The Bank of England's Planned Handling Of The Mortgage Problem
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 Special Liquidity Scheme

 
April 19, 2008 -- SPECIAL LIQUIDITY SCHEME:  The Bank of England announced a new scheme to enable banks and building societies to temporarily swap assets that are illiquid in exchange for UK Treasury Bills. This briefing note provides information about the function and purpose of the bank's initiative.
Excerpts follow.
ADDRESSING THE PROBLEM

"Financial markets are not working normally, which if left unchecked will have an impact on the wider economy. Across the world, there is a lack of confidence in assets created from packages of bank loans, most notably mortgage-backed securities. That lack of confidence was prompted by the downturn in the United States housing market and, in particular, the problems associated with sub-prime mortgages there. The markets that normally trade these assets have, in effect, closed, so it has become very difficult for banks to exchange these assets for cash - the assets are currently `illiquid'. As a result, banks in all the major financial centres have on their balance sheets an `overhang' of these assets, which they cannot readily sell or use to secure borrowing. It is not that banks, at least in the United Kingdom, have made unsustainable losses. But by stretching their balancing sheets, this overhang has created uncertainty about the financial position of banks. They have, as a result, been reluctant to lend, even to each other. That reluctance is evident in the interest rates charged on interbank lending, which have risen, even though Bank Rate has fallen. This situation is affecting all banks and building societies and has started to affect their willingness to lend money to individuals and businesses. It had been hoped that these problems would be resolved as markets returned to normal. But it is now clear that there is no immediate prospect that markets in mortgage-backed securities will operate normally. The situation will improve only if the overhang of illiquid assets on banks' balance sheets is dealt with. Only then will banks be willing to lend to each other and, importantly, to the wider economy.
CENTRAL BANK OPERATIONS

Banks routinely borrow money from central banks in exchange for assets. They do so to manage their day-to-day cash needs as they lend and borrow funds. In response to the stresses in financial markets, central banks worldwide have extended their lending facilities. Since August, the Bank of England has increased by 42% the amount of central bank money made available to financial institutions. It has increased from 31% to 74% the proportion of its lending to the market that is for a term of at least three months. Since December, the Bank has also widened the range of high-quality assets accepted in its 3-month lending operations to include mortgage-backed securities. The stock of outstanding lending against that wider range of collateral is £25bn. These changes have aimed to alleviate the problem of financing the large overhang of illiquid assets on banks' balance sheets.
THE NEW SCHEME

To tackle this problem decisively, the Bank of England has designed a Special Liquidity Scheme to allow banks and building societies to swap for up to three years some of their illiquid assets for liquid Treasury Bills. The purpose of the scheme is to finance part of the overhang of currently illiquid assets by exchanging them temporarily with more easily tradable assets. The banks can then use these assets to finance themselves more normally.

All of the banks and building societies that are eligible to sign up for the standing deposit and lending facilities within the Bank's Sterling Monetary Framework will be able to take part in the Scheme.

Usage of the scheme will depend on market conditions.
The Scheme will involve the Government, through the Debt Management Office, issuing new Treasury Bills to lend to the Bank of England.
At all times, the banks must provide as security to the Bank of England assets worth significantly more than the Treasury bills they have received in return. If the value of their assets pledged as security falls, the banks must provide more assets to the Bank of England, or return some of their Treasury Bills.
The Bank of England will decide the margin between the value of the Treasury bills borrowed and the value of the assets banks are required to provide as security.
The Scheme is designed to deal with the overhang of existing assets on banks' balance sheets, not to create artificial incentives to undertake new lending. To that end, only securities formed from loans existing before 31 December 2007 will be eligible for use in the Scheme."