Results
24.01.2007highlights
Northern Rock plc today issued its Preliminary Results for the year ended 31 December 2006.
Operating Performance
- Record gross lending of £33.0 billion - an increase of 22.7%, with record net lending of £16.6 billion - an increase of 14.2%.
- Share of UK gross mortgage lending of 8.3%, with share of redemptions of 5.9% - generating a net market share of 13.4%. Closing share of stock of UK mortgages of 7.1%.
- Total underlying assets of £100.5 billion - an increase of 23.9% from December 2005. Risk weighted assets increased by 17.2%.
- Credit quality remained robust throughout the year. 0.42% (31 December 2005 - 0.39%) of mortgage accounts 3 months or more in arrears - under half of industry average.
- Well balanced funding mix with strong retail savings net intake of £2.5 billion, four successful mortgage backed securitisation issues, raising net £10.5 billion, covered bond net intake of £2.7 billion and net non-retail funding of £2.9 billion.
Profits
- Statutory Profit Before Tax of £626.7 million up by 26.8% compared with 2005. Statutory Profit Attributable to Shareholders of £394.5 million, up by 31.2%.
- Underlying Profit Before Tax of £587.7 million up by 16.5% compared with 2005. Underlying Profit Attributable to Shareholders of £367.0 million, up by 19.1%.
Costs
- Statutory Cost to Income ratio improved to 27.3% (from 30.2% in 2005). Underlying Cost to Income ratio improved to 28.4% (from 29.8% in 2005).
- Cost to Asset ratio improved to 0.31% (from 0.34% in 2005).
Shareholder Value
- Statutory Return on Equity of 23.5% and 21.9% on an underlying basis. Strategic target range increased to 20% - 25%.
- Statutory EPS of 94.6p - an increase of 30.5%. Underlying EPS of 88.1p - an increase of 18.6%.
- Final dividend per share of 25.3p - giving a total dividend per share of 36.2p, an increase of 20.3%.
- Our IRB application under Basle II is progressing well and it is anticipated that the approval process will be completed during the first half of 2007.
Social Responsibility
- The Northern Rock Foundation - supporting charitable causes - to receive £31.4 million, making a total of £175 million since flotation in 1997.
Adam J Applegarth, Chief Executive, said:
“Underlying Attributable Profit grew by 19.1% to £367.0 million, tangible evidence that our profit performance is moving to the centre of our strategic underlying target growth of 20% + / - 5%. Our likely future profit profile and the implementation of Basle II means that our strategic target for Return on Equity is increased to 20% - 25%.
We have low levels of arrears, strong credit risk management and a low risk balance sheet. We do not expect to see a significant deterioration in overall credit quality going forward, given the current economic environment.
Our capital ratios remain strong, enhanced by the issue of £400 million preference shares and we remain well positioned to begin to take advantage of the introduction of Basle II during 2007. We have started to reflect the likely Basle II outcome by increasing dividend growth ahead of underlying profit growth. The proposed total dividend for 2006 amounts to 36.2p an increase of 20.3% over the 2005 total dividend. This reflects our confidence that Northern Rock’s business model remains robust and continues to deliver growth in shareholder value.”
OPERATIONAL REVIEW
Introduction
Following the introduction of International Financial Reporting Standards (IFRS), the balance sheet and income statement are subject to a certain amount of volatility. This particularly arises from accounting for hedges which although economically effective are deemed under IFRS rules to be ineffective. In addition, volatility arises from fair value movements on derivatives taken out to minimise risk in respect of certain financial liabilities and instruments included in non shareholders’ equity which themselves are not subject to fair value treatment. Where appropriate, such volatility is separately identified in the review of financial and operating results to enable underlying performance to be separately identified. Underlying total assets also exclude the fair value of derivative instruments due to volatility in such values.
Overview
Underlying Profit Attributable to Shareholders rose by 19.1% compared with 2005 - in line with our stated objective of growth in underlying Profit Attributable to Shareholders moving to the centre of our strategic target range. Underlying Return on Equity at 21.9% means that this metric has remained well within our strategic target range for the last 6 years. Given the likely future profit profile and Basle II’s implementation, the Return on Equity target range is lifted to 20% - 25%.
