CML news & views

The immediate challenge for governments and central banks around the world is to restore financial stability and the confidence of savers. Although one of the most obvious and immediate effects of the current financial market turmoil has been on the cost and availability of mortgages, the reality is that the continuing disruption has consequences for all types of consumers, firms and financial markets. 

There are, however, different consequences for different types of consumers, including mortgage customers. Those with equity in their property and a good record of managing debt continue to have a range of options. But the ‘have nots’ – those with little or no equity or past payment problems – have fewer choices. The outcome will be the same in all credit markets.

While there will inevitably be a debate about financial exclusion at some stage in the future, the focus now must be on what governments and central banks around the world should be doing, both collectively and individually, to mitigate the affects of the current market upheaval. 

In different countries, they have been acting in different ways, and with differing degrees of effectiveness. 

The US plan

The boldest plan is currently being pursued by the US Treasury department. It now has authority to spend up to $700 billion to buy “troubled” assets from financial institutions “to promote market stability and help protect American families and the US economy.” 

The scale and scope of the Treasury department’s plan means that it will have a major impact – but will it be the one that everyone is hoping for? Behind it there is at least a fundamental recognition that only when the financial system is working properly again will money and capital flow to and from households and businesses, not only to fund lending – including mortgages – but economic activity more widely.

The Treasury department will use much of its funding to buy up residential and commercial mortgage-related assets in the US. Illiquid mortgage assets, it argues, are blocking the system and “the clogging of our financial markets has the potential to significantly damage our financial system and our economy, undermining job creation and growth.” But the Treasury department also wants flexibility to buy other assets as it works to stabilise financial markets.

The UK and the US: problems on a different scale 

The magnitude of its proposals is, of course, a reflection of the scale of problems in the US mortgage market. In recent years, sub-prime borrowing grew rapidly in the US to account for around 25% of the overall market, compared with only 8% in the UK. And there were other features of the US market – including the scale and means of securitising mortgages, the absence of comprehensive regulation and the exaggerated impact of increases in interest rates – that compounded the problems.

The result is that as many as five million US home-owners are now in arrears or facing foreclosure. It is, of course, concern about potential exposure to problems on this scale that triggered the financial crisis in the first place. 

Payment problems in the US dwarf the scale of difficulties in the UK, where 170,000 cases of arrears and 45,000 possessions are expected this year. Looking at those numbers another way, almost 99% of UK mortgages are not in significant arrears, and only one borrower in 250 faces possession.

Like other mortgage markets around the world, the UK will benefit if the US plan delivers the intended results. Removing badly performing US mortgage assets from the financial system is a crucial step towards restoring investor confidence in mortgage-backed securities. And all mortgage markets will benefit from an improved flow of wholesale funding.

Intervention in Australia

The Australian Office of Financial Management (AOFM) has also intervened – but on a much smaller scale than in the US – to help improve conditions in wholesale funding markets. It wants to buy highly-rated residential mortgage-backed securities (RMBS), with two initial purchases of AU$2 billion each “to re-invigorate the residential mortgage-backed securities market and support competition in mortgage lending.” 

In announcing the plan, the AOFM said: “Unlike the US, Australia’s banking system remains profitable and soundly capitalised. Australian banks do not have significant exposures to troubled mortgage-related assets, reflecting our robust lending standards and low rates of mortgage default.

“Whereas the US Treasury is being forced to issue debt to invest in existing troubled mortgage assets, such as securities backed by sub-prime mortgages with high default rates, the AOFM will invest only in newly issued, AAA-rated RMBS that meet strict criteria in relation to the quality of the underlying mortgages.”

