The Bank of England has confirmed that it will be embarking on a controversial scheme which will allow banks to swap their mortgage-backed assets for government bonds.
Under the 'Special Liquidity Scheme', banks will be able to swap mortgage-backed and other securities of 'sufficiently high quality' for Treasury Bills – the Government says the plans will help put some liquidity back into the struggling UK mortgage
For a six month period which starts today, banks will be able to enter into 'new asset swaps'. They will last for one year, but banks will be able, at the discretion of the Bank of England, to renew them each year for a maximum of three years, which is when the scheme will close.
The Bank has not confirmed the exact amount it will be pumping into the banking system, but in a statement it said: "Discussions with banks suggest that initial use of the scheme will be around £50bn."
The Bank of England and the Government have been under immense pressure over recent months to act to improve the struggling mortgage market. Due to the credit crunch – sparked by the US sub prime crisis last summer, banks have been reluctant to lend to each other due to the uncertainty surrounding mortgage-backed assets. This has, in turn, meant they have also been reluctant to lend to borrowers.
"With markets for many securities currently closed, banks have on their balance sheets an ‘overhang' of these assets, which they cannot sell or pledge as security to raise funds. Their financial position has been stretched by this overhang so banks have been reluctant to make new loans, even to each other," said the statement.
"Under the Scheme, banks can, for a period, swap illiquid assets of sufficiently high quality for Treasury Bills. Responsibility for losses on their loans, however, stays with the banks. By tackling decisively the overhang of assets in this way, the Scheme aims to improve the liquidity position of the banking system and increase confidence in financial markets."
The BBA has already voiced its support of the scheme, and Peter Spencer, chief economic advisor to the Ernst & Young ITEM Club says it is the only option left. "If international investors will not buy our mortgages what will they buy?" he said.
"The high degree of risk aversion in international markets means there is only one answer – government bonds. Like it or not, the Treasury must use its standing in the international markets to borrow and fund the mortgage lenders directly.”
The scheme has already received criticism due to the fact that the risk associated with the banks' mortgage-backed assets will lie with the taxpayer once they are 'swapped', meaning that if borrowers default on their repayments, it will be the UK taxpayer that pays the price.
"It is obviously necessary for urgent action to be taken to unblock the mortgage market and to break the crippling effects of the credit crunch," said Liberal Democrat Treasury spokesman, Vince Cable. "However, we cannot have a situation where the banks are able to privatise their profits and nationalise their losses."
"The cost of Northern Rock is quite enough without the Government taking on all the other risks and losses of the banking sector." he added.
But Mervyn King, Governor of the Bank of England, explained that under the scheme, "the risk of losses on the loans they have made remains with the banks."
"Banks will need, at all times, to provide the Bank of England with assets of significantly greater value than the Treasury Bills they have received. If the value of those assets were to fall, the banks would need to provide more assets, or return some of the Treasury Bills. And if their assets pledged as security were to be down-rated, the banks would need to replace them with alternative highly-rated assets," the report said.
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