A £50bn injection, but the patient won't be up and about soon
The Bank of England is trying to get lenders back to work by swapping gilts for 'toxic' assets. Simon Evans asks if it has left the cure too late
Sunday 27 April 2008
Last summer Mervyn King, Governor of the Bank of England, tied the knot with his long-term partner, Barbara Melander. But the honeymoon was put on hold as the Northern Rock disaster unfolded.
Last week's news of a £50bn rescue package from the Bank, intended to spark life into the ailing financial markets, must have had Mrs King reading the holiday brochures in the hope things get back to normal soon. But she'd be wise to wait a while.
For if initial reactions are anything to go by, the Governor's Special Liquidity Scheme won't improve things quickly.
One of the first signs the SLS is working would be a fall in the lending rates between financial institutions. But last week these were still stubbornly high, with fear of further write-downs and possible collapses still stalking the money markets.
Libor, the rate at which banks lend to each other, is now horribly divorced from the cost of borrowing as measured by the base rate.
But the Bank had to act, and according to sources close to Threadneedle Street, the asset- swap option was the only "realistic one on the table".
Certainly, the Bank's rationale was sound, if rather belated compared to the prompt reactions of other central banks, according to most in the City. The toxic mortgage-backed assets eating into the balance sheets of banks can now be swapped for high-grade government-backed gilts. Those gilts are then lent in the markets, raising cash and ending the lending stalemate. Money market funds, gripped by understandable conservatism, will begin trading once again and the wheels of the giant system will grind back into action.
At least that's the theory. In practice, there are some catches.
This plan isn't about bailing out greedy institutions that have fouled up, so borrowing quality assets comes at a hefty price. Banks face a discount of up to 27 per cent for the highest-risk collateral placed with Threadneedle Street under the scheme. And that could stymie the whole process. Mark Durling, analyst at Brewin Dolphin, says: "In my opinion there are no winners in this scheme because they are swapping good-quality assets at a massive discount. You don't get something for nothing."
Valuing the assets lent to the Bank could be a thorny issue too. "The big questionmark has to be how the Bank of England is going to be able to value mortgage-backed securities for swap purposes when the banks and ratings agencies have got this so badly wrong in the past," says Jean Pierre Douglas-Henry, a partner at lawyers LG. "This will inevitably lead to disputes and potential litigation."
Lawyers aside, who gains most from the scheme is a moot point. In theory, the beleaguered taxpayer could have to foot the bill for an asset swap in the event of things going badly wrong. But one senior banker says: "This is a pretty decent deal for the taxpayer. It's very secure."
The scheme certainly won't provide a lifeline to those mortgage payers loaded up with 100 per cent deals who now find themselves stranded. But it will provide relief to the big mortgage-lending banks such as HBOS and Bradford & Bingley. The latter, the subject of continued speculation over a rights issue, said it had a moral obligation to make use of the scheme and oil the lending wheels.
Sources close to the Bank deny the scheme was part of some Faustian quid pro quo with ailing banks, but conspiracy theorists think otherwise.
"No more forced takeovers or nationalisations and nearly all the liquidity you need, but existing shareholders must suffer through dilutive rights issues and dividend cuts," says Neil Dwane, chief investment officer at fund manager RCM. "The European Central bank got things right straight away – the Bank of England didn't."
Soundings from the UK's largest banking houses show that all intend to participate in the scheme to varying degrees.
An executive at one of Britain's big five retail banks says: "A lot of people have criticised the Bank for inaction, but I think it has got things spot-on with this. The ECB has been offering short-term cash – I think the longest available was for eight days over Christmas. In contrast, the Bank's liquidity scheme gives the market the term cash it has been craving. It's a very clever move."
Under the guidelines of the asset swaps, banks can borrow for a period of one year, with deals allowed to roll renewed for up to three years – perhaps indicating how long the Bank thinks the credit crunch could be with us.
Whether £50bn is going to be enough is under scrutiny too, with many in the Square Mile forecasting that £100bn will eventually have to be stumped up. Comments from Mr King last week indicated that he already has his finger on the liquidity button, ready to inject new cash should the market require it.
"There's no way £50bn will be enough," says one observer. "But it's a good start."
Under the terms of the SLS, we'll never find out who has borrowed what and when. Indeed, we'll have to wait six months to find out any meaningful detail on the scheme, including how much has been borrowed in total.
Mr King is said to have cut a relaxed figure last week. "He really dislikes the term bailout," says a City source. "But he's confident that this will work."
For the sake of the UK economy, not to say his wife's holiday plans, let's hope he's right.
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