Bringing liquidity back to the market

Allowing banks and societies to swap a range of asset-backed securities for bonds is a good idea and should ease liquidity constraints.

The proposal aims to provide liquidity and doesn’t transfer credit risk, so the howls about poor value for taxpayers are baseless.

For a start, banks are using securities backed by mortgages and credit card loans as collateral, not the underlying assets themselves. Only the most creditworthy ones are eligible and even they will be discounted.

Even if the underlying assets deteriorate banks will still be liable for the full amount they borrow from the Bank of England.

The BoE’s plan will see banks and building societies swapping illiquid assets for liquid ones. Right now asset-backed securities are difficult to value so are held in low regard by investors. This has slowed down the circulation of money through the banking system and LIBOR has spiralled as a result.

The plan is designed to enable banks to park illiquid assets for up to three years, access increased liquidity in the interim and then resume normal treasury operations once the market improves.

The best-case scenario is that banks and societies will recover sufficient liquidity through the scheme to resume normal lending practices. This will stimulate the economy and avert a recession. The worst-case scenario is that house prices and mortgage performance will continue to deteriorate over the next three years so banks will fail to recover.

When they come to repay their BoE loans they’ll find that the collateral underpinning them has fallen further in value.

As a result they will have to find more cash from their balance sheets to repay them, further weakening themselves in the process.

The worst-case scenario is unlikely to happen as it would imply a severe recession lasting several years. Fundamentally the UK economy remains relatively strong – even the International Monetary Fund suggests it will grow by 1.6% this year and next.

The key point is that the proposal aims to combat the liquidity crisis and is not designed to resuscitate the mortgage market. The latter may be a byproduct of the former but it is not guaranteed.

House price rises of recent years are unsustainable. As prices fall net lending is likely to decline even if transaction volumes hold up.

Those who see the BoE scheme as a panacea for the mortgage market’s ills will be disappointed. Belts should remain tight, costs low and credit risk controlled until the improved liquidity has a chance to make an impact.