Monday, 21 April 2008
The bailout begins
Today, the Bank of England announced the details of its bailout. Here are a few disparate and immediate reactions.
The asset swaps will be for long terms. Each swap will be for a period of 1 year and may be renewed for a total of up to 3 years.
The press leaked the length of the asset swaps over the weekend. Nevertheless, today’s announcement confirms the fears that commercial bank problems are deep-seated. The BoE is preparing for a protracted period of liquidity support.
The risk of losses on their loans remains with the banks.
Losses can remain with the banks so long as they are viable. What happens if a bank holding these swaps runs into serious solvency problems? I think we know the answer to that question. Generous Mrs. Taxpayer will have to reach for her purse.
During the lifetime of an asset swap, banks will be required to pay a fee based on the 3-month London interbank interest rate (Libor).
I am still a little confused about who is paying what.
Let us be clear about terminology. A swap is a “derivative in which two counterparties agree to exchange one stream of cash flows against another stream”. These new treasury bills will presumably pay a coupon, which I assume that the banks will receive. In return, the BoE receive the interest receipts generated from the collateral. These two income streams do not have to be equal. However, today’s announcement suggests that the BoE will also charge an additional fee to banks wishing to access this facility.
Alternatively, the banks and the BoE may not be exchanging income streams. If that is the case, then this arrangement is not really a swap. So far, I have yet to find a clear explanation on this key point.
Why is this issue so important? It largely determines the extent of taxpayer liability.
Banks will need, at all times, to provide the Bank of England with assets of significantly greater value than the Treasury Bills they have received. If the value of those assets were to fall, the banks would need to provide more assets, or return some of the Treasury Bills. And if their assets pledged as security were to be down-rated, the banks would need to replace them with alternative highly-rated assets.
This bailout is starting to look expensive for the banks. If it is as expensive as it looks, then why would any bank use this facility? There is only one answer and it isn't a pretty one; the banks are desperate.
Banks have to provide “assets of significantly greater value than the Treasury bills they have received”. Again, the question of income streams arises; who is receiving what? On the face of it, why would banks give up large amounts of mortgage debt in return for smaller quantities of treasury debt? That nasty word - desperation - again makes an appearance.
The Bank of England is today launching a scheme to allow banks to swap temporarily their high quality mortgage-backed and other securities for UK Treasury Bills.
The accompanying market notice suggests otherwise. It says that “AAA-rated tranches of UK, US and EEA Asset-Backed Securities (ABS) backed by credit cards”. Credit card debt does not exactly sound like high quality.
US assets issued by Fannie and Freddie Mac are also eligible, which is ironic, since today, CNN carried a story suggesting that both institutions might need its very own bailout. Therefore, the BoE is accepting collateral from foreign institutions that may also need a bailout from their own central bank.
The Debt Management Office will supply the Bank of England with the necessary Treasury Bills.
The UK’s public sector debt ratio has just climbed a couple of notches. It will be fun watching Darling deny the fact that the UK government is now more heavily indebted as a result of this bailout.
Discussions with banks suggest that use of the scheme is initially likely to be around £50 billion.
I don’t like that word “initially”. It suggests that this scheme is just starting out; £50 billion is just the beginning. Where will it end?