A layman’s guide to the latest mortgage offer from the government

Today we will hear a statement from the Chancellor announcing a much heralded statement offering up to £50 billion of near cash to the banks in return for some of their mortgages.

How is this done?
The government itself will borrow the money, by issuing bonds – IOUs – on the taxpayer.It will lend this money to the banks. It will secure these loans with banks’ mortgages. It will require a discount on the mortgages – in other words it will accept the mortgages for say 90 pence for every pound of mortgage. This discount will give us, the taxpayers, some protection against mortgages within the packages of loans that go wrong and are not repaid, and against failure to pay the interest on some of them. After the transactions the banks have £50 billion more of government bonds which can easily be sold in the market for cash, whilst the government has security of around £55billion of mortgages. The interest received on the mortgages should exceed the interest on the loans. The government/Bank will ask for top up of security if the values of mortgages continue to fall.
The taxpayer will not be out of pocket if the government judge it correctly, but the taxpayer will be at some small risk until the transactions are unwound once the crisis has gone away. At some point the government and taxpayer have to get rid of the mortgages again and repay the borrowings with which they have paid for the loans based on them.The exact arrangement is more akin to loans to the commercial banks, which gives the taxpayer more protection than buying the mortgages.

Good news or bad news? Will it sort out the mortgage market?
This transaction will of itself help in alleviating the shortage of cash in markets, and on its own should lead to new lending by the mortgage banks. As the mortgage banks acquire more cash/short term government bonds so they can lend more money to people seeking mortgages. It was a shortage of cash to meet depositors requirements and the lack of confidence in Northern Rock that led to the run on the Rock. If money and government bonds had been available like this in September 2007 there would not have been a run on the Rock.

However, it has to be seen in context. There are at least three other considerations which will limit the impact this helpful proposal will have:

1. At the same time the authorities are tightening regulation of the banks, demanding that they keep more cash on deposit at the Bank of England for any given amount of lending. Every pound of additional cash they have to keep cuts the value of this package, as it becomes a circular process. The authorities demand more cash for security from the banks. The banks do not have such cash. The authorities then give them the cash to meet the tougher requirements. No-one can borrow an extra penny, as the new cash is frozen.
2. The larger banks are international. Whilst the money will be offered to the UK subsidiary and intended for the UK mortgage market, in practise international banks look at the balance of their global business. Not all of the extra money, after allowing for bigger reserve requirements, will necessarily find its way into the UK mortgage market.
3. The UK market still has the problem of Northern Rock, which remains a negative influence on reviving the mortgage market because the government nationalised it. If instead of nationalising Northern had been offered this kind of support, it could now be offering new loans on a significant scale. Because it is under strict controls to repay the £24 billion taxpayer debt, and under strict surveillance not to be too competitive as a subsidised bank, it cannot play an important role in reviving the mortgage market in the UK.

So will it work?
It is a helpful package. Whether it is enough depends on how much further the authorities go in tightening reserve and cash requirements, and how quickly they want the Northern Rock money back.

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15 Comments

  1. crown
    Posted April 21, 2008 at 8:09 am | Permalink

    It may work to help lower bank borrowing rates slightly, but it will not help the lenders maintain their crazy lending criteria from last year. There are other factors in play as well.
    http://thecrownblogspot.blogspot.com/2008/04/quad

  2. tim holden
    Posted April 21, 2008 at 9:32 am | Permalink

    They have moved from total arrogance to blind panic. The situation has become extremely volatile, and the next few weeks might not be survived by the current crew. Their single advantage is the apparent lack of choice in Labour's leadership – but some of them, inadequate as they are, harbour their own little illusions on that score. It is possible that the Gordon Brown Story is drawing to a swifter conclusion than many thought likely.

  3. Posted April 21, 2008 at 10:27 am | Permalink

    A week ago this evening the BBC screened a programme called 'Flat Broke' as I reported on my blog, it showed distressed sale 'buy to let' flats in the North failing to get any bids at auction at roughly half the prices paid only a short time ago.

