Leapfrogging Ben
Because the US economy is the world’s largest, and the US’s financial system the world’s most complex, the big first move in resolving the global credit gridlock had to come from the US – and, as I posted in banking on value, the US took that step, as I explained at length, over the long Saint Patrick’s Day weekend.
A month later, the Fed’s move attracted a key follower: the Bank of England, as reported recently in The Economist:
It’s easy once you’ve shown me how
A lifeline for banks
Apr 24th 2008
Helping to keep bankers afloat
The Bank of England’s bold initiative should calm frayed financial nerves
Nice to see they agree with me J.
EVER since the money markets capsized last August, top bankers have criticised
Have you completed your financial reforms, young man?!?
Since our current situation is unprecedented, journalists and commentators have a tendency to measure its severity by reaching ever further back in time. Most of us agree it’s long since worse than 1990, probably worse than 1974. Since very few of us were alive in the Great Depression, our comparative yardsticks are rhetorical.
Not happening yet
In any case, it’s bad.
Now they no longer have cause to grumble. The Bank of England has taken a decisive step to restore confidence in the banking system. The “special liquidity scheme” launched this week puts
“Honorable members, it’s a really big facility.”
Although some have called the plan, which is likely to provide banks with at least £50 billion ($100 billion) of extra liquidity, a “bail-out”, Mervyn King, the Bank of England’s governor, rejects that charge.
It’s not a bailout without a parachute, is it?
The initiative is a modern version of the time-honoured central-banking practice of ensuring that solvent banks do not trip up in troubled times for want of ready cash.
The Bank’s facility is simply the sovereign-lending equivalent of what are known as Tender Option Bonds (or TOBs), in which Merrill Lynch (among others) specialized. For reasons nobody quite understands – but definitely have to do with consumer confidence, and quite possibly due to fears about the creditworthiness of the TOB counterparty – yield spreads on TOBs widened dramatically in January and have stayed wide.
Into this void, and prompted by the Fed’s action, leapt the Bank of England, substituting its sovereign credit for that of private investment banks.
The need for the Bank of England to reinterpret [its] sacred text[s] has been apparent for several weeks. A telltale sign of the continuing distrust in and among banks has been the elevated interest rate at which they lend to one another for three months. This LIBOR rate, off which much lending is priced, is normally close to the central bank’s base rate. The gap widened extraordinarily when the financial shock started last August (see chart).
The
There’s a possibility that LIBOR was being manipulated to generate artificially wide spreads.
What’s it doing above the Bank’s rate, anyway?
It seemed remarkable to me, but if true, those doing it are guilty of economic treason.
“Here’s the LIBOR spreads, captain Andre”
After falling back at the start of this year, the spread has recently opened up again.
The “special liquidity scheme” is similar to the $200 billion “term securities lending facility” which the Federal Reserve announced on March 11th.
As I posted at length in Anatomy of a Coup, the Fed’s action is bold, revolutionary, and I believe irreversible.
Like the American scheme, it involves the central bank swapping easily tradable assets for illiquid assets that the banks are holding.
I get, you get
In other words, banking on value.
The British facility will let banks swap mortgage-backed and other securities for bills issued by the Treasury. But three features of the British scheme make it more ambitious than its American counterpart.
Go ahead, John, one-up me
1. There is no cap on its size; and the expected initial take-up of £50 billion will be bigger, given the relative size of the two economies, than
2. The asset swaps will not be provided through weekly auctions, as in
3. The swaps will be much longer than the Fed’s, which extend for just 28 days. Instead they will last for a year and indeed, after renewal, for as long as three years.
The Bank of England has thus leapfrogged the Fed’s action.
Don’t be such a tomato, it’s easy to expand credit!
Taxpayers are at risk, but there are several safeguards to protect them.
Let us count the ways.
Only high-quality securities will be accepted.
Good collateral are securities that have value even if not resold; they can be farmed even if it can’t be sold.
A fee will be charged.
If you charge people for a facility, they will use it only when they need it. So the facility will sunset.
Banks will get less back in Treasury bills than the value of the assets they are swapping. For example, a bank offering mortgage-backed securities would receive roughly between 70% and 90% of their worth in Treasury bills.
The Bank of England is thus replicating the sound loan-to-value (LTV) principle used in Tender Option Bonds. They’re not reinventing the wheel.
We thought it up all by ourselves!!
[The borrowing bank] would have to provide more assets or return some of the bills if the value of the securities then fell.
This feature – a commitment to swap in good collateral for loans that go dodgy – is a common make-whole or collateral-substitution provision also adopted from Tender Option Bonds.
Taxpayers will have to pay up only if [x] a bank defaults and [y] the central bank has incurred losses on its swaps.
This is very unlikely, since the TOBs are backed by low-LTV collateral.
In short, the Bank of England has leapfrogged the Fed’s lead and extended the amount, term, and durability of the TOB-type swaps.
Ah kin out-jump you, Ben
This is a lot of liquidity, and should ease the pressure on British banks.
The Bank of England has deliberately limited the assets eligible for the swaps to those existing at the end of 2007, which means that the facility cannot be used to finance new lending.
Limiting the TOB to loans already made reduces the risk of moral hazard – except for the fact that the Bank’s move creates an economic policy precedent to be cited in future crises.
Thus the bank’s facility is well named: it doesn’t expand lending volume, it simply provides liquidity to banks that have substantial assets and too little cash.
To increase liquidity, squirt goop
It eliminates the risk of execution on certain collateral. As such, it’s a stopgap, and it should work to restore liquidity and lender confidence. By itself, however, it won’t loosen up mortgage financing:
The Bank of England’s scheme is designed to underpin the banking system, not to prop up the housing market. The quid pro quo expected of bankers is that they strengthen their balance-sheets.
Build up those balance sheets!
They must write down losses realistically and boost their capital (see article). Painful though this will be, it is an essential part of rebuilding the financial system.
Although no explicit deal has been struck, the banks will clearly have to play a part now in resolving the financial crisis. But their side of the bargain will not entail steps to ease conditions in the mortgage market, [despite what] Alistair Darling, the chancellor of the exchequer, has suggested.
Banks and building societies have been toughening the terms on which they extend new home loans and refinance old ones because they are recognizing risk that they had underestimated before.
With the risk curve still being repriced, we’ve now heard from the
Will Trichet be next?
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