Tuesday, April 29, 2008

Some further thoughts on the Bank of England’s Special Liquidity Scheme

(Willem Buiter at the FT) Tim Young makes three interesting comments on my blog on the Bank of England’s Special Liquidity Scheme:

(1) The Treasury bills involved are of nine months original maturity, not one year.

(2) In the event that the borrower defaults, the public sector gets stuck with a loss if the value of the collateral is less than the value of the t-bill loan, even if the issuer of the securities posted as collateral does not default. Presumably this is much more probable than a simultaneous default, especially if the borrower is widely known to be a holder of such securities.

(3) US mortgages are not in general non-recourse.

As regards Tim’s first point, the Bank of England Information sheet states: To provide banks with the certainty about liquidity that is needed to boost confidence, assets will, unless they mature within one year, be swapped for one year and banks will have the opportunity, at the discretion of the Bank of England, to renew these transactions for a total of up to three years.” In the Market notice for the SLS, it says that “The Bills lent under the Scheme will be for an original maturity of nine months and will have been created within the month preceding the drawdown. Bills must be delivered back to the Bank 10 days prior to their maturity and will be exchanged for a further 9-month Bill.” So Tim is correct. Although the banks will be provided with liquidity through Tbills for a year, the Tbills that are issued as part of the initial swap of Tbils for MBS will have an orginal maturity of nine months. These Tbills will be swapped 10 days before maturity for further 9-month bills, which will be held by the banks for no more than 4 months before the MBS swap reverses (unless the scheme is extended, as is likely).

As regards your second point, the Bank of England Information sheet states, in a section headed (ii) Credit risk stays with the banks: “….the Scheme is indemnified by the Treasury but is designed to avoid the public sector taking on the risk of potential losses. That risk will remain with the banks and their shareholders. The assets are pledged by banks as security against which they will borrow the Treasury bills. When a swap transaction expires, the assets are returned to the banks in exchange for return of the Treasury Bills.”

I interpreted the statement that “The assets are pledged by banks as security against which they will borrow the Treasury bills”, as meaning that the transaction was a collateralised loan of Treasury bills, where the lender of the Treasury bills (the Bank of England) has recourse to the borrower (the bank) and to the collateral. In that case the risk to the Bank of England would indeed be the risk of the joint default of the borrowing bank and of the issuer of the collateral offered by the bank. This interpretation was supported by the Bank of England’s News Release on the Special Liquidity Scheme . The News Release and the Information sheet also makes the separate point that “If the value of those assets were to fall, the banks would need to provide more assets, or return some of the Treasury Bills. And if their assets pledged as security were to be down-rated, the banks would need to replace them with alternative highly-rated assets.”

However, some recent discussions with Helen Parry of Complinet.com have convinced me that Tim may well be right, and that the so-called swap does in fact shift the default risk on the illiquid bank assets to the Bank of England, without recourse to the borrowing bank. The swap is technically/legally a customised stock lending agreement. In a note on the issue, Helen writes: “Officials at the Bank of England have confirmed that this is the case. Furthermore, while officials at the International Stock Lending Association have indicated that the contractual terms differ in some respects from the standard terms to be found in the ISLA Global Master Securities Lending Agreement, the agreement does provide for the fact that title to the borrowed securities passes to the borrower. This is the normal provision in a stock lending agreement. This means that the title to the illiquid securities will pass to the Bank of England.”

If Tim’s and Helen’s interpretations are correct, the language used by the Bank (and also by the Treasury, as is evident from the Chancellor’s statement to the House of Commons on 21 April 2008) are misleading, to say the least. The assertion by the Chancellor that This means that the banks will continue to hold the risk on the securities they provide, so it is them rather than the Bank of England that will be exposed to any fall in value.would be the exact opposite of the truth.

I look forward to further enlightenment on the issue.

As regards the third point, Tim is right again. While most first mortgages in the USA are non-recourse, this is not true for all states, and it is also generally not true for second mortgages.[1]

[1] From Wikipedia, “nonrecourse debt or non-recourse debt or nonrecourse loan is a secured loan (debt) that is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable. If the borrower defaults, the lender/issuer can seize the collateral, but the lender’s recovery is limited to the collateral”.

(Comment from David Rule, ISLA) I do not know the terms of the legal agreement that the Bank of England is using. But the interpretation of a standard securities lending transaction (eg under the Global Master Securities Lending Agreement) above is incorrect. In such a transaction, legal title over the mortgage-backed securities (the Collateral) would indeed pass to the lender (in this case the Bank). But the lender has a contractual claim on the borrower (in this case the commercial bank) to deliver Equivalent Collateral if the value of the Collateral falls below that of the Loaned Securities (ie it does have recourse to the Borrower). If the Borrower defaults, obligations are accelerated and the current market value of the Collateral is set off against the current market value of the Loaned Securities so that one party has a net claim on the other. In this way the lender will only lose money if the borrower defaults and the value of the Collateral falls below that of the Loaned Securities.

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