Tony Curzon Price (London, oD): The FT's Martin Wolf, whose commentary I have consistently admired throughout subprime, has another excellent column in which he asks for house prices not to be propped up by government intervention (much as I did below).
However, he takes a largely approving stance on the BoE plan to swap good tax-payer money for bad bank loans:
Whatever the source of the problem, a case exists for further action by the Bank of England in its role as lender of last resort. At present, it is working, in conjunction with the Treasury, on a scheme to swap high-grade mortgage-backed securities for government debt for terms of one to three years, after a sensible "haircut". But credit risk would still remain with the banks.
His defence relies critically on the euphemism of the "haircut." Samson-like, some investors get shorn of their valued locks when they have to accept a loss on an investment. Happens all the time in the cut and thrust of finance. The idea is that if a bank owns £100,000 of mortgage, the BoE might swap it for £75k of tax-payer backed debt. The £25k difference reflects, on average, the anticipated fall in the value of the housing collateral. The £25k haircut is spread amongst banks' shareholders and managers and whoever actually owns the mortgage backed securities. Of course, all the securitisation of recent years has made the story more complicated - there is now a queue for the hair-dresser. The barber needs his yard of hair, and will cut the locks of those in the queue until he gets it. Coming out, some will be skin-heads and some will be Samsons. Those at the back, at the top of the pile of investors, hope, Rapunzel-like, to keep all their beautiful hair. Whether or not they do depends on whether the housing downturn turns into a rout of "walk-outs" as households give up paying for negative equity.
But what is the right discount? what is the pound of hair the taxpayer should ask for? As Martin himself points out in his column:
At long last, investors in mortgage-backed securities, all too aware of what has happened in the US, have realised the dangers in the UK. They must understand that it becomes extraordinarily difficult to know what such securities are worth as soon as house prices start to fall.
There is no way the BoE, as our agent in this transaction, can chop locks without also taking a position on long term house prices and on the default risk of various pieces of securitised lending. That is what a "fair haircut" amounts to. If it does not do so, there is no way to operationalise Martin's admirable goal of "keeping credit risk with the banks." If we don't cut the hair aggressively enough, we will have taken credit risk.
We obviously can't ask the banks how much of a haircut they need, and if we offer a swap rate that is stringent, the banks will do everything they can to avoid taking up the offer. As the monks of Salamanca determined long ago, not even God knows the Just Price, so we certainly can't hope to get the haircut right.
Supply of funds into the mortgage market will not resume until house prices have fallen to levels where the default risk on new contracts is sensible. As Martin agrees, let that happen fast. Banks have stocks of assets that were ultimately backed by collateral that turns out to be shaky. Like Samson shorn of his locks, they no longer have the power to lend because the quality of their reserves is impaired. Regulation as well as prudence is turning banks into cash-hoarders.
The real worry is that this will stop banks from making sensible loans, for example to small businesses (large corporations don't really need banks any more to raise capital - they go straight to markets and pick the instrument most suited to market conditions at the time). It is the high street banks who have the relationships, knowledge, loan officers and procedures to check whether business X is good for its money. Without these loans, some small businesses will go under.
This suggests an alternative way of going after the subprime casualties. Don't let us, as taxpayers, ask that our agent the BoE try to play Vidal Sassoon in the mortgage market - it's too far out of kilter. Instead, let's offer to swap business loans for tax-payer backed bonds. This is what we want to save - while the skin-heads, Samsons and Rapunzels sort themselves out in the mortgage market.
