Bank set for fresh battle with Treasury over mortgage bail-out plan

The Bank of England will today begin fighting a rearguard action to prevent the Treasury from extending its bail-out scheme for mortgage lenders to new home loans.

The idea, which will be floated in a preliminary report to be published today by Sir James Crosby, the former HBOS chief executive, will be bitterly opposed by the Bank, despite the possibility it could revive the virtually frozen mortgage market and save property prices from collapse.

Ministers are thought to be sympathetic to an extension of the Bank's Special Liquidity Scheme (SLS), which is one option suggested by Sir James. However, Mervyn King, Governor of the Bank of England, has repeatedly insisted that new loans should not be eligible for the SLS, which enables banks to swap unmarketable mortgage-backed securities for gilts, and that the SLS is purely a mechanism for clearing the backlog of old problems.

Sir James was asked in April by the Government to report on "options for improving the mortgage-backed securities market, including measures aimed at broadening the investor base for mortgage-backed securities and improving the robustness of the market". His remit is to come up with measures that would unstuck the mortgage market, where lenders have cut back on home loans, a major contributor to the fall of house prices over the past 10 months.

Alistair Darling, the Chancellor, may therefore be tempted by the political benefits of a high-profile effort to stabilise the housing market and help "hard working families" to weather the credit crunch.

Sir James will suggest a series of possible solutions to the mortgage crisis today, but attention will focus on a proposal for the SLS to be reformed to include securitisation of new mortgages. One possibility is the launch of a "kite mark" to indicate that a mortgage securitisation comprises only the finest quality of loans.

The Council of Mortgage Lenders and other interested groups have already suggested extending the SLS, as their members have slashed the number of new mortgages for house purchase to two thirds of last year's levels. Analysts say that, on current trends, new mortgage lending will virtually disappear by the end of the year, with even more dire consequences for property prices.

When the SLS was launched in April, for an initial period of six months, the Bank was at pains to stress that only securities based on mortgages granted before the end of 2007 would be eligible to be "swapped" for gilts. It thought this would release funds for the commercial banks to lend to home buyers, and other borrowers. Some £50bn was quoted as the rough size of the funding then, although there was no "cap". The banks have to pay a penal rate of interest and suffer a "haircut" on the valuation of the securities they offer the Bank as collateral.

The scheme is thought to have been a success, although the credit crunch is still very much a fact of financial life. The Bank says it will report on the SLS and possible options for its extension in October. However, Mr King has made no attempt to signal that he has changed his mind about the function of the scheme or its remit, leading to speculation that another rift between the Treasury and the Bank may be about to develop.

Mr King said in April that the SLS was not aimed at "kick starting" the mortgage market: "I think it would be a serious mistake to go back to where the mortgage market was a year ago," he warned. "There is the need for an adjustment in the mortgage market, but I do think the improved confidence in the banking sector, which I think this scheme will eventually restore, will feed through to borrowers and we'll see the mortgage market operating on a more normal basis." The Governor also said an adjustment in the property market was "not a process we can, or should try to, stop".

Mr King has also said that "a longer-term solution must focus on the overhang of assets and not subsidise issues of new assets. One of the lessons of this financial crisis is that providers of mortgage finance had underestimated the risks and, hence, the true cost of the securitisation process."

Last year the value of new mortgage lending ran to around £100bn. If the Bank and the Treasury do agree on the extension of the SLS, it will be as a result of both agreeing that the major part of the risk in such a move must lie with banks' shareholders rather than taxpayers.

Sir James' final report is due to be released with the pre-Budget report in the autumn.