    What are mortgages on such increasingly unlettable properties now worth? The seven per cent discount you mention as being offered by HMG seems already lost by the real market facts.

    The fifty billion further erodes the value of sterling so talk of housing maintaining any kind of a market value thus becomes meaningless when expressed in an ever increasingly valueless currency.

    Only tying sterling to some fixed commodity value, which could result in an inward surge of otherwise homeless and similarly floating foreign funds (flotsam or jetsam?), will now seem to offer any hope.

    Can you ask the PM why he allowed house prices to be removed from inflation indices on Mervyn King's appointment?

    Reply: It is likely a discount of 10-20% will be applied to a mortgage valued at the already lower market rates, according to the most recent intelligence coming from the press. That offers more protection.

  4. Iain
    Posted April 21, 2008 at 11:09 am | Permalink

    It seems to me there is also an inflationary aspect to this as well , for the previous money cycle was- we buy goods and oil from the Far East and Middle East , and they, with their savings take up our securitised mortgage debt. Now we continue to buy their goods but its the Bank of England coming up as the buyer of securitised mortgagee debt, adding £50 billion to our already bloated money supply.

  5. Tim Skinner
    Posted April 21, 2008 at 12:29 pm | Permalink

    Why should the government be trying to prop up the property market? If property prices fall that is not obviously a bad thing, even if it is bad for some people.

    Why should the government prop up the banks? Are not the ones most at risk those which took the greatest risks?

    The politicians attempt to control and manipulate the markets, and are currently feeling thwarted that market interest rates do not respond to central bank/government interest rate changes as they once did.

    Rather than think what the markets might be telling us, and what the markets might usefully be doing in terms of reallocating resources, instead the politicians seek to overwhelm the market signals and reassert "control" so they can carry on the old inflationary vote buying game.

  6. Posted April 21, 2008 at 1:09 pm | Permalink

    While I broadly welcome this decision, I have to say that it is action that should have been taken sometime ago. I hope people don't believe that this is going to be passed on to the consumer anytime soon. In fact my Bloomberg screen has only shown a marginal improvement on the LIBOR / base rate spread.

    I will just leave this quote from my blog entry:
    Just about every Central Banker in the world realized sometime ago the exigency of the moment, while the Bank of England lacking leadership from the Prime Minister and the Exchequer, seemed more intent on riding their moral high horse (moral hazard). The refusal of the Mervyn King to pump much needed liquidity into the markets as early as last August was an incongruous decision.

  7. Steven_L
    Posted April 21, 2008 at 2:30 pm | Permalink

    I also think that to some extent we are still at the mercy of the US economy. If it goes into recession more assets will slump in value and banks will see more risk that their counterparts' balance sheets are not up to scratch.

    From my observations our markets seem to react much more to events in the USA than they do to events and annoucements regarding the UK economy. I don't think we have enough leeway to borrow and spend our way out of a US slump like we did after dotcom without creating serious problems for the future.

    If problems in the US keep freezing up our interbank lending I question the extent to which we can avoid a recession by continuing to throw money at the problem.

