Can the Mortgage Bailout Revive Credit Markets and the British Pound?

Source: Daily FX

Over the past eight months, the global credit market has been roiled by the subprime meltdown in the US. However, until recently, many had considered the problem largely isolated to the US financial markets. This theory has been summarily disproved though as the contagion has clearly spread to the economies of both industrial powerhouses and emerging markets. And, in the wide-spread devastation, no economy seems to be as vulnerable to a sustained credit crunch as the UK.

The nation’s housing market is already suffering its worst downturn since the last recession and the financial sector has been riddled with massive write downs. With the consumer and general economic growth the next dominos to fall, policy officials have finally stepped in to unfreeze the credit market and avert a possible recession by offering to swap bank’s government bonds for their mortgage-linked securities. Will this plan thaw credit markets or is this move too little, too late? That likely depends on the details of the plan.

The Special Liquidity Scheme
Dubbed a ‘Special Liquidity Scheme’, the central bank’s planned liquidity injection is similar to recent policy operations in the US. In the plan, devised by the Bank of England and Treasury (and further backed by the Government), the central bank will temporarily swap high quality mortgage-backed assets for UK Treasury Bills (often referred to as Gilts). Theoretically, this would reassure the markets as to the solvency of both lenders and borrowers and encourage the regular movement of money once again.

However, the overall effectiveness of this plan and its burden on the taxpayers really relies on the proposed details. According to the BoE, there are three key features to this scheme:

1. Swaps are Long Term: The first element is that each asset swap will be for a relatively long term. Each swap will last for the period of one year and may be renewed (at the bank’s discretion) for each year for an additional two years. This point alone will be essential as the credit market crunch will not likely be worked through over the 28-day term that the Federal Reserve makes its TSLF loans for.

2. Banks Keep Losses: The second, highlighted point is that the risk of losses through the loans will remain with those banks that swap their securities for gilts. This aspect of the loan is specifically tailored to protecting the government and taxpayers’ money. The guarantee that the swap provides comes from the public coffers as the government will hold the far more risky mortgage-backed assets. In essence, this will ensure that the BoE is helping stabilize the financial markets without condoning the moral hazard of taking too much risk and encouraging a similar situation in the future.

3. Debt Only Up to 2007: The final point looks to boost the effectiveness of the scheme while simultaneously avoiding the unwanted effect of encouraging excessive risky lending. Policy officials will only allow swaps on assets that were existent at the end of 2007. No assets taken after that point can be used as collateral. This will ensure that banks won’t finance new lending with the lending facility; and instead, the scheme will be aimed specifically at helping unfreeze the credit market.

A Flawed Plan?
Every plan has its faults; and this one happens to have many. Perhaps the greatest shortfall to this proposal is its estimated size. While the Bank of England has not offered a definitive number on how much monetary relief they will offer liquidity-starved banks, they have forecasted a ball park figure of £50 billion. This is a meager figure considering the size of the UK credit market. Furthermore, since the discount window will be open for six months, this sum could be spread rather thin. What’s more, considering the credit market freeze is a global problem, policy makers will have to have an impact on global confidence to truly make a difference. The estimated limit will no doubt be hit relatively soon; and the BoE’s commitment to saving the market will depend on their willingness to expand their lending efforts.

Another major stumbling block for the liquidity scheme is found in the effort to limit the central bank’s exposure to risk in the swap. The BoE’s insistence that only assets that were held in the bank’s book before the end of 2007 will do its part in preventing risky, speculative lending going into the future. On the other hand, banks can secure their old, hard to value loans and still take on additional risk going forward – essentially funding future speculation. And, looking more closely at the details of the plan, this may actually be the least oppressive clause. Another issue is that the BoE will swap for only high-quality assets including the AAA-rated UK and European residential mortgages. The true problem for the credit market are those assets that have lower ratings and are therefore more risky and harder to valuate. The most threatening issue through is the hair cuts (fees charged for the swap) banks will have to take on the lending. Lending rates will run between 12 and 22 percent. In addition, the bank’s will need to provide assets with significantly greater value than the Treasury Bills at all time and they will need to provide more when the value of their collateral falls. Not only will this be a great expense, it will carry a stigma with it that may discourage bank’s from seeking help as it could be a signal to the market that the firm is in trouble.

A Global Problem
Looking beyond the confines of UK financial markets, we need to remember that the credit crisis is a global issue. As suggested above, the liquidity scheme has to contend with unfavorable lending conditions the world over. As such, even if British banks find comfort in the swap, it may still be difficult to price risky assets and cross-boarder lending will still be essentially frozen. This point is characterized particularly well through the failure of other central bank’s efforts to revive lending through their own liquidity injections. The Federal Reserve has steadily increased its own auction facilities to the current $200 billion TSLF plan while adding the condition that mortgage-backed securities and other so-called ‘toxic’ structured debt could be used as collateral. The ECB has been even more accommodative by recently extending its loans to a six-month period; and they have always allowed mortgage-backed assets as a guarantee.

Conclusion
Moving forward, the Bank of England’s efforts to restore lending may only be a drop in a very big bucket; but the help is certainly needed. The United Kingdom’s economy has already been roiled by the credit crunch; but conditions could get much worse. While the housing market has already slumped and financial services have been brought to the edge, the consumer has been relatively resilient. However, considering Britian is the most indebted nation in the world with household debt totaling £1.19 billion and 84 percent of GDP (compared to 75 percent in the US), the economy and pound could be wracked be the next leg of the credit meltdown. On the other hand, a return to confidence could be just as contagious as the fear that froze the market; so traders need to keep aware of the appetite for risk and the health of the credit market.