At 31 December 2006, our statutory and underlying assets exceeded £100 billion. The growth in underlying assets in 2006 was 23.9% (2005 - 24.9%) consistent with our medium term aim of achieving asset growth towards the middle of the strategic range of 20% + / - 5%.
Estimated gross residential lending market share at 8.3% for the full year reflected a stronger second half performance, with an 8.7% share compared with 7.8% in the first half. Our estimated market share of redemptions at 5.9% remained well below our estimated closing share of UK mortgage balances of 7.1% resulting in an estimated share of the UK’s net residential lending of 13.4% for the year. Our estimated net lending share of 14.5% in the second half was also higher than the 12.2% achieved in the first half. These statistics confirm our ability to achieve balance sheet growth targets in a competitive mortgage market without having to significantly increase our market share of gross lending. They also reflect the growing success of our customer retention proposition. Commercial lending and standalone personal unsecured lending grew more slowly reflecting our low appetite for risk. Asset quality also remained robust across all loan portfolios.
All of our funding arms performed well during 2006, with improvements in pricing for issues from both our securitisation and covered bond programmes. Following the second Whinstone transaction (with its transference of residual risk from within the Granite securitisation programme) in the first half of the year our senior unsecured credit rating was increased to A+ by Standard & Poor’s in August 2006.
Lending
During 2006 Northern Rock again achieved record levels of total lending. Total gross lending was £32,989 million, an increase of 22.7% (2005 - £26,879 million), with total net lending of £16,621 million, an increase of 14.2% (2005 - £14,555 million). Prospects for 2007 are good, with a total opening pipeline of £6,230 million (1 January 2006 - £5,300 million) including a residential lending pipeline of £5,815 million (1 January 2006 - £4,779 million), an increase of 21.7%.
The composition of our lending portfolios has continued to be low risk. At 31 December 2006, 90% of our loans to customers were residential secured loans (31 December 2005 - 90%), 2% commercial secured loans (31 December 2005 - 2%) and 8% (31 December 2005 - 8%) within our personal unsecured portfolios. This mix is not expected to change significantly going forward.
An analysis of new lending by portfolio is set out in the following table:
| £ millions | Residential | Commercial | Unsecured | Total |
|---|---|---|---|---|
| 2006 | ||||
| Gross | 28,972 | 423 | 3,594 | 32,989 |
| Net | 15,090 | 40 | 1,491 | 16,621 |
| Closing balances | 77,292 | 1,560 | 7,277 | 86,129 |
| 2005 | ||||
| Gross | 23,618 | 408 | 2,853 | 26,879 |
| Net | 13,350 | 5 | 1,200 | 14,555 |
| Closing balances | 62,257 | 1,523 | 5,789 | 69,569 |
Note: Gross and net lending represents net cashflows excluding fair value adjustments. Closing balances are stated including fair value adjustments.
Residential – UK market
The UK residential lending market remained buoyant throughout 2006 resulting in estimated gross lending for the year of £346 billion, an increase of 20% over the £288 billion seen in 2005. Gross lending associated with house moving represented around 60% of lending with 40% driven by remortgage activity. Remortgage activity reflects increased market liquidity following the removal of overhanging early repayment charges. Estimated UK residential net lending in 2006 at £110.4 billion represented an increase of 21% (2005 - £91.3 billion) supported by higher levels of house moving and average house price inflation of around 10%.
The buy to let market continues to be strong, representing approximately 10% of UK gross residential lending. This market will continue to be supported by demand, particularly from pre first time buyers, for student accommodation and from migrant workers.
We expect gross lending in 2007 to be a little higher than 2006, with house price inflation broadly in line with increases in earnings. Lending volumes will continue to be supported by favourable economic conditions, healthy volumes of housing transactions, buy to let and continued remortgage business. These conditions will provide a substantial and robust gross lending market for us to be able to achieve our lending targets.