  8. Matthew Reynolds
    Posted April 21, 2008 at 3:47 pm | Permalink

    Financial markets should be further deregulated so that rules are made simpler to boost the value of this plan . They could also double the repayment period for Northern Rock thus boosting its amount of ready cash ( as its repayments would be 50% less & would take twice as long meaning that in the short term it would have more funds ). The MPC could get back all its powers , its independence could be enhanced by giving its members non – rewable 7 year terms and new members would have to have their appointments approved after an investigation & questioning by the Treasury Select Committee . They could make a recommendation and the House of Lords could have a debate & vote ( they could block the appointment if the vote went against the nominee ) . The MPC should have to use monetary policy to slash RPI-x ( the more reliable inflation target ) to 2% within four years and then have a pepetual two year RPI-x target of 2% ( which would be the basis of their monthly monetary policy decisions ). Stamp duty should be axed on shares , the first £500,000 of all property deals exempt from stamp duty while rates come down to 1% , non dom tax hikes get the axe and CGT goes down to a 10% flat rate . You could fund that via the public spending cuts that I suggest in my response yesterday . Public spending growth must be restricted so that the PSBR is wiped out in five years time . Passing on debts to future generations due to present day profligacy is morally wrong and economically insane as it means more tax to service the debt interest payments and the harm done by rising taxes under Labour is clear for all to see ( just ask Frank Field & 6 Labour PPS’s ! ) .

    This would mean an end to the immediant banking crisis , a more effective anti inflation policy , measures to boost the Square Mile & property market ( at a time when we need them to do well so that a recession can be averted ) and a less risky , more prudent fiscal policy . That would give economic confidence a shot in the arm when the PSBR , inflation & unemployment may start rising and share prices, banking sector and housing market are looking shaky . I think that to revive our dodgy 1970’s style economy that Brown has created we need the kind of policy agenda that I suggest – i.e. the response to the Labour created mess needs to be bolder than was announced earlier .

  9. Cliff
    Posted April 21, 2008 at 4:52 pm | Permalink

    John,

    I watched you on Sky News today, you provided a clear set of opinions that gave those like myself with no understanding of economics, some insight into the workings of public finances.

    Am I right in thinking that many banks have made record profits in recent years? If so, have they taken a leaf out of our government's book and not set aside anything for a rainy day during the days of sunshine and plenty?

    Is the BOE, for all intents and purposes, acting like a factoring company for the banking sector by effectively putting up cash against the debtors ledger of the banks?

    REPLY;The Bank of England is lending to the banks, as they need more cash and near cash, in rerturn for taking claims over their other assets.
    Yes the banks have made good profits in recent years, but now are having to show they in practise lost a lot of money on poor loans which now have to be written down or off.

  10. mikestallard
    Posted April 21, 2008 at 5:12 pm | Permalink

    In among all this loose talk of squillions, billions and the dreaded hundreds of thousands, let's go for perspective.
    Every year the total government take in taxes is between £600 and £700 billion.
    The Northern Rock fiasco cost, according to the Telegraph leader today, £100 billion.
    Now we see a further £50 billion at risk.
    This, let me point out is one quarter (OK – round about) of the government's annual income at risk.
    If I went out and put one quarter of our family yearly income on, say, a horse, my wife would not be a happy camper.

    Meanwhile, back on the farm, an attempt to tax rich people (non doms) failed.
    At the moment, an attempt to tax poor people is failing too.

    Do you remember Necker?

    Reply: The cost of the Rock will not be £100 billion – it will be the losses we have to pay for which have not yet been incurred. The £50 bn should be safe, as they are planning to take plenty of cover for the loans. But, yes the government has borrowed and spent too much.

  11. Steven_L
    Posted April 22, 2008 at 1:21 am | Permalink

    "Am I right in thinking that many banks have made record profits in recent years?" (Cliff)

    A lot of them are annoucing good profits this year, but it's not their profit and loss accounts people seem to be worried about. From what I'm reading (and I'm no economist either, I just try to keep up as best I can) it's their balance sheets that are the problem from what I can make out.

    I think there are definately good arguments to be made for letting the weeker banks sink and be swallowed by their more prudent competitors a la Bear Stearns. If the government had let Lloyds TSB grab Northern Rock the taxpayer would arguably be exposed to less risk.

    One thing I do know about economics is that it is not an exact science. There is no crystal ball that can predict without fail the day to day decisions of the consumers, investors and businesses that make up the world economy. This swap is an attempt to manipulate those decisions in some respects by trying to get banks lending to each other and closer to target rate and tackling what politicans believe is irrational behaviour in the debt and credit markets.

