Monday, April 21, 2008

B of E offer bailout for Troubled Mortgage Industry

Today the Bank of England unveiled a package to inject up to £50 billion into the banking sector. [Independent link] Their scheme allows banks to exchange unpopular mortgage securities for trusted government securities. In theory it is hoped this will enable the banking sector to find it easier to raise money and reduce the cost of interbank lending. It is hoped this will reduce the cost of mortgages and make more mortgage products available for first time buyers.

Why is the Tax Payer Bailing out the Banking Sector?

Since the subprime crisis in the US, it has become very difficult for banks to raise finance for mortgages. This has led to many mortgage products being withdrawn and the cost of mortgages going up. This has caused a fall in mortgage lending and has precipitated a shorp fall in house prices. It is feared that falling house prices will reduce consumer spending and lead to recession.

It is hoped that the scheme will enable the money markets to 'unfreeze' leading to lower mortgage rates, especially for first time buyers. It is also hoped that the scheme will not actually cost the taxpayer anymoney. The Bank of England is not giving money but offering to exchange the type of securities that banks hold at a commercial rate.

Is The Bailout a Good Deal for Tax Payers?

Mortgage debt is currently riskier than government debt and in theory taxpayers money is at risk. However, the Bank of England argue banks will be paying commercial rates because they will have to offer more 'risky' mortgage securities in exchange for 'safe' government bonds.

The taxpayer could lose out if mortgage defaults rise excessively and a bank defaulted on its payments and the securities it offered proved inadequate. This is unlikley to occur with base interest rates more likely to fall rather than rise. (However, nothing is impossible given recent events)

If the scheme is successful and softens the housing crash and softens the slowdown in growth, the taxpayer could benefit from avoiding a recession and the corresponding decline in tax revenues.

Is it Not Better Just to Let the Housing Market Crash and Allow House prices to return to Normal Levels?

Many argue that since house prices are overvalued, this scheme merely delays the inevitable. Therefore, it is better to get the pain with over quickly and not intervene.

However, if house prices are overvalued there are benefits to encouraging a slow and gradual readjustment rather than rapid shock which could precipitate a recession. Also the mortgage markets have gone from one extreme to another. 12 months ago, the market was very competitive and overly keen to lend. Recently banks have become excessively cautious, causing lending to become much stricter and tighter than necessary. This scheme will hopefully help restore a little confidence to interbank lending and enable a less extreme readjustment.

Will The Bailout work?

The markets were rather cautious about the scheme's capacity to stop the slump in falling house prices.

There is no guarantee banks will use the extra finance to reduce mortgage rates for consumers. (The Bank admit they are powerless to tell the commercial banks how to use this extra finance). Some argue the extra funds are not particularly attractive, because commercial banks need to give a premium to attract sufficient funds.

If necessary the Bank hinted they could free up to £100 billion.

See also: Overvalued Housing Market

Bank details £50 billion lending boost

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