Residential – Northern Rock performance
We achieved gross residential lending of £28,972 million (2005 - £23,618 million) and net residential lending of £15,090 million (2005 - £13,350 million), representing increases of 22.7% and 13.0% respectively. The following table sets out our market share statistics for each of the last four years:
| Residential lending market shares | 2003 FY |
2004 FY |
2005 FY |
2006 H1 |
2006 H2 (estimated) |
2006 FY (estimated) |
|
|---|---|---|---|---|---|---|---|
| Gross lending | 5.4% | 6.8% | 8.1% | 7.8% | 8.7% | 8.3% | |
| Redemptions | 4.1% | 4.5% | 5.1% | 5.9% | 5.9% | 5.9% | |
| Net lending | 7.7% | 11.2% | 14.5% | 12.2% | 14.5% | 13.4% | |
| Closing balances | 4.8% | 5.5% | 6.4% | 6.7% | 7.1% | 7.1% | |
Lending
The table above shows the success at growing gross market share and containing levels of redemptions through our customer retention process and fair and transparent policy of allowing existing customers, subject to their contractual terms, to transfer their loan to any product available to new borrowers. Our approach to customer retention, which is unique amongst the major volume mortgage lenders, means that we do not need to significantly grow our gross lending volumes from new customers to achieve our stated asset growth targets. We intend to improve our retention performance in respect of home movers both for direct business and through intermediaries.
Our distribution network continues to evolve as our business grows. In 2006, 89% of our mortgage business was sourced via the intermediary market (2005 - 90%) with 90% of this business being conducted on-line by the end of the year, benefiting service levels and operational efficiency. We will continue to develop our on-line facilities and intend to roll out e-commerce options for direct and product transfer customers during 2007.
We will continue to strengthen our key account relationships with major intermediary groups as well as opening up opportunities with new intermediaries. At the same time we intend to increase our branch sales network to up to 100 branches over the next 3 to 4 years, with new branches in major centres of population. We will also continue to invest in our Northern Rock Direct telephone operation to enhance our direct lending activities.
We offer customers a wide range of innovative and attractive products comprising lifestyle products and traditional price-led products with a planned mix of approximately 40% and 60% of new lending respectively. Most of our products have inbuilt flexibility giving customers the opportunity to overpay, make redraws and subject to advance agreement and after a qualifying period, take payment holidays provided that their account is fully up to date.
Our lifestyle products, which are margin enhancing, comprise our “together” family of products, Lifetime and residential Buy to Let mortgages. The “together” products combine a secured and unsecured loan at one interest rate and one monthly payment. Our Lifetime range is aimed at homeowners aged 60 and over who wish to utilise equity in their homes to enhance their lifestyle. Residential Buy to Let lending is focussed on lending to small portfolio borrowers rather than single applicant landlords. An analysis of lifestyle lending is set out in the following table:
| Lifestyle lending | Together | Lifetime | Buy to Let | Total | |
|---|---|---|---|---|---|
| 2006 | |||||
| % share of new lending | 31.4% | 0.9% | 7.3% | 39.6% | |
| % share of closing balances | 23.4% | 2.7% | 5.7% | 31.8% | |
| 2005 | |||||
| % share of new lending | 28.7% | 1.4% | 7.1% | 37.2% | |
| % share of closing balances | 20.6% | 3.0% | 4.9% | 28.5% | |
Of our traditional price-led mortgage products, fixed rate mortgages remained the most popular with 33.0% (2005 - 25.3%) of total new lending accounted for by short term fixed rate products up to two years, and 22.5% (2005 - 28.8%) by longer term fixes, normally up to five years. The increased demand for short term fixed rate products reflected customer demand for protection against anticipated increases in interest rates.
Overall, the profile of our new lending has remained low risk despite strong growth in volumes. Lending to first time buyers remained stable as a proportion of new lending at 24% (2005 - 24%), a reduction from the first half at 27%, as we adjusted our risk appetite. 76% (2005 - 76%) of new customers to have a proven mortgage payment track record. Consistent with this trend, the average Loan to Value ratio (“LTV”) of new lending in 2006 has remained the same as in 2005 at 78%. New lending at or below 90% LTV improved to 78% (2005 - 70%) of completions. The average indexed LTV of our mortgage book is now 60% (31 December 2005 - 58%) which continues to provide strong cover in the event of default. In line with house price increases, our exposure to large loans has increased with 5.1% of new loans by value over £500,000 (2005 - 3.4%). The credit risk on this lending remained excellent with such loans attracting an average LTV of only 73%. New lending continued to be geographically spread across the UK in line with the demographics of the population.
