Bank of England unveils huge bond swap operation

By Chris Giles
Financial Times, London
Monday, April 21, 2008

http://www.ft.com/cms/s/0/316cfef4-0f80-11dd-8871-0000779fd2ac.html

The Bank of England introduced a huge new operation to ease the liquidity problems of Britain's banks on Monday morning, offering to swap difficult to sell mortgage-backed assets for Treasury bills.

Under the new "special liquidity scheme," which is already in place, banks are able to offload high-quality AAA-rated mortgage-backed securities that existed at the end of last year for Treasury bills for a one-year period, renewable for a total of three years.

The Bank does not have a fixed amount of government paper on offer, but expects about L50 billion to be demanded from banks, making the liquidity scheme twice as big as its existing three-month lending against mortgage-backed securities, which it started in December.

That lending has proved successful, but not sufficient to address the liquidity problems of Britain's big banks, which are hoarding cash and have what the Bank of England describes as an "overhang" of mortgage-backed assets, "which they cannot sell or pledge as security."

Initial indications are that the conditions on the Bank's special liquidity scheme are more draconian than expected and the price the banks must pay for the new facility -- a cross between a temporary purchase of assets and a loan -- will be quite steep.

This might lead to a lack of demand for its use by the banking sector or stigma being attached to the lending programme, but should ensure that taxpayers are not exposed to any significant risks of losing money.

The Bank has been trying to walk a tightrope between providing banks with the liquidity they have been demanding and avoiding any sense that the taxpayer will bail them out.

To avoid accusations of a bailout it has put three tough conditions on the swap arrangements.

First, there will be a fee charged at a rate representing the difference between the rate at which banks can borrow in the market -- the three-month Libor rate -- and the interest rate on three-month government paper. Currently that gap is 1 percentage point, but if the scheme works at bringing down Libor rates, the fee will drop at three monthly intervals to a minimum of 0.2 percentage points.

Second, for every L1 of mortgage-backed assets handed to the Bank, commercial banks will get significantly less government paper in return. These "haircuts" will range between 12 per cent and 22 per cent for AAA-rated mortgage-backed securities, with the highest rate for those securities with maturities longer than 10 years.

These are tougher haircuts at short maturities than the three-month lending the Bank has performed since December and there is a higher haircut for securities denominated in foreign currencies of 0.03 percentage points.

Third, the securities will be valued at "observed market prices" which are currently low and part of the problem the Bank is trying to address. With market prices being paid, the scheme is unlikely to provide the floor for mortgage-backed security prices that many banks had been hoping for.

The Bank has put in place these stiff conditions because it wants to sort out the overhang of difficult-to-sell assets on banks' books rather than subsidise new lending. To stop new assets being used, only securities on banks' books at the end of 2007 will be eligible.

Mervyn King, governor of the Bank, said, "The Bank of England's Special Liquidity Scheme is designed to improve the liquidity position of the banking system and raise confidence in financial markets while ensuring that the risk of losses on the loans they have made remains with the banks."

Shares in the UK's banks fell following the publication of the details of the scheme and sterling was also weaker, having risen at the end of last week when details of the plan began to emerge.

Royal Bank of Scotland, which on Monday confirmed it is considering a rights issue, fell 2.8 per cent to 373 1/4p. Barclays, which has also been reported to be thinking of launching new shares to improve its capital ratios, was 2.9 per cent weaker at 481 1/2p and HSBC, the country’s largest lender, was down 0.8 per cent at 848 1/2p.

HBOS, the owner of Halifax and the country's largest mortgage lender, fell more than 1 per cent to 552p, and Lloyds TSB, the largest lender of unsecured debt in the UK, slipped 0.6 per cent to 450 1/4p.

The pound fell 0.5 per cent to $1.9883 against the dollar, lost 0.5 per cent to Y205.95 against the yen and sliding 0.8 per cent to £0.7976 against the euro.

The three-month sterling Libor rate fell slightly from Friday's fix of 5.89375 to 5.885, still well above the Bank’s base rate of 5 per cent.

Traders said the reaction to the Bank’s plans reflected the fact that they had already been widely trailed. Indeed, the pound rallied at the end of last week as details of the plans started to emerge.

Martin Slaney, head of derivatives at GFT, said: "The market reaction at least in the short term may well be one of disappointment that further funds have not been earmarked as part of a more long term plan."

"This rescue plan has been touted as a jump start to the lending markets but it is more likely to serve as a one-off bailout which plugs a hole for now. We are a long way off from returning to a more liquid lending market where mortgages are freely available."

Another analyst said: "The facility is helpful but the haircuts make it more onerous than expected for banks to participate. The funding gap remains much larger than this facility."

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