Why are taxpayers footing the bill for banks’ losses?

The government has unveiled details of its second banking bail-out scheme, which will see the Treasury take a proportion of toxic debt off banks' balance sheets, technically insuring firms against future losses.

The Asset Protection Scheme, which was first announced back in January, also has its first participant in the form of Royal Bank of Scotland. The bank announced it would take part in the scheme as it published its financial results, which revealed losses of £24.1 billion last year - the largest annual loss in UK corporate history.

RBS plans to put £325 billion of bad debt into the Treasury’s scheme. Although the bank will bear its first loss - of £19.5 billion – any subsequent losses will be shouldered 90% by the Treasury and 10% by RBS.

The Asset Protection Scheme aims to boost bank lending by shifting their losses onto the Treasury – and therefore the taxpayer. But what will you get in return?

Well, for a start, the premise of the scheme is to help banks free up funding. By offering security against future losses, the government hopes banks like RBS will be more able, as well as willing, to increase their lending.

The Treasury says the scheme will: “[…] remove continuing uncertainty about the value of banks' past investments, cleaning up banks' balance sheets, and providing them with greater confidence to rebuild and restructure their operations and increase lending in the economy.”

Banks must pay a fee to access the scheme – they will also have to enter a legally binding agreement to increase the amount of lending they provide to homeowners and businesses.

In the case of RBS, around £25 billion of new lending will be made available over the next 12 months. Of this, £9 billion is likely to be channelled to consumers via RBS' mortgage lending arms while £16 billion will be made available to businesses.

An additional £25 billion will be released in 2010.

However, RBS says the new funding will only be available to homeowners and businesses that meet its current “credit and pricing criteria”.

Stephen Hester, chief executive of RBS, said in a statement: "Participation in this scheme would assist us in reducing risk for shareholders while providing greater support for UK customers via increased lending. It would provide increased certainty to the market by limiting potential losses on a significant proportion of our balance sheet."

This is not the first move the government has made to force banks in which it has a financial interest to open their doors to new custom. Just days before RBS announced its participation in the Asset Protection Scheme, Northern Rock revealed that it plans to increase the amount of mortgages it lends by £14 billion by 2011, with £5 billion this year alone.  
The decision to step-up lending at Northern Rock marks a clear reversal from the reasoning behind taking the troubled bank into state ownership in the first place. Following its £27 billion nationalisation, Northern Rock was ordered to reduce its mortgage business by 60% and start paying back the taxpayer. 
Gary Hoffman, chief executive of Northern Rock, said new and existing customers of the bank will benefit from the plans. It is estimated that £14 billion of new lending could finance the sale of more than 126,000 properties.

Hoffman added the move is an "important step" in returning Northern Rock to financial health and, ultimately, the private sector.

Lloyds Banking Group, which the government has a 43% stake in, is also expected to participate in the Asset Protection Scheme. It is due to publish its financial results on 27 February, and is expected to confirm a £10 billion loss. 

Current state of the mortgage market

The latest Nationwide house price index shows that prices fell by 1.8% in February, meaning property values have plummeted by 17.6% in the past year.

Fionnuala Earley, chief economist at Nationwide, says the price of a typical house is now £147,746, down from £179,358 this time last year.

While lower house prices do appear to be sparking interest among cash-rich investors as well as potential buyers, restricted access to mortgages continues to act as a barrier to homeownership.

“Sharp cuts in interest rates have helped affordability, but have not yet affected housing market confidence sufficiently to boost the levels of new transaction activity or slow the pace of house price falls,” explains Earley. “Early signs of increased interest in housing, as reported by the pick up in new buyer enquiries, have yet to filter into sales, but do suggest that falling prices and interest rates are raising curiosity now, which could flow through quickly once confidence returns.”

On the plus side, falling inflation, lower house prices and interest rate cuts are helping to improve affordability.

Earley says a typical first-time buyer at the end of 2007 would have paid about £150,000 for a property, borrowed about 90% of the value and paid an interest rate of around 6%, depending on the type of loan chosen. The monthly outgoing would have been about £915.

“Today the fall in house prices and mortgage rates means that outgoing would be around £530, if the buyer qualified for one of the best tracker deals of 3.99%,” she says.

But there is one major factor holding people back from borrowing: deposits. In Earley’s scenario, the borrower would have to raise a deposit of over £25,000.

Without such a deposit, the cost of the loan would increase. However, Earley calculates that a fixed-rate at 90% would still cost £167 less than at the end of 2007, even though the fixed rate is higher. This is due to the fall in house prices, which also means these borrowers can put down a smaller deposit. 

Attracting first-time buyers back into the market would be a big step in getting the housing market moving again. While Earley says affordability is improving among this group of buyers, other research suggests there is still some way to go before we see the return of the first-time buyer.

According to data provider Moneyfacts, rates on fixed-rate mortgages are as much as seven times the Bank of England base rate (currently 1%), providing little incentive for new borrowers to get on the first rung of the ladder.
Although most first-time buyers opt for fixed deals, variable-rate mortgages only fare slightly better, with rates still up to 300 basis points above the base rate.
Michelle Slade, an analyst at Moneyfacts, says: “First-time buyers are meant to be the life blood of the property market, but with the average rate as high as 7.02%, there is little incentive for them to step onto the first rung of the ladder.
“Prior to the credit crunch, the difference in the average rate on fixed rate mortgages for those with a 5% deposit and a 35% deposit was just 0.30%. Today the gap is 2.18%.”

As part of its deal to step up lending, Northern Rock confirmed it was looking at re-introducing deals of up to 90% of a property’s value. However, Northern Rock says 90% mortgages will be available on a very limited scale only. They are also unlikely to be offered to first-time buyers.

Will the Asset Protection Scheme work?

Seema Shad, property economist at Capital Economics, is not convinced that the Asset Protection Scheme will be enough to get the property market back on the road to health.

“Mounting job losses and declining job security mean that, even if the Asset Protection Scheme resolves the issue of tight mortgage credit, weak buyer demand will prevent a sustained recovery in the housing market,” she explains.

“It seems likely that house prices will also continue to fall next year. The upshot of this is that we expect prices to fall 20% this year, and a further 10% next year.”

The aim of the Asset Protection Scheme is to allow banks to offload bad debt from their balance sheets, freeing up funding for new lending. But this won't happen overnight, and as RBS is, thus far, the only bank to participate in the scheme any return to 2007 lending levels is a long way off.

Vicky Redwood, UK economist at Capital Economics, says: "We remain sceptical that [these measures] are enough to get the economy back on its feet again. For a start, how can anyone be sure that all of the banks’ toxic assets have been guaranteed? The Asset Protection Scheme may therefore fail to restore full confidence in the banks or to solve the lingering problems in the interbank lending market."

Even once banks like RBS start to increase the amount they lend, it is not clear how much power this will have to rescue the economy from the clutches of recession. The global downturn, rising unemployment and possibility of deflation all pose major risks for the UK; so, while making more money available in the form of mortgages and business loans will help, it is not a solution to the overall problem.

In total, the latest government measures should increase new lending by between £45 billion and £50 billion per year both in 2009 and 2010, according to Capital Economics. This is equivalent to just 3% of overall bank and building society lending to firms and households.

Even with more credit available, there is no guarantee that people will want to access it; a lack of consumer confidence in house prices and fears about job security continue to act as barriers to homeownership, alongside a lack of available credit. 

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