July 24, 2008
Time for the Bank of England and the UK Treasury to pull their finger out to stimulate new mortgage lending
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.
what a joker. the banks and careless borrowers should have to reap what they have sewn. let the free market deal with it without nannying from the state. have you not noticed - whenever government intervenes, it only ever makes things worse?
Posted by: chris | July 24th, 2008 at 9:31 pm | Report this commentIs the solution not for the banks and mortgage houses to re-structure their asset backed paper so that it is attractively priced and marketable?
Do they not need to focus their minds on the quality of the paper that they wish to sell; the interest rates offered; how it is packaged, and what guarantees are offered over it? Is this not, in fact, what is happening, and should this process not be left to run its course? That it will be painful is neither here nor there. The sooner property prices and interest rates adjust to some sort of equilibrium, the better.
The banks can sell their paper, they just have to price and package it correctly. For the BOE to intervene in this process will simply distort the market and shift risk.
Posted by: jgk | July 25th, 2008 at 1:24 pm | Report this commentThat’s the whole point. Get the BoE to end up as buyer of last resort, load it up on toxic waste collateral that will never be redeemed in order to stimulate new lending and thereby prop up the current excessive valuations.
Anything at all to avoid transparent price discovery.
After all if the sheeple ever wake up and realise that they have in real terms commited to handing over a lifetimes wages for a massively overpriced two bed “executive” appartment they may just be tempted to hand back the keys.
We don’t want to let the debt serfs escape or even to rouse them from their consumer zombie stupor.
Who gets to unload their waste to the bank? Realistic haircut - do me a favour, with the regulatory capture that has taken place this is never going to happen.
This is just whitewash for a covert bailout. Still singing the same tune, “privatise the profits, socialise the losses”.
Posted by: London calling | July 25th, 2008 at 5:00 pm | Report this commentIt would be in the long term interest of the UK Economy if the BoE were to preside of a long term drop in property prices.
High property prices may be good for banks and a few individuals approaching retirement but for everbody else they are a disaster.
Nobody would be pleased if the government announced water prices had doubled over the last five years, why should it be any different for housing?
High property prices divert a massive proportion of the oridinary citizens income into a dead non-productive asset. Almost any other use of this money would benefit the individual and the economy more.
From a business point view your customers spending most of thier money on a mortgage rather than on you product, at, the same time the biggest expense for most small businesses is over inflated commercial rents.
If the Bank of England, or indeed any government department wants to improve the economy and quality of life of its citzens the value of property should be allowed to fall and then kept low.
If a few reckless banks go bust and some overpaid bankers lose thier jobs in the process then — so what? We were quite happy to let the Textile, Car, Coal, Steel and Shipbuilding industries disapear when they had passed htier usefulness. Whats so different about banks?
Posted by: James Anderson | July 28th, 2008 at 3:03 pm | Report this commentwho says the market isn’t working? the issue here is that buyers have no interest in supporting the market at current levels. the fundamental problem is the lack of demand for rmbs not the valuation. what makes prof buiter think the the boe is in a better position to judge fair value than the market place?
Posted by: fi-geek | July 29th, 2008 at 12:13 am | Report this commentThe Bank of England should include house prices in its inflationary measures. If that had been the case, there would never have been such a bubble.
Since mortgage lenders have got us into this spot, listening to them is the last thing that one should do. A good number of banks need to go bust and the weighting of the financial sector in the UK’s economy should return to where it was 50 years ago.
Posted by: Alfred | July 29th, 2008 at 6:22 am | Report this commentCurious advice. Believing that prices will fall 30%, the government should step in and finance a valuation 20% less than current value? Does this not leave someone - us - with a loss of 10%?
Perhaps it is better to look at the ability of the individual borrower to service the debt they want to incur. Leave the issue of valuation up to the borrower.
Time for a vacation methinks.
Posted by: Chris J | July 29th, 2008 at 11:46 am | Report this commentWe have had the boom, now we are entering the bust. Surely it is better to not intervene allow the market to correct itself quickly rather than intervene in an attempt to support the market and make the bust longer and more protracted. Interventions are typically politically motivated (to make the voters feel better and allow governments to be re-elected) and this makes them dangerous.
Also, if the bank should only accept MBS where the loan to value ratio is 80% or less and income verification has been done and monitored by a credible third party then these are the sorts of products that should be very marketable anyway. The whole problem has been that no-one has been doing these checks and no truly independent third party monitors them properly.
