Comment on tomorrow’s announcement by the Treasury and Bank of England

The Bank of England and HM Treasury are likely to announce a package to take some illiquid assets off the banks’ balance sheets. It is hoped that this measure will (a) encourage the banks to engage in more mortgage lending to homeowners and (b) will help unfreeze the markets for residential mortgage backed securities (RMBS) that have been dead since last August. The amount involved is rumoured to be about £50 billion, an amount equal to just under half the net home lending in the UK last year, and probably close to the amount of net home lending we will see in 2008 (even with the injection of Treasuries that will be announced).

(1) If the swap involves the exchange of 50 billion pounds of gilt- edged government bonds for mortgage-backed securities rather than the swap of cash (e.g. reserves with the Bank of England) for RMBS, some unnecessary lack of clarity is introduced into the arrangement. Swapping government securities for RMBS is what the Fed does in the US through the Term Securities Lending Facility created for the Primary Dealers (mainly investment banks) who don’t have direct access to the Fed’s liquidity facilities, either at the Fed’s discount window or as counterparties in open market operations.

However, most of the UK mortgage lending banks are eligible for discount window access (at the Bank of England’s standing lending facility) and as counterparties in open market operations. Exchanging the RMBS for cash, either by accepting them as collateral at the standing lending facility or in repos, would only exclude the non-bank, specialised home-loan financing entities, and it isn’t clear that these will be able to access the gilts-for-RMBS swap facility in any case.

By swapping gilts rather than cash for RMBS, the Bank ensures that there is no direct effect of the operation on the stock of base money (banks’ reserves with the Bank of England plus currency in circulation). Of course, the banks, who now find themselves with excess gilts, will sell them, either to other private parties who have pockets of excessive liquidity or, more likely, to the Bank of England.

The banks can effectively force the Bank of England to buy their excess gilts, because the Bank of England is committed to keep the overnight rate in the interbank market close to the official policy rate (Bank Rate). By acting to reduce their reserves with the Bank of England (because they have liquid government securities coming out of their ears) the banks will put upward pressure on overnight rates. The Bank of England will have to offset this (as they try to peg that rate at the level set by the MPC) , and it will neutralise the effect on the overnight rate by making collateralised loans to the banks. Effectively, the banks use the increased amount of gilts they have acquired as collateral for increased borrowing from the Bank of England.

Why do the cash for RBMS swap in two stages: first a swap of gilts for RMBS, then a swap of cash for gilts? Why make things simple when they can be difficult, transparent when they can be made obscure?

The increase in liquidity that will result from this operation is not inflationary, because it is the response of an increase in liquidity preference – an increase in the demand for real base money at a given price level and at a given expected rate of inflation. The increase in liquidity preference is the directly result of the financial crisis we are going through.

When markets normalise again, the additional liquidity injected by the Bank of England will have to be taken out of the system again, because when liquidity preference falls again, the current injection of liquidity will become inflationary.

(2) If the amount is indeed £50 billion a year (with the facility to remain in place for a year), it would be a good start, but by no means enough to have either an appreciable effect on home lending or on the degree of wholesale market paralysis. I expect that, before victory can plausibly be declared, the Bank of England will have injected a further a further £250 bn (gross) over and above what it would have done without the crisis.

(3) Don’t expect home lending to increase by the amount of the operation (£50 billion, say), either compared to what it would have been without the operation, or compared to the just over £50 billion estimate for net home lending in 2008 recently made by the Council of Mortgage Lenders. The ‘additionality’ of the operation can never be verified objectively.

The only things that is certain is that the banks will use the additional £50 billion to do whatever they consider to be most profitable to do, whether that is mortgage lending, corporate lending, building up liquid asset reserves, buying old masters or commodity futures, or engaging in increased purchases of overseas securities.

No doubt the government (I hope not the Bank of England) will solemnly declare that the banks have made a firm and verifiable commitment to use the additional liquidity for lending to deserving homeowners. The banks may well confirm this. No reason not to. It is non-verifiable. An increase in home lending that would bring it back to the 2007 level would in any case be most undesirable. Lending volumes in 2007 still reflected the unsustainable boom and bubble conditions that had turned the housing market and the mortgage markets into lunatic asylumns. £54 billion of net mortgage lending in 2008 would be a perfectly respectable figure, and if house prices fall as much as I expect them to, it will be more than adequate.

(4) It is essential that the illiquid securities the Bank of England will take onto its balance sheet are priced properly, with a generous (to the tax payer) allowance for any credit (default) risk attached to them. The pricing and haircuts (discounts) on the valuation should be in the public domain, so there can be proper accountability.

(5) It won’t be made a requirement for participation in the swap that the banks benefiting from this public support operation desist from dividend payments for a year and commit to a significant rights issue. But it ought to be.

(6) The Bank of England’s business is liquidity, not the management of portfolios of illiquid private securities. It would therefore be desirable for the Bank of England to swap with the Treasury, for gilts, the illiquid securities it obtains in its gilts for RMBS swap with the banks. The Debt Management Office (part of the Treasury) and its portfolio investment unit, the CRND (Commissioners for the Reduction of the National Debt) would be a possible place to park these illiquid securities.

It would make even more sense to leave the Bank of England out of the operation altogether, and instead to have the CRND/DMO/Treasury swap gilts directly for the illiquid mortgage backed securities with the banks, again at a proper, default risk-reflecting discount. No doubt the banks would then swap their liquid gilts for ready cash at the Bank of England (as explained earlier). It would have the advantage of making clear the division of labour between the provision of liquidity, which is the job of the Bank of England, and the bearing of credit risk and the intelligent management of the government’s financial assets, which is the responsibility of the Treasury, on behalf of the tax payer.

But simplicity, clarity, transparency and accountability are Typhoid Maries in politics today. So if tomorrow we are presented with complexity, opaqueness and obfuscation of responsibility, don’t be surprised.


Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website