As announced at the Interim Results, we will very soon be launching mortgage products for the near prime, sub prime and self certified markets on behalf of Lehman Brothers. We will not take any credit risk nor will we administer the loans post completion, but will earn fee income for their origination. By offering such products we will complement our existing product portfolio and gain access to mortgage intermediaries with whom we currently have no relationship, thereby expanding our distribution network.
Unsecured
Our personal unsecured credit portfolios comprise the unsecured element of “together” lending and standalone unsecured loans not linked to a residential mortgage. An analysis of lending volumes on the separate elements of our unsecured portfolios is shown in the following table:
| £ millions | Standalone Unsecured |
Together Unsecured |
Total | |
|---|---|---|---|---|
| 2006 | ||||
| Gross | 2,332 | 1,262 | 3,594 | |
| Net | 782 | 709 | 1,491 | |
| Closing balances | 4,221 | 3,056 | 7,277 | |
| 2005 | ||||
| Gross | 1,970 | 883 | 2,853 | |
| Net | 744 | 456 | 1,200 | |
| Closing balances | 3,408 | 2,381 | 5,789 | |
The growth in standalone unsecured gross lending has slowed in line with the number of borrowers who satisfy our credit score and our risk appetite. Net lending has stabilised as the portfolio matures and redemptions and repayments naturally increase.
Volumes of new “together” unsecured lending have increased broadly in line with the growth of “together” mortgage lending with the unsecured element remaining around 13% of combined “together” advances.
Commercial
Competition in the commercial secured lending market remained strong throughout 2006, with certain lenders being particularly aggressive on price and LTV levels at which they are prepared to lend. Both gross and net lending within our commercial lending portfolio remained constrained as a result of maintaining our emphasis on quality rather than volume of lending. Gross lending in the year amounted to £423 million (2005 - £408 million) with net lending of £40 million (2005 - £5 million).
Included within advances secured on residential property are £1.0 billion (2005 - £0.8 billion) of loans secured on commercial Buy to Let portfolios, which are managed within our commercial lending operation.
Arrears and Possessions
The arrears position of each of our main personal lending portfolios based upon numbers of accounts three months or more in arrears is set out in the table below. Comparison with the half year position is provided to demonstrate the continued strong credit performance of our loans.
| Residential | Together Secured |
Standalone Unsecured | Together Unsecured |
CML Residential Average |
|
|---|---|---|---|---|---|
| 31 December 2006 | 0.42% | 0.84% | 1.09% | 0.85% | n/a |
| 30 June 2006 | 0.45% | 0.95% | 1.08% | 0.97% | 0.96% |
| 31 December 2005 | 0.39% | 0.84% | 0.98% | 0.84% | 0.97% |
Note: CML Residential Average arrears shown at 30 June 2006 and 31 December 2005. Data at 31 December 2006 not yet available. Source: Council of Mortgage Lenders.
Residential accounts three months or more in arrears at 0.42% remained well below half the CML residential average of 0.96% at 30 June 2006 (31 December 2005 - 0.97%) and below the equivalent figure of 0.45% at the half year. The “together” secured three months plus arrears have improved during the second half to be 0.84% at the year end from 0.95% at the half year (31 December 2005 - 0.84%) and remain below the CML average for residential lending. Residential Buy to Let arrears on the same basis were 0.53% (31 December 2005 - 0.39%) compared with the CML residential buy to let average at 30 June 2006 of 0.73%, confirming the quality of this portfolio.
At 31 December 2006, properties in possession held were 662, representing 0.09% of all accounts compared with 628 (0.09%) at the half year and 576 (0.09%) at the end of 2005. This increase is in line with our policy of rapid movement towards recovery where it is clear the borrower is unwilling to maintain payments and where we have higher risk.
