The Council of Mortgage lenders has made a constructive proposal for reviving the markets for securitising residential mortgages. The response from the Bank of England and the Treasury has been a deafening silence. I believe the Bank and the Treasury are making a mistake.
Legitimate fear of moral hazard should not degenerate into pointless and unnecessarily costly moralizing: they have sinned, therefore they must be punished, even if the punishment goes beyond what is necessary to induce better behaviour in the future.
There is no doubt that in 2005, 2006 and the first half of 2007, mortgage lending in the UK was out of control. There was reckless lending and reckless borrowing. Ludicrous loan-to-value ratios became the norm (no mortgage really should exceed 80 percent of the value of a residential property – ever). Income and asset verification became perfunctory and often degenerated into self-certification. Just as self-regulation means no regulation, so self-certification means no checking and no verification of the borrower’s capacity to handle increased indebtedness. Banks and other mortgage lenders offered ludicrously low interest rates on mortgage borrowing. Borrowers believed that these low rates were part of the New Jerusalem of painless credit. Even today, real interest rates on mortgages continue to be low, even as nominal mortgage rates have risen. Further increases, to ensure normal spreads over the funding costs of mortgage lenders, can be expected.
But the correction since the middle of 2007 has been brutal. New mortgage approvals are at the lowest level ever in a series that goes back to 1987, that is, well before the last great housing market collapse. Turnover in the housing market is likewise at its lowest level since 1987. I am aware that both mortgage approvals and turnover were dangerously inflated prior to the middle of last year. A lot of churning in the housing market may make estate agents and solicitors happy, but does not contribute to economic well-being per se. Some turnover is a necessary condition for labour mobility, but there can be little doubt that just before the bust, growing numbers of buyers were taking out mortgages they were not planning or expecting to service, because they expected instead to be able to sell the newly acquired property at a higher price soon after completing their purchase.
But both turnover and new mortgage approvals now have fallen to excessively low levels. There probably are a number of factors driving this. One of them is unrealistic and inconsistent price expectations on the part of both buyers and sellers. Nothing much can be done about that, other than waiting for time to bring education. I expect prices to fall on average by about another 20 percent or so, bringing the cumulative decline from the most recent peak to around 30 percent.
Another reason why new mortgage approvals and turnover in the housing market have collapsed is that banks and other mortgage lenders still cannot fund themselves in the wholesale markets. New mortgage-backed securitisation is all but dead. There has been only one issue of new residential imortgage-backed securities since last summer, a £500m issue by HBOS in May 2008. Since then, the securitisation market has dried up again.
Through the Special Liquidity Scheme adminstered by the Bank of England, the Treasury allows up to £100bn of asset-backed securities (including mortgage-backed securities) to be swapped for a year against Treasury Bills. Only securities backed by mortgages issued before December 31, 2007, are eligible as collateral at the SLS, however. While this has no doubt allowed some stabilisation of the balance sheet of the mortgage lenders, it has done nothing to promote new mortgage lending.
I believe that the current state of near death of the market for new residential mortgage-backed securities represents a form of market failure that can be remedied by a joint intervention by the Bank of England and the UK Treasury, along the lines suggested recently by the Council of Mortgage Lenders.
The CML effctively proposes , that the Bank of England accept as collateral in its repo operations residential mortgage-backed securities (RMBS) backed by mortgages issued after December 2007 and covered bonds (CB) (bonds collateralised by residential mortgages issued after December 2007.
The CML adds an interesting wrinkle. In their words “To qualify, the RMBS or CBs would first have to be sold to investors in a public issue. This is of crucial importance, as it would ensure that the market itself is essentially delivering the solution, with the repo facility simply acting as a catalyst to restore market confidence. The investors would take the credit risk in the usual way. But the repo facility would give them confidence, and so help to break the current vicious circle.”
With some further clarifications, the proposal makes sense. I would require that the mortgages backing the new RMBS or CB would meet high and verifiable standards. No mortgage should be for more than, say, 80% of the value of the property that acts as collateral. Income and asset verification for the borrowers and other creditworthiness checks have to be rigorous and it should be possible for a third party to monitor this.
