Bank of England unveils plan to crack the credit crunch

14 April 2008

The Bank of England has confirmed plans to pump £50 billion into the British banking system to allow lenders to temporarily swap mortgage-assets for government bonds.

Despite the proposal being leaked to the media last week, the central bank has only this morning unveiled details of the scheme.

For the next six months only banks will be able to swap “high-quality” assets, such as mortgage debt, for Treasury bills for up to three years.

It is hoped that once these assets have been moved off their balance sheets, banks will see their financial positions strengthened, enabling them to increase their lending to consumers and other financial firms.

There have been criticisms that the scheme is simply bailing out banks, and puts taxpayers’ money at risk. However, the Bank of England says responsibility for any losses on loans stays with the banks.

Mervyn King, governor of the Bank of England, says: “The Bank of England’s special liquidity scheme is designed to improve the liquidity position of the banking system and raise confidence in financial markets while ensuring that the risk of losses on the loans they have made remains with the banks.”

The scheme – which is only available for the next six months - will allow banks to swap their assets for a year, with the option to renew the deal for up to three years.

However, the deal will not be free. Banks who take advantage of the scheme will have to pay a fee based on the interbank rate of interest known as Libor. This is currently around 0.89% over the Bank of England base rate making it expensive for banks to fund new lending.

In addition, banks will not be able to use the scheme to finance new lending, and will only be able to swap assets that were already on their balance sheets at the end of 2007.

The Council of Mortgage Lenders, which represents British mortgage lenders, has said that any move to allow banks to swap mortgage assets for bonds is to be welcomed. But it has also warned that this does not offer a “silver bullet solution”.

Simon Denham, managing director of Capital Spreads, has also questioned whether the scheme will be enough to bring confidence back to the housing market.

To avoid banks being stigmatised by drawing on this new facility, the Bank of England will not reveal which institutions it has lent money to until the six month period is over. However, smaller building societies and specialist lenders will not be allowed to make use of the scheme.

Simon Ward, chief economist at New Star, says the scheme is unlikely to reduce the reduce gap between interest rates and libor.

He also criticises the "penal" fee structure of the scheme: "The relatively restrictive nature of the scheme suggests the libor-bank rate spread will remain elevated and the onus will be on the Bank's Monetary Policy Committee to bring market rates down via further cuts in its bank rate. 

Ward also warns that some banks may have agreed to participate in the scheme in order to reduce the stigma for their peers. 

Will this make mortgages cheaper?

The aim of the scheme is to help banks reduce their mortgage rates by offering them access to funds not currently available from private firms. In theory this should bring down the rate of Libor and enable lenders to reduce mortgage rates or at least not continue to increase them.

But the proof will be in the pudding. The Council of Mortgage Lenders says the scheme will not make mortgages cheaper.

Its director general Michael Coogan says: “Further details are also awaited on how much of the additionalliquidity might be recycled responsibly into mortgage products orpricing, so that lenders can bridge the gap between how much consumerswant to borrow and how much funding is available this year.

“The recent trend of mortgage products being removed and mortgageprices increasing for new customers will be affected more by how LIBORresponds to the announcement.

"The improved liquidity is unlikely toreverse the trend to higher mortgage costs we have seen in recentweeks.”

Impact on taxpayers

Although the Treasury is putting up the money to allow the Bank of England to roll out this scheme, it shouldn't cost taxpayers any money because the banks will be forced to take responsiblity for any money they borrow.

In addition, banks exchanging mortgage assets for bonds will do so at below market value - so any falls in the value of assets should be offset.

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