Standalone personal unsecured loan arrears remain significantly better than industry average, due to our policy of attracting high quality lending and use of our bespoke scorecard to avoid lower quality lending. At 31 December 2006, three months plus arrears were 1.09%, reflecting our strong credit arrears management and tightening of our application score cut offs. This should reduce our exposure to risk of loss from over indebted customers and customers with a propensity to resort to IVA orders and personal bankruptcy. Together unsecured arrears have improved along with “together” secured arrears to 0.85% from 0.97% at the half year.
At 31 December 2006, only 7 of our total commercial loans (0.31% of accounts) with balances outstanding of £20.5 million were three months or more in arrears compared with 10 accounts (0.42%) with outstanding balances of £5.8 million at 31 December 2005.
Funding
Northern Rock has four distinct funding arms enabling it to attract funds from a wide range of customers and counterparties on a global basis. In recognition of our broad and innovative access to a cost effective and diverse capital markets investor base, Northern Rock was awarded the prestigious International Financing Review’s 2006 Financial Institution Group Borrower of the Year award.
Flows of new funding and closing balances are shown in the following table:
| £ millions | Retail | Non-Retail | Securitisation | Covered Bonds |
|---|---|---|---|---|
| 2006 | ||||
| Net flow | 2,527 | 2,876 | 10,628 | 2,733 |
| Closing balances | 22,631 | 24,240 | 40,226 | 6,202 |
| 2005 | ||||
| Net flow | 2,809 | 2,317 | 8,831 | 2,378 |
| Closing balances | 20,104 | 22,253 | 31,156 | 3,830 |
Note: Net flow represents net cashflows excluding fair value adjustments. Closing balances are stated including fair value adjustments.
Retail
Retail funding comprised a net inflow of funds of £2.5 billion, including interest credited of £577 million. This builds on the successful funding in 2005, again demonstrating the strength and diversity of our retail franchise.
Funding during the year was largely into our Silver Savings accounts, which are available on-line, via post and through our branch network, Fixed Rate bonds and our Irish based accounts. Balances in our Ireland operation rose to £1,520 million (31 December 2005 - £1,026 million), with £2,094 million (31 December 2005 - £1,940 million) in our Guernsey based off-shore subsidiary. We will be launching our new retail funding operation in Denmark next month, supplementing our diverse retail franchise.
Non-Retail
Our non-retail funding provides a balanced mixture of short and medium term funding with increasing diversification of our global investor base. Following substantial inflows from securitisation during the first half, we repaid net £2.3 billion, mainly short term funds. In the second half we raised a net £5.2 billion, leading to a full year net funding of £2.9 billion.
During the year, we raised £3.2 billion medium term wholesale funds from a variety of globally spread sources, with specific emphasis on the US, Europe, Asia and Australia. This included two transactions sold to domestic US investors totalling US$3.5 billion. In January 2007, we have raised a further US$2.0 billion under our US MTN programme.
Key developments during 2006 included the establishment of an Australian debt programme, raising A$1.2 billion from our inaugural issue. This transaction was the largest debut deal in that market for a single A rated financial institution targeted at both domestic Australian investors and the Far East.
In August 2006, our long term credit rating with Standard & Poor’s was increased one notch to A+, supported by our £400 million preference share issue and a second Whinstone transaction (see below). Our current credit ratings are set out in the following table:
| Standard & Poor’s | Moody’s | FitchIBCA | |
|---|---|---|---|
| Short term | A1 | P-1 | F1 |
| Long term | A+ | A1 | A+ |
Funding
Securitisation
Funding through securitisation has remained an important part of Northern Rock’s funding strategy. During 2006, four residential mortgage-backed issues were completed raising £17.8 billion gross (£10.5 billion net) through our Granite vehicles. The characteristics of the mortgages securitised, in terms of product type, LTV and geographic distribution remain similar to those of our non-securitised mortgages. We continue to diversify our investor base aided by comprehensive global investor roadshows. The Granite issuances continue to price at lower spreads than earlier deals and significantly below maturing older deals.
