Monday, April 21, 2008

Bank of England Swaps Bonds to Revive Bank Lending (Update6)

By Jennifer Ryan and Brian Swint

April 21 (Bloomberg) -- The Bank of England offered to swap government bonds for mortgage securities to kick-start bank lending, with Governor Mervyn King pledging to meet demand even if it exceeds an estimate of 50 billion pounds ($100 billion.)

``There is no arbitrary limit on this so it could well go higher,'' King told reporters in London today. He said the plan aims to restore confidence to the banking system and the most important aspect of the scheme is that ``everyone needs to know this is there for them to access as needed.''

The banks will retain responsibility for losses from the assets they loan to the Bank of England. The swaps will be for a period of one year, renewable for up to three years. Only assets existing at the end of 2007 can be used in the swap.

The measures, backed by Prime Minister Gordon Brown's government, mimic a similar swap of $200 billion of securities by the U.S. Federal Reserve last month. Policy makers are attempting to encourage lending after a surge in borrowing costs prompted British institutions to withdraw their best mortgage offers, threatening to exacerbate the worst housing downturn since 1992.

``We will make sure there is enough liquidity in the economy to make sure people can buy their own houses,'' Brown said in a speech today in Inverness, Scotland. ``We can get markets working again in a way that we can ensure that jobs.''

U.K. government bonds rose and the pound fell after the announcement, which some economists said leaves the way open for the Bank of England to cut interest rates again to stave off an economic slowdown.

Market Reaction

The pound fell to $1.9825 by 11:20 a.m. in London, from $1.9979 at the end of last week, when it climbed 1.5 percent. Gilts rose, depressing the yield on two-year notes by 6 basis points to 4.27 percent. The central bank cut its key rate three times since December to 5 percent.

``Our guess is today's measures will help spreads to normalize'' between market lending rates and the bank's benchmark, said Peter Dixon, an economist at Commerzbank AG. That ``will allow the Monetary Policy Committee to use interest rates to tackle economic issues rather than market problems.''

The plan is a change of approach by the Bank of England after its interest-rate cuts failed to ease the logjam. The European Central Bank, the first central bank to react to the credit crisis in August, has extended the maturity of money auctions to help cash-strapped institutions.

The swap is double the value of loans King extended in September to prop up Northern Rock Plc. The government in February nationalized the mortgage lender, the first U.K. bank to fall victim to the credit freeze stemming from the collapse of the U.S. subprime market.

BBA Reaction

``The collateral swap arrangement is an innovative and unique policy response,'' the British Bankers Association said in a statement. ``The banks are participating in this arrangement and expect it to make a significant contribution to alleviating the pressures in the U.K. money markets. Restoring confidence in the wholesale funding market will strengthen the financial system and the stability of our economy.''

European banks sold 25.7 billion euros ($41 billion) of mortgage-backed securities so far this year, down from 91.2 billion euros in the same period last year, according to Deutsche Bank AG.

Investors are demanding yields as high as 155 basis points above the interbank lending rate to hold the top-rated bonds backed by U.K. mortgages, up from 65 basis points at the end of last year, according to Dresdner Kleinwort on Friday. Bonds backed by U.K. credit cards are trading at about 205 basis points, up from 80 basis points at the end of last year.

`Right Thing to Do'

``If we didn't do this there was a risk that the situation would have become worse,'' Chancellor of the Exchequer Alistair Darling said today in an interview with Sky News. ``This is the right thing to do to stabilize the situation. At the moment there is little or no market for assets backed by mortgages.''

Darling will speak to Parliament in London about the decision at 3:30 p.m. today. Darling will meet members of the U.K. Council of Mortgage Lenders tomorrow, aiming to agree measures to help borrowers who fall into arrears on loans.

The banks will be able to enter into a swap at any time over the next six months. Assets that can be used must have the top AAA ratings. They will include mortgage debt and credit card debt. ``Raw mortgages'' and derivatives are excluded.

``The length of these transactions will provide banks with the certainty about liquidity that is needed to boost confidence,'' the bank said in a statement.

Plan Goals

The central bank's move allows financial institutions to add government bonds to their inventory of liquid assets and make it easier for them to both raise cash and lend, especially to consumers seeking home loans. In return, the government will hold the riskier mortgage-backed assets as security.

``With markets for many securities currently closed, banks have on their balance sheets an 'overhang' of these assets, which they cannot sell or pledge as security to raise funds,'' the bank's statement said. ``Their financial position has been stretched by this overhang, so banks have been reluctant to make new loans, even to each other.''

To date, the Bank of England has widened its collateral requirements just for three-month lending. It accepts only top- rated government securities at its weekly auctions.

The bank said the public is exposed to a loss only if a lender participating in the program defaults and the assets they have placed with the central bank are insufficient to cover the value of the Treasury bills in the swap. That's why the bank is asking for collateral of greater value than the Treasury bills it lends.

`Punitive' Measures

``The BOE's actions do seem to be quite punitive, in that there is a significant haircut and there's a fee against the libor,'' said James Nixon, a director of Societe Generale SA in London. ``The sense yet again from the Bank of England, is that it will provide an absolute backstop to the financial system, but won't make any effort to ease the market's liquidity.''

The U.S. Federal Reserve last month made up to $200 billion available to banks in return for debt including mortgage-backed securities. The European Central Bank, the first central bank to react to the credit crisis in August, has extended the maturity of money auctions to help cash-strapped institutions.

Former Bank of England policy maker Willem Buiter, now a London School of Economics professor, said on April 18 the plan's success ``all depends on the scale.''

Size Matters

``In total, they would have to do -- not in one big go --at least 100 billion for it to really actually make a difference to the liquidity position of banks, but also act as the catalyst for getting that market going again,'' he said.

The risk is that a slide in house prices worsens, undermining support for Brown's government. Mortgage lenders including HBOS Plc and Lloyds TSB Group Plc have raised the cost of loans, even after three, quarter-point rate cuts by the Bank of England to 5 percent.

House prices dropped 2.5 percent in March from a month earlier, the biggest drop since 1992, HBOS, the country's largest mortgage lender, said April 8. Brown's approval rating dropped faster than for any U.K. leader on record as support for the opposition rose to the highest in 16 years, a poll published on April 13 showed.

``It might just free up a bit more liquidity,'' Simon Rubinsohn, an economist at the Royal Institution of Chartered Surveyors, said in an interview on Bloomberg Television. ``It's not going to turn things round in the housing market.''

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