Monday, April 21, 2008

Bank of England Swaps Bonds to Revive Bank Lending

(Bloomberg) -- The Bank of England offered to swap government bonds for mortgage securities to kick-start bank lending, with Governor Mervyn King pledging to meet demand even if it exceeds an estimate of 50 billion pounds ($100 billion.)

``There is no arbitrary limit on this so it could well go higher,'' King told reporters in London today. He said the plan aims to restore confidence to the banking system and the most important aspect is that ``everyone needs to know this is there for them to access as needed.''

The measures, backed by Prime Minister Gordon Brown's government, mimic a swap of $200 billion of securities by the U.S. Federal Reserve last month as central banks around the world struggle to prop up financial markets. A surge in borrowing costs prompted U.K. banks to withdraw their best mortgage offers, threatening to exacerbate the worst housing downturn since 1992.

``This package may help ease money-market strains, and provide a welcome route to liquidity for some particular banks and building societies that otherwise may face extreme difficulties in obtaining funds,'' said Michael Saunders, chief western European economist at Citigroup Inc.

The banks will retain responsibility for losses from the assets they loan to the Bank of England. The swaps will be for a period of one year, renewable for up to three years. Only assets existing at the end of 2007 can be used in the swap.

Bank Losses

The swap is double the value of loans King extended in September to prop up Northern Rock Plc. The government in February nationalized the mortgage lender, the first U.K. bank to fall victim to the credit freeze. That stemmed from the collapse of the U.S. subprime market, which has now cost more than $250 billion in bank writedowns and credit losses.

U.K. government bonds rose and the pound fell after the announcement, which some economists said leaves the way open for the Bank of England to cut interest rates again to stave off an economic slowdown.

The pound fell to $1.9830 at 11:59 a.m. in London, from $1.9979 at the end of last week, when it climbed 1.5 percent. Gilts rose, depressing the yield on two-year notes by 6 basis points to 4.27 percent. The central bank cut its key rate three times since December to 5 percent.

``Our guess is today's measures will help spreads to normalize'' between market lending rates and the bank's benchmark, said Peter Dixon, an economist at Commerzbank AG. That ``will allow the Monetary Policy Committee to use interest rates to tackle economic issues rather than market problems.''

New Strategy

The plan is a change of approach by the Bank of England after its interest-rate cuts failed to ease the logjam. The European Central Bank, the first central bank to react to the credit crisis in August, has extended the maturity of money auctions to help cash-strapped institutions.

``We will make sure there is enough liquidity in the economy to make sure people can buy their own houses,'' Brown said in a speech to the Labour Party today in Inverness, Scotland.

``The collateral swap arrangement is an innovative and unique policy response,'' the British Bankers' Association said in a statement today.

European banks sold 25.7 billion euros ($41 billion) of mortgage-backed securities so far this year, down from 91.2 billion euros in the same period last year, according to Deutsche Bank AG.

Bond Yields

Investors are demanding yields as high as 155 basis points above the interbank lending rate to hold the top-rated bonds backed by U.K. mortgages, up from 65 basis points at the end of last year, according to Dresdner Kleinwort on Friday. Bonds backed by U.K. credit cards are trading at about 205 basis points, up from 80 basis points at the end of last year.

``If we didn't do this there was a risk that the situation would have become worse,'' Chancellor of the Exchequer Alistair Darling said today in an interview with Sky News. ``This is the right thing to do to stabilize the situation. At the moment there is little or no market for assets backed by mortgages.''

Darling will speak to Parliament in London about the decision at 3:30 p.m. today. Darling will meet members of the U.K. Council of Mortgage Lenders tomorrow, aiming to agree measures to help borrowers who fall into arrears on loans.

The banks will be able to enter into a swap at any time over the next six months. Assets that can be used must have the top AAA ratings. They will include mortgage debt and credit card debt. ``Raw mortgages'' and derivatives are excluded.

Confidence Boost

``The length of these transactions will provide banks with the certainty about liquidity that is needed to boost confidence,'' the bank said in a statement.

The central bank's move allows financial institutions to add government bonds to their inventory of liquid assets and make it easier for them to both raise cash and lend, especially to consumers seeking home loans. In return, the government will hold the riskier mortgage-backed assets as security.

``With markets for many securities currently closed, banks have on their balance sheets an 'overhang' of these assets, which they cannot sell or pledge as security to raise funds,'' the bank's statement said. ``Their financial position has been stretched by this overhang, so banks have been reluctant to make new loans, even to each other.''

To date, the Bank of England has widened its collateral requirements just for three-month lending. It accepts only top- rated government securities at its weekly auctions.