Posted by: Alan | July 29th, 2008 at 12:48 pm | Report this commentThe plan by CML and Buiter suggestions raise a lot of interesting ideas such as the treasury or the Bank of England playing an indirect role in the mortgage market as long as the repo facility exists. It’s clear by now that the root cause of the financial crisis was the miss-pricing of risks due to the conduct of financial institutions. I remember the Chancellor saying in response to this that the situation called for a gold-standard of mortgage backed security that investors could trust and since the market couldn’t offer it as it patently clear by the role of the ratings agencies in this mess, this could mean that the treasury will have to do this itself.
Posted by: James Edwards | July 29th, 2008 at 5:27 pm | Report this commentIt does no good to say the central bank, the Bank of England, should not act as a quasi fiscal agent for The Treasury. That is precisely what it does and cannot do otherwise. The Treasury manages the National Debt and the Bank is its public face, its agent in the markets. Both the Bank of England and The Treasury know very well how to value mortgage assets and to do so both technically and macro-economically, far better than commercial banks. What differentiates The Treasury and the Central Bank from other financial institutions is that they have the luxury to take a longer term view of the credit and housing price cycles. The Treasury has a far wider income net than banks by which to calculate (across the whole political-economy) the total economic profit or loss of their actions over a longer timeframe, over a whole economic cycle. We should worry less about the narrowly conceived propect of a short term loss to taxpayers, real or theoretical, and more about whether The Treasury and the Bank of England are allowed and trusted to work productively together to secure a better path for the economy, especially when the other main sources of credit creation, the banks, are lying about much deflated in both their liquidity resources and their self-confidence. Economists have long feared what happens when banks act pro-cyclically. We are now finding out in the worst way possible: the banks are currently unable to do other than deepen the crisis. We therefore have to expect and welcome the deepest pockets and superior ability of government finances to shoulder all the burden of liquidity support and economic recovery.
Posted by: Robert McDowell (Banking Economist) | July 30th, 2008 at 6:15 pm | Report this commentThe interesting problem to understand is: What are the fundamentals and real causes of the inflation in the UK? In other words: How will the Bank of England manage the inflation in the periods of economy growth or downturn. In some cases, the UK Treasure like to state that the growing money supply to the economy, which is not balanced with the increase of GDP is the only cause for the raise of inflation expectations. Going from this point of view, the restrictions placed on the governmental money printing machine may solve the problem easily. In reality, the restrictions on supply of capital may lead to the liquidity crisis and subsequent economic crisis. However, there is another opinion that the inflation can be fought by the introduction of measures to stimulate the products producers, services providers and mining/extraction industries builders. These measures will certainly increase the GDP and help to decrease the inflation expectations. My personal opinion is that the complex approach has to be used to stop the spreading of galloping inflation in the UK. This approach may include the measures to control the money supply to the national economy as well as the actions to stimulate the businesses to produce/provide the products and services with the purpose to increase the US GDP.
Posted by: Viktor O. Ledenyov | July 31st, 2008 at 12:51 pm | Report this commentFrom the viewpoint of the man in the street, the main causes of inflation are the rising prices paid for housing and energy. Energy prices of course also feed through into many other items we need such as food.
There are simple remedies within the remit of national governments - make more land available for building with fewer restrictions on what those houses should look like, and use less energy while creating more renewable sources.
Instead of tackling the beast by its horns, governments everywhere are resorting to ever more creative ways of printing new money - and we all know where that leads. If the money pumped into Northern Rock and others had been put into wind farms (eg) we might all be better off in the longer term
Posted by: Chris J | August 5th, 2008 at 9:55 am | Report this commentThe stagflation, recession, depression. Does it remind you the most recent scenario of the economic developments under the Bush administration in the US? The Bank of England and the UK Treasury have to avoid the repetition of the negative events in the US economy by changing its failed strategy toward the opening unlimited access to the capital for the UK based manufacturers and service providers.
Posted by: Viktor O. Ledenyov | August 28th, 2008 at 9:41 am | Report this commentWhat we in the Eurozone has noticed during the last months is the will of the British Government and media to influence the European Central Bank from outside forcing it to do something against the decission of its Council of Government as the UK needs to keep interest rates almost at 6% to compete with ECB´s 4%.
Sorry, but if you want to have a say in the decissions taken by the Executive Board of the E.C.B. you have to join the Eurozone and participate in the decission making from the inside with a member in its Executive Board. Easy.
Posted by: Enrique | August 30th, 2008 at 5:58 pm | Report this commentare there any positives at all here???
Posted by: srinivasan solaraj | September 2nd, 2008 at 4:58 pm | Report this comment