Hamish McRae: The £40bn question: do we bail out the banks to get the mortgage market moving?

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The Independent Online

In the next few days the Treasury and the Bank of England will announce their plan to rescue the mortgage market. It will be huge. The big number will have to be about £40bn and it may be quite a bit larger than that. This would be in addition to the £15bn fed into the markets yesterday by the Bank of England on more conventional terms.

Under the new and separate scheme, banks would be able to swap some of their present mortgages, which cannot be sold on to anyone else, for government securities, which can. The scheme will not suddenly revitalise the housing market, for that is a longer-term issue, but it will mean that the banks can resume granting new mortgages and rolling over existing ones on a reasonable scale. That is a necessary first step in stopping something more serious happen ing to the economy.

The details are not finalised yet and none of the players – the Treasury, the Bank of England and the commercial banks – can talk about it. There was a meeting at Downing Street between the Prime Minister, the Chancellor and the heads of the major banks yesterday but nothing has come out. But listen to what Gordon Brown has subsequently been saying, and look at what is needed, and it is not difficult to piece together the outlines of the plan.

The core of the problem is that the mortgage lenders have on their books existing loans that they are struggling to finance. Most of us probably think that if we get a mortgage the lender is using its own deposits to finance it. Not so. Net mortgage lending last year was £108bn but of that, only £27bn ended up on the books of the bank that made the mortgage. The other £81bn was passed on to other lenders, sometimes bank subsidiaries financed by borrowing on the wholesale markets.

These markets have been functioning very badly since last summer as banks do not want to lend to each other because they are not absolutely certain they will be repaid. That is a global problem, not just a British one. But we have to cope with the British manifestation of it and that has been made worse by the debacle over Northern Rock. Just before its demise, it was doing 20 per cent of new mortgages in Britain. Now it is doing very few and trying to unload some of the ones it has got. So the burden on other lenders is all the greater.

A large proportion of all the mortgages in the country have been bundled together into securities. That was how our banks managed to finance the demand for their wares. Now, these don't look like loans but more like shares or bonds that can be bought and sold. Except that they can't at the moment. So what will happen is that banks will be able to swap their illiquid mortgage securities for government securities that can be traded.

Once their current problems are eased, the banks can begin to think about how they will finance the demand for new mortgages this year. The number will not have to be as big as the £81bn noted above. Simon Ward at New Star has come up with a figure of a gap of about £40bn this year and that squares with other calculations. But it is big – as big as the Government's whole fiscal deficit for the year – and it has to be accounted for somewhere on the national accounts.

How you show the debt is one problem. It looks bad, post-Northern Rock, to have another great wodge of housing debt loaded onto the taxpayer. The Bank of England has been feeding money into the markets, and taking bank securities as collateral, as part of its normal money market operations and those numbers have shot up in recent months, as we witnessed with the new tranche yesterday.

But this is bigger, too big for the Bank to do on its own. The Government has to sign off the deal. But if it is to give the banks gilts in exchange for mortgage-backed securities, it has to be pretty sure that these securities are not duds. Or rather it has to make sure that the banks, and not the taxpayer, carry the risk should things go belly up.

There is a crucial distinction between credit risk and liquidity risk. Take a 10-year loan that has to be rolled over every year. The credit risk is whether the borrower can keep up the interest charges and repay the debt at the end of 10 years. The liquidity risk is whether the lender has the resources at the end of each year to roll it over for the next 12 months. The plan has to take the liquidity risk off the banks but leave them with the credit risk. Theoretically, it is simple but like so many things in life the devil is in the detail. There are other issues, such as how long should this swap arrangement run and what are the charges, but getting the risks accurately placed is the most important.

If this is a complicated technical banking matter, it is also about politics and about power. At a power level, it is a tussle between the banks and the authorities. On the one hand, the Government does not want to be seen to be bailing out the banks. Banks are not popular and there are no brownie points for being nice to them. They are under fire at the moment for not fully passing on the cut in interest rates to mortgage holders. Yet there are very good reasons why some of them cannot do so: though official interest rates have come down, their own access to funds may be as tight and as expensive as ever. Thus Northern Rock, actually owned by the Government, does not appear to be doing what the Government urges on the banks as a whole.

In any case, while the Government does not want to be seen to be nice to the banks, it has to rely on them to keep the funds flowing to mortgage holders and at a reasonable price. The banks, and this may surprise some people, don't want a total bail-out either. They have to maintain their credibility in the long-term, so while liquidity help is welcome and actually essential, they will want to go back to a normal hand-off relationship once the crisis is past. Detail, and presentation of that detail, is important.

Then there are the politics. It is hard to see this one playing well for the Government. Their problem is not this particular deal, or even its presentation, which is going to be tricky. Rather it is the economic picture as a whole. The shadow Chancellor George Osborne made it clear in a speech on Monday that the Tories would support a swap of mortgage securities and government stocks on the lines suggested above. But he has also come up with some suggestions of how to change bank capital requirements to try and iron out the swings from boom to bust, ideas that have aroused favourable comment in the City. You can see the pitch: we have the big ideas to stop problems arising in the future while you are stumbling around patching your past mistakes.

Politics apart, the substance of this is that something has to be done to maintain the flow of mortgages. In an ideal world, we would not be here at all, for in an ideal world the authorities would not have allowed the housing bubble to occur on the scale it did. So there are lessons for the future that any government of any political hue has to learn. But right now there is a problem that has to be fixed and we just have to hope that the fix is fair to both home-buyers and taxpayers. We also have to hope it works.

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