CML news & views

As we sift through the details of the Bank‘s Special Liquidity Scheme, speculation is increasing on the potential risks to all involved.  

Of particular interest are the concerns of risks to the tax payer. The idea that the public shoulders the risk when the Bank of England accepts securities as collateral is misguided and the underlying assumption is that UK mortgage assets accepted through the current repo facility are risky or toxic. 

Under the Bank of England’s Special Liquidity Scheme and previous open market operations a range of ‘high quality collateral’ are accepted from lenders in exchange for liquidity.  

However, this is not a transfer of credit risk. The financial institutions seeking this facility retain the credit risk, not the Bank of England.  

In the unlikely situation that an institution participating in this facility fails, then the Bank of England would retain the assets to meet the debt. 

But what are ‘high quality collateral’?  This is AAA rated securities, primarily in the form of AAA rated covered bonds and residential mortgaged backed securities (RMBS). These are high grade UK assets and substantially different to the US assets that have brought about the credit crunch, just as the UK mortgage market is substantially different to the US market.  

UK mortgage assets are originated in a strongly regulated environment. All lending to homebuyers is regulated by the FSA’s mortgage conduct of business rules. While in the US, less than half of sub-prime lending has been made by federally regulated banking institutions.  

Adverse credit lending has accounted for a tiny proportion of UK mortgage lending. In 2006, up to a quarter of US loans were ‘sub’ or ‘near’ prime, compared with around 5 - 6% in the UK. This figure will have decreased markedly recently as many adverse credit lenders have re-priced or withdrawn products from the market.  

The sub-prime products available have also differed. While lending policies did become more lenient in the UK, the risks were not layered. US lenders were simultaneously offering combinations of second charge loans, no or little income verification and high loan-to-value ratios, features not seen in the UK.  

Deeply discounted rate products are also much less prevalent in the UK and the interest rate increases much more modest than the US, so payment shock will not be nearly as intense.  

To our knowledge, no publicly rated UK RMBS tranche has defaulted since securitisation started in the mid 1980s. As a result we believe it would be safe for the Bank to accept lower rated tranches than AAA. 

So while we pore over the details of this new announcement and speculate on the possible outcomes, concerns around the risks of bailing out lenders need to be weighed up against the risks to the housing market and wider economy if the shortage of mortgage funding continues.