As a further condition, the Bank of England should have to sole authority to value or price the RMBS or CB (and/or the underlying mortgages) when there is no liquid market for these assets. This does not just mean that there will be fees and that a liquidity haircut (discount) will be applied on securities offered as collateral to the Bank of England. These liquidity haircuts are applied to a valuation or price for the security that must be determined somehow (in my view unilaterally by the Bank of England) when there is no liquid market for the security offered as collateral.
When these securities are illiquid (as they will typically be, if the mortgage lenders want to offer them as collateral in repos), their pricing or valuation by the Bank of England should be aggressive, even punitive, in order to avoid subsidising the mortgage lenders. There would be a ‘subsidy’ if the expected, risk-adjusted rate of return to the Bank of England on the loan is below the Bank of England’s opportunity cost of funds. Auctions (strictly speaking reverse auctions) are a useful tool for solving the mechanism design problem of valuing illiquid collateral so as to lend against it without providing a subsidy to the borrower, even when the buyer in the auction (the Bank of England) is less informed than the sellers about the risk and return characteristics of the underlying mortgages.
There also should be accountability to Parliament and to the UK tax payer for public funds put at risk through this new facility, just as their ought to be for the existing facilities, including the SLS. This means that the Bank of England should put in the public domain the models and/or methods its uses to value/price illiquid RMBS and CB offered as collateral. It should also publish as soon as possible (that is, as soon as commercial confidentiality concerns no longer are a signficant concern) the actual prices/valuations put by the Bank on each specific kind of collateral that it accepts from the mortgage lenders.
Thus far, the track record of the Bank of England and of the UK Treasury as regards providing Parliament and the public with the information required for proper accountability for the use of public funds is woeful. We still don’t know the terms on which Northern Rock was given access to its Liquidity Support Facility. We don’t know the terms on which deposit guarantees and other credit guarantees were made available to Northern Rock. We don’t know how the Bank of England valued the collateral offered by Northern Rock. We don’t know how the Bank of England values/prices the illiquid collateral offered by banks accessing the SLS. This lack of transparency and accountability serves no efficiency-enhancing purposes. It is driven either by posterior-covering motivation or by the belief in the Bank and the Treasury that there is no need to provide Parliament and the public with the necessary facts to judge their performance, because that is against the great British government tradition of keeping everything secret, lest any of it may prove politically embarrassing.
Finally, any illiquid collateral acquired by the Bank of England, either by being offered as collateral in repos or through outright purchases (something not currently under consideration and not part of the CML proposal) should be taken off the Bank’s balance sheet immediately and transferred to the balance sheet of the Treasury.
The central bank should not act as a quasi-fiscal agent for the Treasury. Even if illiquid collateral is valued properly ex ante, and a valuation is assigned that reflects the best information about the credit risk associated with the collateral, there is a risk that, ex post, the mortgages will go oink and the Bank of England will be stuck with a capital loss. Such losses should be fiscalised, that is, assumed by the Treasury. If they are not, the independence of the Bank and its ability to achieve its price stability objective could be undermined.
In repos and other transactions involving illiquid securities purchased outright or accepted as collateral in repos or at the discount window, the central bank should just act as an immediate liquidity-providing agent of the Treasury, not as a fiscal agent. All the illiquid securities should therefore be transferred immediately (at the valuation placed on them by the central bank) to the balance sheet of the Treasury. The central bank could, for instance, swap the illiquid RMBS and CB it has acquired from the mortgage lenders, immediately with the Treasury for Treasury Bills. If the Treasury worries about accepting the Bank of England’s valuations of illiquid collateral, the Treasury itself can do the valuation/pricing instead.
Apart from the central bank not having long-term non-inflationary deep pockets, if the collateral goes sour, because it does not have the power to tax, the central bank also does not have the staff and the knowledge to manage portfolios of illiquid mortgages, RMBS or CB. I want Mervyn King to worry about Bank Rate and the supply of funding liquidity and market liquidity. I don’t want him to manage a mortgage debt collection agency. The Treasury or an on-budget and on-balance sheet vehicle designated by the Treasury can do that.
With these additional safeguards, the Council of Mortgage Lenders proposal for getting the securitisation of new residential mortgages going again makes sense. It is the natural expression of the Bank of England’s responsbility to act, at a price, as the market maker of last resort whenever a systemically important financial market goes belly up.