My King for a repo

Should the Bank reduce its collateral quality requirements and/or buy ABS outright? It is certainly thinking about it. The FT reports:

Mervyn King indicated on Wednesday that the Bank of England was poised to take a revolutionary step and buy or swap illiquid assets on banks’ books for cash or liquid assets as way to find a “longer-term resolution” to the problems faced by British banks.

One of Mervyn's motivations is to try to reopen the market for these assets, or at least allow them to be financed until such a time as the market reopens.

Commenting on the “fragility” that exists in the financial system, Mr King said there was an “overhang on banks’ balance sheets of assets in which markets have closed”

“These assets cannot now be sold or used to secure funding in the market – they are difficult to finance. That has created uncertainty about the strength of banks’ financial positions”.

This is, if late, at least right. Many ABS assets have no market at the moment. Hence they cannot be marked to market. That in turn means that they are not good collateral and hence they cannot be used in secured funding. Having to use unsecured funds to finance these assets is gumming up banks' balance sheets and making them reluctant to lend. A short term answer to this problem is a key step in regularising the markets. However, this intervention needs to be strictly limited. The FT reports:

In the short-term, [King] said the Bank would continue to lend against mortgage-backed securities and other asset-backed securities where markets are closed, but he added that such lending, while “a useful bridge to a longer-term solution” can “be only a temporary measure”.

Weaning the banks off cheap financing of illiquid assets will be difficult and there is very little experience to draw on. But still King's proposed action is the right one, even if he does not know how the story ends.

He was not specific about the longer-term resolution, since he said “it is too soon to say where these discussions will lead”, but he indicated more radical moves were necessary because “it is unrealistic to assume that markets for many asset-backed securities are likely to re-open speedily or, when they do, to their previous levels of activity”.

It is important to ensure that this does not introduce too much moral hazard, nor does it act as a guarantor for new issues.

“First,” [King] said, “the risk of losses on their lending should remain with banks’ shareholders”. This implies the Bank would only accept assets at well below face value, or would insist on banks’ indemnifying taxpayers for the credit risk they would adopt if they took hold of the assets.

“Second,” he added, “a longer-term solution must focus on the overhang of assets and not subsidise issues of new assets”. Mr King is keen not to allow another frenzy of lending and it implies the Bank would not be willing to take any new mortgage-backed securities on its books.

The devil is in the details, of course, but all-in-all the Bank's strategy is encouraging.