Monday, April 21, 2008

Helpful but... the SLS verdict

(FT Alphaville) Salvation is not yet upon us. The much-heralded Great Unbung of the UK banking system got a lukewarm reception on Monday.

The terms are arguably tougher than the banks were expecting.

Banks will be charged a fee equal to the spread between three-month Libor and the three-month general collateral repo rate. The latter, which involves the temporary exchange of cash for gilts, should be close to risk-free rates on gilts of a comparable duration. So the fee paid by banks should narrow as Libor, hopefully, returns towards risk-free rates. The cut off spread of 20bp is about where Libor would normally sit, versus the 90-odd basis points at which it’s been stuck. In opting for a spread over the GC repo rate, rather than the base rate itself, the Bank has maintained a market risk element in the spread.

The penalty is contained in the “haircuts” at which the Bank will accept ABS collateral. They are, exclaimed one analyst on Monday, HUGE.

Remember these are all triple-A rated securities. But a residential MBS, say, that’s floating rate or that’s fixed with less than 3 years to maturity will get a 12 per cent haircut. Then there’s the extras: 3 per cent more for currency risk when securities are non-sterling and 5 per cent for own name eligible covered bonds, RMBS and credit card ABS.

Crucially there’s also a 5 per cent extra penalty for “securities for which no market price is observable.” That final hit will be imposed on a valuation using the Bank’s own calculation and “the Bank’s valuation is binding.”

The central bank isn’t giving lenders much leeway here - with the gap between the amount borrowed and the value of collateral ranging from 10 to 30 per cent. That’s rather more than under the Bank’s recent three-month lending programme.

On the upside, say Commerzbank:

This is a clever design feature which, by raising the cost of borrowing well above lending rates, should prevent institutions from borrowing from the BoE in order to conduct new lending and serves to emphasise that the package is a “helping hand” rather than a bailout.

Which politically is good news.

But, cautioned another analyst:

The facility is helpful BUT the haircuts make it more onerous than expected for banks to participate. The funding gap remains much larger than this facility.

The spin may be about the housing market. But this is really about the money markets. In tying the fee to Libor, the cost of borrowing against their collateral under the SLS is tied to the banks’ reluctance to lend to each other.

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