In focusing on proposals to restore investor confidence in high-quality RMBS, the Australian plan is similar to CML’s own proposals, currently being considered as part of the Crosby review. Both plans differ from the US, where the focus is on removing poorly performing assets. But all three share the same broader goal of restoring confidence in wholesale funding markets 

Developments in Europe

In other countries, the measures implemented have been different, more urgent and aimed directly at boosting consumer confidence. In Ireland last week, the government intervened to try to bolster the confidence of savers. It introduced a two-year guarantee for all deposits, covered bonds and other wholesale liabilities for six named Irish institutions “and specific subsidiaries” approved by the government. It said the named firms would pay for the guarantee so that taxpayers’ interests were protected. 

The plan was criticised on the grounds that it was anti-competitive, but has been followed by similar measures in other European countries. Authorities in Greece gave a guarantee for all savings, and an announcement in Germany was initially interpreted as an unlimited guarantee to depositors for private savings. 

Commentators have questioned whether such guarantees can actually be delivered, particularly where the liabilities are significant – for example, in Iceland. There have also been concerns about a fragmented approach within Europe, with other countries taking steps to bolster national savings markets. 

The fear is that such measures could encourage a flow of savings between countries, and this could be a particular problem in the euro zone, where a single currency makes it easier to move funds around. 

Concern about this has added to the sense of panic among consumers and across financial markets. And with mortgage funding currently heavily dependent on retail deposits, there is a fear that volatile movements of savings could worsen conditions for the mortgage markets in the UK.

Action in the UK

The UK government has, of course, also acted to protect depositors, but has so far fallen short of providing an unlimited guarantee.  UK deposits of up to £50,000 are being safeguarded from today. But while this protects around 97% of savers in building societies and 98% in banks, the size of deposits in the remaining accounts could have a destabilising effect if there is a flow of funds to deposit takers offering more comprehensive guarantees. 

The UK government has also been trying to protect the interests of taxpayers. In nationalising Bradford & Bingley last month, it made the Financial Services Compensation Scheme (FSCS) responsible for any payments under depositor protection measures. In the short term, £14 billion of funding for this is being provided by the Bank of England. But the FSCS will pay interest on the loan at a commercial rate.  And after three years, repayment of the principal will also start. 

This arrangement has sparked a debate about whether responsibility for funding the FSCS should more accurately reflect the risks associated with different institutions.  There have also been concerns that, while some firms can divert resources from shareholders to meet the costs of funding the FSCS, institutions like building societies do not have this option. In those circumstances, the costs are borne directly by customers. 

While the government has sought to protect taxpayers and savers, the Bank of England has been trying to help firms by extending the special liquidity scheme (SLS) until January. A revision of the Bank’s liquidity management arrangements has also been promised. The reality is, however, that any modifications will be new and untested, with little time for consultations to get the details right. 

What we need now

We therefore believe that it would be better for the SLS to continue in its current form, and for it to remain in place until the funding shortage is over. That will certainly not have happened by January. At that stage, UK house prices will still be falling and mortgage arrears rising. 

So, while the SLS will have to remain in place, what else is needed? Wholesale markets, which have funded a significant proportion of mortgage lending in recent years, remain paralysed. And even at the onset of this paralysis, virtually no-one – whether from within the industry, or from regulatory authorities or academic institutions – expected that wholesale markets would dry up so completely and for so long.

The health of the financial system is now the over-riding priority. Part of the remedy for restoring it involves central banks offering liquidity against those assets that financial institutions are able to offer – including mortgages. Last Friday, the Bank announced it would accept a wider range of assets as collateral, including the highest rated securities backed by consumer loans. There is, however, much further to go before the current crisis is over.

The recent turbulence has had a dramatic effect on share prices, with sharp falls at the end of September being followed by a decline in the stock market of almost 8% on Monday. The reality is the environment in which the government can intervene is worsening rapidly.

We therefore believe there is a case for targeted intervention at the earliest possible opportunity, beginning with the interest rate decision by the Bank of England’s monetary policy committee on Thursday. Market conditions also mean that the overdue Crosby review should be published as soon as possible to help provide a template for concerted action to re-build confidence in the markets for funding mortgages.