In 2007 to date, we have completed a £6.1 billion residential mortgage-backed securitisation issue, which was heavily oversubscribed.
At 31 December 2006, securitised notes amounted to £40.2 billion (31 December 2005 - £31.2 billion), representing 43% (31 December 2005 - 40%) of our total funding portfolios. This proportion is expected to stay broadly stable going forward.
Covered Bonds
In 2006 we increased the size of our covered bond programme established in 2004 to €20 billion and raised €4 billion (£2.7 billion) from two benchmark issues. Covered bonds continue to provide further diversification of our investor base while at the same time lengthening the maturity profile of our funding. We have issued covered bonds in a range of maturities from 5 to 15 years with a current weighted average maturity of 7.1 years. The covered bonds are secured by a pool of ring-fenced residential mortgages. The credit risks associated with these loans have subsequently been transferred into the capital markets by means of synthetic securitisation transactions (Graphite) providing further capital benefits.
Assets
At 31 December 2006, total assets on a statutory and an underlying basis (excluding fair value adjustments) exceeded £100 billion for the first time. Total assets on a statutory and underlying basis are set out in the following table:
| £ millions | 31 December 2006 | 31 December 2005 |
|---|---|---|
| Statutory | 101,011 | 82,709 |
| Underlying | 100,468 | 81,057 |
On an underlying basis, total assets were 23.9% higher than at the previous year end and on a statutory basis have increased by 22.1%.
Total Income and Margins
The tables below show net interest income and total income on a statutory and underlying basis (see notes 4 and 5). The underlying basis excludes volatile hedge ineffectiveness as management considers that our hedging is economically effective and that movements in fair value on individual hedges and underlying instruments will offset over time and do not form part of operational performance.
| Statutory | Underlying | Statutory | Underlying | |
|---|---|---|---|---|
| £ millions | 2006 | 2006 | 2005 | 2005 |
| Net interest income | 849.1 | 823.0 | 752.3 | 706.8 |
| Other income | 152.8 | 152.8 | 129.0 | 129.0 |
| Hedge ineffectiveness | 14.9 | (56.4) | ||
| Total income | 1,016.8 | 975.8 | 824.9 | 835.8 |
On a statutory basis, total income in 2006 amounted to £1,016.8 million, representing an increase of 23.3% over statutory total income in 2005. On this basis the ratio of total income to mean total assets at 1.11% compares with the 2005 ratio of 1.12%. Total income as a proportion of mean risk weighted assets at 3.56% compares with the 2005 ratio of 3.34%.
On an underlying basis total income in 2006 amounted to £975.8 million, representing an increase of 16.8% over underlying total income in 2005. On this basis, the ratio of total income to underlying mean total assets at 1.08% compares with the 2005 ratio of 1.15%. Total income as a proportion of mean risk weighted assets at 3.42% compares with the 2005 ratio of 3.41%.
Statutory interest margin at 0.96% and statutory interest spread 0.80% compares with the 2005 ratios of 1.03% and 0.87% respectively.
On an underlying basis net interest margin was 0.93% and net interest spread 0.77%, compared with 0.97% and 0.81% in 2005. The majority of this reduction was seen in the first half of 2006 when margin and spread were 0.89% and 0.75%. During 2006, 3 month Libor was on average 21bps higher than Bank Base Rate with the gap 14bps in the first half increasing to 28 bps in the second half, which together with the additional costs in 2006 of the Whinstone transactions resulted in a negative drag on net interest income. These negative effects were partially offset by the benefit of funding received from the issue of preference shares in 2006 (with no offsetting interest expense) and gains realised on available for sale assets. Excluding these effects, retail spreads on our core business remained relatively stable during 2006.
Other income primarily comprises commissions and administration fees. Commissions are generated on sales of third party products such as building and contents and payment protection insurance. Administration fees are those fees not included within interest margin. Other income also includes a charge in respect of a provision of £15 million which was absorbed by the additional gains realised on available for sale assets in total income. This provision has been made in relation to compensation in respect of Mortgage Exit Administration Fees charged over and above original contractual amounts. These fees are currently subject to an industry wide review by the FSA.
