Least favoured option now reality

The British government now finds itself running a high street bank, writes Fiona Walsh, in London

For a brief moment yesterday, Alistair Darling's mask slipped.

"The government can't run a bank; governments don't do that," he told reporters, insisting that Sunday's dramatic decision to nationalise Northern Rock is merely a temporary measure.

For a few fleeting seconds, the chancellor of the exchequer appeared as bemused as the rest of the British public - just how had the government managed to manoeuvre itself into this mess in the space of less than six months?

Whatever his protestations, the government is now running a bank - or at least a team appointed by the Treasury is. After emergency legislation is rushed through parliament in the next few days, Northern Rock will become the first British company to be nationalised since the 1970s.

Just 12 months ago, Northern Rock was one of the banking sector's brightest stars. Under its aggressive young chief executive, Adam Applegarth, it was making huge inroads into the British mortgage market with its range of keenly priced home loan products.

But the vast bulk of the new loans were supplied not by savers' deposits but by funding obtained on the risky wholesale money markets.

When the crisis in the American subprime housing market exploded into a global credit crunch last summer, Britain's fifth-largest mortgage lender saw its funds dry up virtually overnight.

News that it had been forced to go to the Bank of England for emergency funding sparked the first run on a British bank in more than a century, a run that saw borrowers queuing round the block to withdraw funds at the rate of £1 billion a day.

Instead of letting Northern Rock go to the wall, or allowing a rescue deal from the likes of Lloyds TSB, Darling stepped in to guarantee savers' funds in the mortgage lender. It was a dramatic intervention and it stopped the run on the bank but it also set the government on the inexorable path towards nationalisation.

Lloyds TSB had been prepared to mount a rescue bid for the bank before the crisis became public in September, but its offer was conditional on it being allowed continued access to the Bank of England's emergency funding.

And later, when other bidders such as JC Flowers came up with viable plans, they too were rejected on the grounds that shareholders would be left with virtually nothing.

In the end, there were only two bids on the table - the offer from Virgin's Sir Richard Branson and proposals from the management team.

Sir Richard had earlier enjoyed preferred bidder status but closer scrutiny of his proposals, which included a hefty fee for use of the Virgin name, found them well short of fair value.

With so much taxpayer money at stake, the government could not risk accusations of selling Northern Rock on the cheap. And thus nationalisation, which Darling and his boss, Gordon Brown, the prime minister, had been desperate to avoid, became inevitable.

Shareholders will still end up with virtually nothing and the government faces the embarrassment of having the bank under its ownership for several years, while the new management team struggles to rebuild the business sufficiently to ensure repayment of the taxpayers' cash.

In the meantime, Northern Rock's shareholders are threatening legal action and the bank's competitors are muttering darkly about unfair competition from their stricken, but state-controlled rival.

There will also be a hefty bill landing on Darling's desk from investment bank Goldman Sachs for its months of intensive work on the abortive sale process.

The bank was, to all intents and purposes, already nationalised as its extensive liabilities had been taken on to the government's books.

If only Darling and Brown had been brave enough to take decisive action five months ago, then at least the worst might now be over.

But for the British government, for the thousands of Northern Rock employees who face losing their jobs and for the 100,000 shareholders who will lose almost all their entire investment in the bank, the worst is still to come.