Page last updated at 17:25 GMT, Tuesday, 15 April 2008 18:25 UK

No easy answers to the credit crunch

By Stephanie Flanders
Economics editor, BBC News

Bankers leaving after their meeting with Gordon Brown
Bankers want the government's help to relieve the credit crisis

Downing Street insists that Gordon Brown's morning meeting with the bosses of Britain's leading banks was "routine".

It is a fair bet that the bankers pressed for urgent help to resolve the credit crunch, and the prime minister stayed on the fence.

But if the government did decide to take more action - what options does it have?

It is a simple enough question. The answers are anything but.

For starters, it depends on which of the many problems afflicting the credit markets you decide you want to fix.

One reason banks do not want to do as much mortgage lending as they did, say, a year ago is simply that housing looks more risky as an investment than it did then.

There is not a lot the authorities can or should do about that - especially if you think the mood in the UK property market last year was dangerously optimistic.

Mortgage rates will inevitably rise, relative to official base rates, as the "risk premium" that investors demand on property-related assets returns to more normal levels.

Unreasonable extremes

What should worry the prime minister when he wakes up in the morning is the idea that this reasonable correction is being taken to unreasonable extremes.

What could the government do?
Increase the amount and time frame of lending to banks
Lend against a wider list of collateral
Swap banks' risky assets for safer government securities
Buy risky assets from banks outright

Investors are so scared of what happened to sub-prime mortgages in the US that they have decided they do not want UK mortgage-based assets at (almost) any price.

If that is true, then there might be a case for the Bank of England and/or the Treasury to intervene.

The uncertainty about the value of the mortgage-backed assets sitting on the banks' balance sheets is making it hard for the banks to simply get on with day-to-day business. Other banks will not lend to them because they do not know how much they are worth.

More broadly, excessive fear on the part of investors could risk becoming a self-fulfilling prophesy. If there is no market for mortgage-backed assets, then a large chunk of Britain's existing mortgages (which were funded by issuing those assets) cannot be rolled over.

Depending on whose estimates you believe, that leaves a hole in the mortgage market of about 40bn a year. Withdrawing that amount of funding from the market, almost overnight, risks creating just the kind of freefall in property prices that "irrational" investors fear.

More funding

Assume the authorities go along with these arguments and decide to act, what, precisely, can they do?

Here things get (even) more complicated - depending on whether the goal is to help the banks deal with the mortgage-based assets they already have, or actively support the creation of more.

Gordon Brown
The prime minister faces pressure from banks

The Bank Governor, Mervyn King, says the Bank is solely concerned with the former - the "overhang" of mortgage-backed assets sitting on banks' balance sheets.

One short-term option for dealing with that is simply do more of the same.

Gradually, the Bank has been making more lending available to banks. Instead of the more usual overnight funding, the Bank has also been offering lending at longer terms - three months or more.

According to Simon Ward, at New Star Asset Management, this kind of lending now accounts for 80% of the money the Bank provides to the banking system, up from 30% in September. (Although a lot of that is to Northern Rock).

In addition, the Bank has extended the list of assets that qualify as collateral for this kind of loan, although here it has been more restrained than either the Federal Reserve in the US, or the European Central Bank.

There have been special auctions letting banks borrow against very high quality (AAA) asset-backed securities. The latest of those took place today.

The Bank could also lend against a wider range of collateral, including regular mortgages, without insisting on a minimum, penalty interest rate (as it did when it tried this last September).

But, given the size of the Bank's balance sheet, there's a limit to how much it can do without extra government cash.

Long-term options

The Bank and the Treasury are looking at "long-term" options for easing that overhang of assets - including outright swaps of mortgage-backed securities for nice clean government securities (gilts) which everyone in the market can be sure of.

That is what the US Fed has been doing, on a scale of tens of billions of dollars. And it is what the Conservatives proposed this week.

Shop workers
The credit crisis could impact the wider economy

But these kinds of swaps are tricky to design - and they have significant downsides from the point of view of the government.

As long as the mortgage-backed assets were on the government's books, the swaps would almost certainly send public net debt through the roof, because the official statisticians do not count mortgage-backed assets as liquid assets.

You would also have to set the right discount, or "haircut", on the value of the mortgage assets to protect the taxpayer from further falls in the price of those assets - without demanding such harsh terms that the banks have no incentive to take part. That is no small matter.

Swallow hard

An even more radical option would be outright purchases of these mortgage-backed securities - something which is being actively discussed in the US, and Willem Buiter, a former member of the Bank's Monetary Policy Committee, has proposed in the UK.

He says the government will ultimately have to go down this road to set a minimum price for these assets in the broader market. But the chancellor would have to swallow very hard before he did this, it looks awfully like an overt bail-out of the banks.

Once again, the price would have to be very low indeed to prevent the taxpayer from losing out. And the lower the price, the more reluctant the banks would be to sell.

None of this directly increases the stock of new mortgages or assets based on them.

The hope would be that once things got back to the normal, that market would re-open of its own accord.

But as Professor Peter Spencer of the University of York points out, the government could more directly increase the banks' capacity to lend by simply taking out large-scale deposits with the lenders themselves.

The Treasury could issue a chunk of new government securities (something which many in the market would welcome in its own right), and simply deposit the proceeds with lenders offering the best terms.

The latter would automatically have more cash to lend on to borrowers. But since these would be liquid, cash deposits, the money would not increase net public debt. And it would not transfer any risk from banks to taxpayers.

It sounds too good to be true - an "immaculate injection", you might say.

But in these days of soul-searching on Downing Street, it is surely food for thought.


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