has written tens of billions of pounds in two-year fixed and tracker mortgages and three-year deals. When these mature it normally rolls them over, offering borrowers the latest cut-price deal.

That strategy is now in peril. “The model means that they had to run fast to keep ahead. Now it looks like they will be swamped. The result is that they are going to have to get out of an awful lot of the mortgage market. Their share is going to be minuscule in the second half,” said Alex Potter, analyst at Collins Stewart.

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