For those of us without a PhD in finance, the £200bn “special liquidity scheme” is difficult to comprehend. But taxpayers should pay attention.

The Bank of England is allowing hard-pressed banks to take the assets they are unable to sell in the market and swap them for crisp, clean Treasury bills.

The big question is: how is the Bank valuing the collateral if no one in the market is willing to put a price on it?

The Bank argues the exposure to the taxpayer is limited. First, they only accept AAA rated securities. Second, unlike the US plan to buy up bad assets, the Bank scheme leaves the private banks responsible for losses.

But these points are worryingly similar to the arguments private banks were using ahead of the crash. After everything we have discovered about rating agencies, why is the Bank ready to accept a security simply because it is marked AAA? Have they been listening to Gordon Brown’s criticisms of how the ratings agencies operated?

And if there are any losses, how will this be recouped from the private banks? Under the scheme the Bank can swap assets out of the programme when they deteriorate. But how will the Bank officials judge when they have deteriorated? And how will they price an asset that no one is willing to buy?

This valuation is critical because under the scheme’s repurchase agreement, if an asset falls in value the Bank either has to ask the private bank for more money or more collateral. Again, who will determine how much? And will the bank be in a position to pay?

These are big decisions. The Bank officials are judging structured finance products that fooled specialists, analysts, investors and some of the most highly paid bankers in the world.

Up to now, the Bank collateral managers have mainly dealt with simple government bonds. According to Paul J Davies’ excellent piece on this subject, they have added “a couple of extra staff” to the team running the £200bn scheme. Let’s hope they are good.

October 30, 2008 7:02pm in UK politics | Comment