Friday, March 21, 2008

Propping up mortgages

(FT) Bank of England officials, initially the dukes of moral hazard when the credit crisis broke, must be worried. They are considering buying up mortgage-backed securities in an attempt to ease conditions in the UK mortgage market, as part of potential concerted action with other central banks.

In difficult times, it is only sensible to consider all the options. The Council of Mortgage Lenders warned on Thursday of “ongoing problems in the mortgage funding markets”, as UK mortgage lending declined 7 per cent month-on-month in February.

The UK authorities lack the wide range of tools available in the US, for example using state-sponsored giants Fannie Mae and Freddie Mac, to help ensure mortgages remain available. And the relatively small size of the UK MBS market – with about £250bn outstanding – means that buying in sufficient quantity to provide support is feasible.

Nevertheless, this would be a huge step. The Bank of England has so far been less active than either the European Central Bank or the Federal Reserve in providing liquidity to financial institutions. Heavily marked-down MBS may now be undervalued. But buying on that basis means engaging in proprietary trading using taxpayers’ money. What if that view turns out to be wrong?

If MBS are substantially undervalued, surely market mechanisms – admittedly functioning poorly of late – will soon kick in? There have been signs of bottom- fishing in the US municipal bond market and hedge funds are reportedly eyeing the MBS market.

There is indeed a real danger that central banks could solve banks’ liquidity problems without breaking the mortgage market logjam. But turning into a buyer, rather than a lender, of last resort would be . . . well, the last resort. However, there is at least a chance that even the prospect of central bank intervention could finally encourage the vultures to swoop in.

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