Collateral Rules

The bank said the public is exposed to a loss only if a lender participating in the program defaults and the assets they have placed with the central bank are insufficient to cover the value of the Treasury bills in the swap. That's why the bank is asking for collateral of greater value than the bills it lends.

``The BOE's actions do seem to be quite punitive, in that there is a significant haircut and there's a fee against the libor,'' said James Nixon, a director of Societe Generale SA in London. ``The sense yet again from the Bank of England is that it will provide an absolute backstop to the financial system, but won't make any effort to ease the market's liquidity.''

The U.S. Federal Reserve last month made up to $200 billion available to banks in return for debt including mortgage-backed securities.

Former Bank of England policy maker Willem Buiter, now a London School of Economics professor, said on April 18 the plan's success ``all depends on the scale.''

Size Matters

``In total, they would have to do -- not in one big go -- at least 100 billion for it to really actually make a difference to the liquidity position of banks, but also act as the catalyst for getting that market going again,'' he said.

The risk is that a slide in house prices worsens, undermining support for Brown's government. Mortgage lenders including HBOS Plc and Lloyds TSB Group Plc have raised the cost of loans, even after three, quarter-point rate cuts by the Bank of England to 5 percent.

House prices dropped 2.5 percent in March from a month earlier, the biggest drop since 1992, HBOS, the country's largest mortgage lender, said April 8. Brown's approval rating dropped faster than for any U.K. leader on record as support for the opposition rose to the highest in 16 years, a poll published on April 13 showed.

``It might just free up a bit more liquidity,'' Simon Rubinsohn, an economist at the Royal Institution of Chartered Surveyors, said in an interview on Bloomberg Television. ``It's not going to turn things round in the housing market.''

The Great Unbung (FT Alphaville)

Why is the UK government opting to swap the banks’ mortgage nasties for gilts rather what everyone really wants, cash?

To avoid the impression that they’re giving the banks money, we assume. Repeat after Mr Darling: this is not a bail-out. This is lending. This is an attempt to “unbung” the banking system, he told Andrew Marr on Sunday. [Fast forward to the 38th minute, after Plaid Cymru, George Osborne, Jeremy Irons and Billy Bragg have had their say].

So instead the banks are to be offered £50bn of short-dated government bonds, in exchange for their mortgage-backed securities. The latter will be handed over to the Bank of England for up to three years, at a “haircut” designed to compensate the central bank for the risk it is taking on and protect it from falling house prices and future declines in the value of these securities.

How does this compare to facilities in the US? The TSLF, which similarly offered Treasuries for ABS, was shorter dated at 28 days and directed specifically at primary dealers. In the general rush by banks for funds, that facility has been notable for the soft demand it has drawn. The UK variant in offering the facility for three years may generate more room for manoeuvre.

There’s an element of smoke and mirrors here. In offering gilts for RMBS rather than cash, argues Willem Buiter, the authorities are introducing an unwelcome lack of clarity. Those banks that find themselves with excess gilts can sell them on, either to other private parties with excess liquidity, or more likely to the Bank itself.

The banks can effectively force the Bank of England to buy their excess gilts, because the Bank of England is committed to keep the overnight rate in the interbank market close to the official policy rate….By acting to reduce their reserves with the Bank of England (because they have liquid government securities coming out of their ears) the banks will put upward pressure on overnight rates. The Bank of England will have to offset this (as they try to peg that rate at the level set by the MPC) , and it will neutralise the effect on the overnight rate by making collateralised loans to the banks.

The government has broadly indicated that it will expect such generosity to be matched by better disclosure of losses by the banks, a process it could usefully start by detailing at what discount the Bank of England will be taking securities off the institutions’ hands.

Suggestions that £50bn will save the housing market is on the face of it laughable. Reports that there may be a further £100bn forthcoming doesn’t do much more to inspire confidence. But this is all about making everyone think the housing market is saved, whether or not that would in fact be a good thing.

To get things moving these would need to be genuinely new funds. It remains unclear to what extent, if at all, the bank will reduce funds going into the system through other channels.

Moreover, the banks would need to start lending. But the government only wants banks to lend correctly - in the appropriate, responsible way. They want banks’ new-found flexibility to be directed towards prudent, deserving homebuyers, especially those politically appealing first time buyers.

They are unbunging, not offering up cheap funds for new business exploits. So there’s a cut-off date likely for the securities that the banks can pledge to the new facility. In reality, notes Robert Peston, the big banks that have access to this standing facility will need to be cajoled to share the goods, with their smaller, cash-constrained comrades, and the general public.

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