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?


Anonymous said...

"I am still a little confused about who is paying what."

I'm glad you said that, I'm fed up giving myself headaches thinking about the ins and outs of this little transaction. Perhaps the details are deliberately obscure. The credit card debt and the foriegn assets add an interesting twist, it would have been nice though if the BofE had demanded that before accepting these swaps banks raise some capital via share issues like the RBS.


ghostwriter said...

This is how it works, I think: the banks give all their crap mortgage loans to the BoE, which gives them gilts that they can then cash in to the BoE for money to lend out. This measure had to be taken because no bank trusts another bank anymore and they won't lend to each other. The BoE will hand out money without the banks having to worry about the state of their books (which are in big trouble, but now they don't have to come clean about their writedowns). I think most of this free money will be used to plug up the leaking holes in the banks' balance sheets. And if the situation worsens, then the taxpayer will just have to empty his pockets (as usual, in matters of this ilk).

This morning I saw an ad on TV for Great Ormond Street Hospital, which is still pleading for funds from the public. I won't give any more money to charity. I am heartily sick of paying out my own money so the frakking government can give away my tax payments to the reckless, profligate, avaricious banks to help them out of a hole, instead of giving it to schools, hospitals, and the collapsing UK infrastructure. It is a goddamn disgrace.

aSteve said...

Alice, While I think most of what you post is extremely astute (and it is all interesting) I think you're judgement is clouded on the issue of this "bailout".

All the risks you highlight are risks, but that doesn't mean that the BoE will necessarily fail to take them into account. It isn't clear if you've read the official announcement:

If you haven't yet, I'd be interested to know how it affects your interpretation. My first reaction is that it is an entirely sensible and justified provision... Debts are real and have some value... the BoE can draw a line in the sand to dictate a worst case scenario - It will be very interesting to see what volume of swaps are done in practice... the greater the volume, the more desperate the situation.

aSteve said...

(Damn, where did your become "you're" - I can spell, honest!

Markbaldy said...

Gordon Brown and his cronies will use every trick possible to prop up the housing market.
The housing market and rising house prices are the heart of the UK economy - not manufacturing or exports... sadly.
They will use smoke and mirrors to sustain this bubble a while longer yet - maybe till a general election.
It will be the NEXT government which will have to sort the whole of the mess out and Gordon Brown will go down in history as the guy who handled the economy well.

Alice Cook said...


Thanks for the comments.

I understand where you are coming from. I did read the market notice, but it left me with more questions than answers.

I will admit that as yet, I don't fully understand what those terms mean in cold hard interest payments.

I think that here is where the real issue lies. The spreads between various assets will determine either a) the desperation of banks to get hold of cash (i.e. the BoE is punishing the banks with penal rates to access this facility) or b) the extent the BoE is subsidizing the banks (banks can access BoE cash more cheaply than the market).

I am beginning to think that this swap is merely an exchange of paper, with the income streams remaining at the BoE and banks. If so, this is not quite what I would call a swap.

Finally, let us not forget that housing defaults have barely changed. The real pressure on bank balance sheets has not even begun. When this thing is finally over, then we will see how hard the BoE has been with the banks.

aSteve said...


You're not alone in finding the analysis of this tricky... It is, to all intent and purpose, unprecedented.

I share your uncertainty about the income streams... and am leaning towards assuming that the treasury bills' income streams are not transferred - since the announcement doesn't specify their rate... (though that's a weak justification, I accept.)

I think the real issue remains with balance sheets. If a bank swaps an MBS with a 10-30% haircut, this means it needs to find 10-30% of face-value somewhere... because no-one will lend on treasury bills at above face-value. Given the thin margins operated by all banks - and RBS/Barclays especially - this is likely to be a significant constraint... I'd have thought.

This, of course, assumes that MBS could previously be used to borrow at face-value, or close to that... I've found no data about the previous collateral value of MBS in the money markets...

Anonymous said...


Don't beat yourself up over the fact you aren't clear on the details. That's the point. As Warren Buffet once said - If I can't understand a company's financial statements its because they don't want me to.

I think the crux of the issue is still locked inside Mervyn King's head. Is he going to do what he said and apply the golden rule of central banking (lend freely in times of crisis at penalty rates against good collateral) or is he doing a Greenspan and just lie, cheat and steal to get the government re-elected. Right now it's pretty much impossible to know which.

Not that it matters. Deflation is almost a given now that banks have exposed themselves as insolvent. No way is LIBOR staying down and no way are new loans going to reinflate any bubbles.