Operating Expenses
Total operating expenses amounted to £277.5 million, representing an increase of 11.3% (2005 - £249.4 million). This increase is below the minimum of the target range for cost growth of one half to two thirds of underlying asset growth (ie 12.0% given the increase in underlying assets of 23.9% over the year) and well below the rise in underlying total income of 16.8%. This resulted in a Cost to Asset ratio of 0.31% (2005 - 0.34%) and an underlying Cost to Income ratio of 28.4% (2005 - 29.8%).
We expect to see continued improvements in cost ratios in 2007 whilst maintaining our investment particularly in premises, to provide capacity and in systems to drive further efficiency gains in our operations.
Social Responsibility - The Northern Rock Foundation
Northern Rock donates 5% of pre tax profit to The Northern Rock Foundation under a deed of covenant. Such donations are used to support community and charitable causes in the North East of England and Cumbria. The covenant from 2006 profits amounts to £31.4 million (2005 - £24.7 million), resulting in approximately £175 million having been donated since its inception in 1997 as an integral part of Northern Rock’s conversion to a plc.
Loan Loss Impairment
The 2006 charge for loan loss impairment amounted to £81.2 million (2005 - £56.6 million) representing 0.10% of mean advances to customers (2005 - 0.09%). As anticipated at the time of the interim results the second half charge of £36.7 million remained below the first half charge of £44.5 million.
Loan loss impairment provisions and coverage at the year end are set out in the following table:
| Residential | Commercial | Unsecured | Total | ||
|---|---|---|---|---|---|
| 2006 | |||||
| Impairment provision £m | 26.2 | 7.4 | 92.4 | 126.0 | |
| % share of closing balances | 0.03% | 0.47% | 1.25% | 0.15% | |
| 2005 | |||||
| Impairment provision £m | 32.5 | 4.7 | 87.1 | 124.3 | |
| % share of closing balances | 0.05% | 0.31% | 1.48% | 0.18% | |
The combination of high quality lending, low interest rates, low arrears and low average LTV of the portfolio have continued to contain the levels of loan loss impairment provisions required for residential mortgages. Provisions for the commercial secured lending portfolio are consistent with portfolio performance and economic conditions for this sector.
The growth in loan loss impairment provision balances against our personal unsecured credit portfolios reflects growth in balances and the maturing nature of the portfolios, as well as the quality of the loan books. As a result, total loan loss impairment provision balances for these portfolios were £92.4 million (31 December 2005 - £87.1 million) with total cover of 1.25% (31 December 2005 - 1.48%).
Taxation
The effective tax rate in 2006 was 29.3% (2005 - 29.3%). We continue to anticipate, with a corporation tax rate of 30% that the ongoing effective tax rate will trend towards 30.0% in the next few years.
Profits and EPS
Details of Profit Before Tax, Profit Attributable to Shareholders and Earnings per Share on statutory and underlying bases are set out in the following table:
| Statutory | Underlying | Statutory | Underlying | |
|---|---|---|---|---|
| 2006 | 2006 | 2005 | 2005 | |
| PBT £m | 626.7 | 587.7 | 494.2 | 504.6 |
| Attributable profit £m | 394.5 | 367.0 | 300.7 | 308.1 |
| EPS p/share | 94.6 | 88.1 | 72.5 | 74.3 |
The reconciliation between statutory and underlying results is set out in note 2 (page 24).
Statutory 2006 Profit Before Tax of £626.7 million represents an increase of 26.8% over 2005 statutory Profit Before Tax, with statutory Attributable Profit rising by 31.2% to £394.5 million.
Underlying 2006 Profit Before Tax of £587.7 million represents an increase of 16.5% over 2005 underlying Profit Before Tax, with underlying Attributable Profit rising by 19.1% to £367.0 million.
Return on Equity for 2006 was 23.5% on a statutory basis and 21.9% on an underlying basis compared with 19.3% and 20.8% on an equivalent basis in 2005.
