What did the Bank of England do yesterday?

The Bank has announced a “special liquidity scheme” to try to get the money markets moving and boost confidence. Under the plan, Britain’s banks and building societies can cumulatively swap up to £50 billion worth of mortgage assets and credit card debt in return for Treasury bills — special bonds backed by the Government — for a fee. The bonds can then be exchanged for cash in the money markets. The bonds became available yesterday and banks have six months to swap them for their mortgages. The bonds will be issued for up to a year but can be extended for up to three years. Only AAA-rated mortgage assets, credit card debt and certain soverign paper is eligible to be swapped as part of the scheme. Mortgages linked to the US sub-prime market are not acceptable.

Why has the Bank had to do this now?

The purpose is to get the banks to start lending to each other and their customers again. Because of the knock-on effects of the credit crunch, banks have become very wary of issuing loans and interbank lending has virtually dried up. This has had a disastrous effect on the mortgage market with several banks and building societies being forced to raise their rates and reduce the amount of products on offer to first-time buyers. This has led to downward pressure on house prices, which in turn has hurt consumer spending and the wider economy. Mervyn King, the Governor of the Bank of England, said the situation has been bad for some time but became markedly worse last month. It is hoped that banks will be more willing to lend if borrowing banks pledge them government bonds — not mortgages — as collateral.

Is taxpayers’ money at risk?

In theory it is, although Mr King insists the risk to the taxpayer is “negligible” and that any losses in the value of the assets would stay with the banks. For the taxpayer to be vulnerable, Mr King says a bank would have to collapse and simultaneously house prices would have to fall dramatically and defaults rise. In that scenario the Bank would be left holding the mortgage assets on its own balance sheet with the taxpayer sitting on any losses. However, the Bank has put in place a series of protective cushions. First, it is charging the banks a fee for the service. It is also demanding a higher amount of mortgage assets in exchange for the bonds. For example, the Bank would demand £120 million in mortgage-backed securities for a bond worth £100 million. In addition, if the value of the assets does fall at any time during the three-year period, Mr King has told the banks they must replace the lower-quality assets with higher-quality ones.

Is £50 billion enough to solve the banks’ problems?

No. The £50 billion on offer is a drop in the ocean when it comes to the banks’ mortgage assets and Mr King himself said yesterday that sum could easily be soaked up in the first month or two. Analysts said the sum equated to about 10 per cent of banks’ wholesale funding needs of £550 billion and less than 5 per cent of the total outstanding mortgage stock of nearly £1.2 trillion. Mr King insisted that the size of the available scheme was open-ended, although it would not be a bottomless pit. He also said it was possible for banks to include traditional mortgage loans held on their balance sheets that have not yet been securitised, which would dramatically increase the size of the collateral pool. Mr King also emphasised that the scheme is restricted to collateral that existed before 2008 and was therefore not designed to encourage new lending.

Doesn’t this amount to another massive bailout for the banks, just like the rescue of Northern Rock?

On some level it does, because the Bank is having to rescue the banks from a situation that they cannot resolve on their own. But Mr King insists that his actions are not designed to protect the banks; rather they are intended to protect the rest of the economy from the failings of the banks. By boosting liquidity in the markets, the aim is to allow the banks to start doing what they are supposed to do — lending money. He says the bonds will not be allowed to be used by failing institutions and can only be given to healthy banks to help to ease the pressures in the money markets.

Will the Bank of England’s actions ease the mortgage market and help first-time buyers?

The Bank’s actions should help to ease the tight conditions in the interbank lending market and encourage the banks to start lending again. That will enable some of the bigger banks and building societies to offer a wider range of mortgage products, but there is no guarantee that lenders will lower the costs of their mortgages to customers. In fact yesterday, Abbey, the third-largest mortgage provider, raised its rates by up to 0.61 per cent. For the mortgage market to be stimulated further, and the cost of mortgages to fall, Mr King would need to cut interest rates again next month by at least another 25 basis points, analysts said. Even if interest rates are cut, however, there is no expectation that mortgage rates will go back to the hugely discounted levels seen last year and house prices are expected to continue to fall.

What's on offer

For £1,000 of AAA-rated mortgage securities, a bank receives:

— Under three years to maturity: £880 (12 per cent discount)

— Three to five years to maturity: £860 (14 per cent discount)

— Five to ten years to maturity:

— £830 (17 per cent discount)

— Ten to thirty years to maturity: £780 (22 per cent discount)

Banks face a total discount of up to 27 per cent for the highest-risk products allowable under the scheme

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