The crunch is still crunching

On Tuesday, mortgage lenders went to see the prime minister to press him to intervene and restore stability to Britain's battered financial markets.

The banks peddled their usual self-serving presentation. The interbank market has disappeared, mortgage volumes are shrinking, and collapsing credit levels have blown away support for obscenely overvalued house prices. The mortgage lenders no doubt finished their account of impending financial apocalypse with a veiled threat connecting house prices with elections results.

Brown would have no difficulty in picking up the deeper implied messages from the lending community. If only credit levels could be restored, then everything would sort itself out. House prices would again increase. Banking sector profitability would be restored. Brown and his New Labour crew could again hope that electoral annihilation isn't waiting for them down the road.

Things are desperate. As the above chart demonstrates, interbank lending spreads are again rising, and they are now approaching the levels reached during the post-Northern Rock bank run. Interbank lending volumes are a fraction of the levels seen before the summer crisis. Trust has evaporated and the banks are screaming for the government to come and take the pain away.

The Bank of England had anticipated the mortgage lenders request for assistance. According to the FT, BoE staff are putting together an arrangement under which quasi-insolvent banks can swap their mortgages for high quality government debt for a period of between one and three years.

Unfortunately, all the ingredients for an unprecedented fiscal disaster are now in place; desperate politicians, greedy executives; a weak central bank and a short-term fix to a deep-seated problem of misaligned asset valuations.

In the long-run, this plan is doomed to failure. It is riddled with dangerous incentive mechanisms that will only make matters worse. Think for a moment, why would any bank transfer a mortgages off their balance sheets. They would only do so if the expected rate of return on those assets were lower than government paper.

Since the plan is a swap, the government would receive the return on the mortgages, while the banks would receive the higher interest rate on the government debt. In reality, this scheme would amount to a subsidy for the banking system. Moreover, the banks would have every incentive to maximize this subsidy. The costs of this scheme could be potentially huge.

Then there is the age-old problem of moral hazard. This scheme would set a precedent. Whenever banks lend recklessly, and solvency problems arise, the government will always be there to sort things out. The risks of further financial difficulties down the road can only increase.

The real problem will remain unresolved. The UK household sector is sliding into its own solvency crisis. Far too many homeowners are carrying too much debt, and it does not matter who is holding the claim - government or bank - people are going to default in large numbers.

The solution to this problem does not start with a resumption of interbank credit and a renewed explosion of retail credit growth. Heavily indebted households need to repair their balance sheets, reduce consumption and save more. However, that solution runs counter to the interests of Brown, the lenders and the rest of the housing bubble industry.