Whinstone Transactions
In November 2005, Northern Rock completed its first Whinstone transaction amounting to £423 million. This transferred around 80% of the reserve fund risk relating to pre 2005 Granite residential mortgage securitisations to third party investors, therefore reducing the potential exposure to downturn credit risk. In June 2006, a second transaction was completed amounting to £169 million relating to the 2005 and the first 2006 Granite residential mortgage securitisations. At 31 December 2006, the balance outstanding on the Whinstone transactions included within securitised notes amounted to £551 million.
The transactions reduce the level of core capital required under credit rating assessments of required capital as well as the regulatory capital deduction in respect of the reserve funds, thereby enhancing capital efficiency and more closely aligning regulatory and credit rating capital. By retaining a small portion of the first loss, Northern Rock continues to align the interests of securitisation investors and the Company and demonstrates its confidence in the credit performance of the mortgage portfolio.
The additional interest cost of the Whinstone transactions will be largely offset by savings in appropriations due to not having to raise subordinated debt to support securitisation capital deductions. Underlying attributable profits will therefore not be significantly affected by these transactions.
Dividends
For 2006 the total dividend per share is proposed at 36.2p per share representing an increase of 20.3% compared with the total dividend of 30.1p per share for 2005. This growth of 20.3% compares with an increase of 19.1% in underlying attributable profits. The proposed final dividend is 25.3p per share payable on 25 May 2007 to shareholders on the register on 27 April 2007.
As the anticipated benefits of Basle II start to become realised our dividend policy will be reviewed with the expectation that dividend growth will exceed underlying profit growth, increasing returns to shareholders.
Capital
At 31 December 2006, total capital amounted to £3,588 million resulting in a total capital ratio of 11.6%, comfortably above regulatory and internal requirements. Tier 1 capital was £2,610 million and the Tier 1 ratio 8.5%. The equivalent ratios at 31 December 2005 were 12.3% and 7.7% respectively.
Tier 1 capital and total capital were enhanced by the issue on 29 June 2006 of £400 million (£397 million net of issue costs) of perpetual non-cumulative callable preference shares. Dividends on these shares are discretionary and subject to Board approval will be first paid on 4 July 2007 and then annually thereafter at a rate of 6.8509%. The issue supports the future growth of lending as well as improving the mix of our capital base.
We continue to work with the FSA in relation to the adoption of our Basle II systems and are planning for the roll out of our approaches for each of our main credit portfolios during the first half of 2007, following completion of the approval process with the FSA. This will result in adoption of Basle II ahead of the majority of the banking sector. As a low risk lender we continue to anticipate significant reductions in risk weighted assets under Basle II. The regulatory capital savings that will derive from these reductions will be partly offset by Pillar II requirements. We are currently finalising our capital plans which are to be subject to FSA review early in the second quarter. We continue to expect Basle II to result in a reduction in our regulatory capital requirement compared with Basle I.
Outlook
We expect UK gross residential lending in 2007 to be a little higher than 2006 at around £360 billion, underpinned by a stable housing market and sustained remortgage activity. Economic conditions will remain fundamentally supportive, with interest rates remaining low compared with the long term UK average. The independence of the Bank of England continues to be a key economic factor. Mortgage volumes will also be supported by continued demand for buy to let lending and by customers reorganising their finances away from more expensive unsecured debt.
Our focus on customer retention, with planned improvements to retaining home moving customers means that our volume targets can be achieved without significant increases in our share of gross mortgage lending from new customers.
We have been a top three lender by flow of business over the last few years; over the medium term we also aim to be a top three mortgage lender by share of stock.
Credit quality remains key to Northern Rock’s business, which will remain dominated by good quality prime residential mortgages. Where necessary we have tightened our credit risk appetite and improved our assessment of customer affordability which, together with continued focus on arrears management, should result in future credit loss charges moving in line with our growth in lending.
We re-confirm our strategic asset and underlying Attributable Profit to Shareholders’ growth target of 20% + / - 5% with both moving towards the middle of the range. We have increased our strategic Return on Equity target range to 20% - 25% and have started to reflect the likely Basle II outcome by increasing dividend growth ahead of underlying profit growth.