    Before this all started I had never heard of LIBOR, I had presumed that mortgage rates tracked B of E base rates. I can't help thinking that given the price inflation most consumers are feeling, and the amount of risky debt around, that this is not just interest rates correcting themselves. I've heard it call a 're-pricing of risk on this blog before, but I've been thinking for a while the decoupling of the LIBOR is basically an interest rate correction. I also think that 'credit boom and bust' is a better description than 'credit crunch' to describe what is actually happening.

    But that's just my opinion.

  12. David Jensen
    Posted April 22, 2008 at 2:58 am | Permalink

    Dear Mr Redwood,

    The exuberance, vast profits(at the expense of the consumer and pensioner) and greedy bonuses was fabricated on a house of cards and was the inevitable conclusion to this chapter. For the downside to now be covered by the BoI and allow continued risk taking with financial instruments globally is not capitalism. I do not know what it is but it smacks of spoiled kids. The club members of the elite have seen their fortunes contract and are now pushing thier political mates, slaves, school chums to induce national arguements for unfair support that they do not deserve.

    If I take a risk with my business and step over my banking covenants through greedy/foolish profit extraction I will be called in and asked to redress my capital position by the banks or put into recievership. The BoI know this but do not force the banks to face their greed in the same way that the banks force their customers to face upto their own actions.

    This money, and there will be much more to come, should be reserved for uk customers and kept away from everything appart form the morgage business.

    Its shocking that excessive profits are owned by the shareholder and the rckless greed of spending these profits is rewarded by the BoI.

    David Jensen

    Reply: It is important that this money is advanced on commercial terms, with no taxpayer subsidy. Without this money there will be less for banks to lend, which means fewer jobs and less business all round.

  13. Adrian Peirson
    Posted April 26, 2008 at 1:48 am | Permalink

    Govts have to intervene otherwise the scam is up, when you deposit money with the Bank, it has already been determined that at any one time only 10 % of deposited money is redeemed.
    Therfore, for centuries now Banks have been lending each Pound on deposit to ten other People, at the same time and at around 8% interest.

    Obviously this is fraud, since it is not theirs to lend out and they do not have the reserves to do this.
    They are able to get away with this so long as too many people do not come back asking where their money is, IE in a Bank run.

    Credit is Obviously thin air and Paper money only costs Pennies to Print.

    Lowering interest rates ensnare Borrowers to take out loans, the banks then raise interest rates hauling in the assets of those who have over exposed themselves.

    Nothing to do with the economy, it is all decided by how many people they have ensnared.

    This is how they have accumulated Vast wealth, the coming tsunami is the final one, it is designed to bring us to our Knees and accept the New World Order with them at the top and use Proles squabbling amongst ourselves at the Bottom.

    This is what Brown ( Not Darling you note ) was discussing with the Bankers in the US.
    http://www.youtube.com/watch?v=OnwLgrSJZKs

    Note Rockefellars Involvement here :-
    http://www.brusselsjournal.com/node/865

    and here
    http://www.youtube.com/watch?v=0gk9sABtJxM&eu

    http://www.bnp.org.uk/?p=191

  14. Adrian Peirson
    Posted April 26, 2008 at 1:49 am | Permalink

    Punish the Bankers, write off Peoples Mortgage debts NOW.

    Reply: Such drastic action would also punish the people. Bankers are people too.

  15. Posted December 25, 2008 at 5:08 am | Permalink

    Nice! i`ll be stopping by from time to time ;)

  • About John Redwood

    John Redwood has been the Member of Parliament for Wokingham since 1987. First attending Kent College, Canterbury, he graduated from Magdalen College, and has a DPhil from All Souls, Oxford. A businessman by background, he has been a director of NM Rothschild merchant bank and chairman of a quoted industrial PLC.
    Published and promoted by Thomas Puddy for John Redwood, both of 30 Rose Street Wokingham RG40 1XU
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