The BBC is reporting that the Bank of England is close to finalising a scheme whereby British banks will be able to swap their mortgage-backed assets for government bonds. The government hopes to avoid this turning into a taxpayer funded bailout of British banks. This hope will fail.
The UK housing market is going to exhibit very considerable price falls and large numbers of repossessions. So there are going to be non-trivial losses on the banks' mortgage-backed assets. So they can't use these assets to get loans at par. Instead, the market collateral value of these assets would involve a discount, reflecting the Market's expectations of house price falls and repossessions and the additional downside risk the Market perceives to its expectations.
Now, the Bank of England will, likewise, insist on discounts. At one level matters may seem simple: if the discounts the Bank demands are greater than those the Market would demand, then banks won't use the Bank scheme, and if the discounts are less then there is a bailout. But the thought is that matters aren't quite like this, because special market conditions mean that the Market's currently demanded discounts would be lower than its true estimate of the losses and risks on these debts themselves - larger discounts would be required because the market is so thin. Hence, if one could formulate a proper estimate of what discount the Market would be offering if it were functioning properly, then the Bank could offer a slightly larger discount than that figure and the market would start to function again. So, the Bank could offer a discount rate between the current Market discount and the "equilibrium" Market discount and there would be no bailout.
Let's for a moment set aside the poor incentive properties of using such a scheme and ignore doubts as to the "logjam" narrative and buy the principle of the story. There remains the question of whether, in practice, the requested discount that the Bank of England will offer that will find any buyers will really lie between the current Market discount and the equilibrium discount. I submit that it will not. Why not? Because for any discount the Bank of England offers there will be an implied set of expected house price falls and repossessions. So, if the Bank offers a discount of X%, one could back out of that estimate that the taxpayer will still not be out of pocket provided that house prices fell by no more than Y% and there were not more than Z thousand repossessions.
But now some political realities enter. For the great likelihood, I submit, is that the British government could not be seen to implicitly endorse the Market's true expectations of price falls and repossessions. For example, my guess is that if the Bank of England's discount implied that house prices fell by 20% and there were 100,000 repossessions, government commentary would be that that was an extremely conservative figure - obviously there would not be nearly so many repossessions as this and obviously there would not be house price falls this great, so a discount of this level would be well below the "equilibrium" level and should be seen to provide comfort to the taxpayer.
But now let us suppose that, instead, the Market were actually expecting 40% falls in prices and 500,000 repossessions, and that the risks to this lay mainly on the downside (i.e. bigger falls and more repossessions). In that case, the discount the government should be requiring should be more like that implying 60% falls in house prices and a million repossessions. But the government could not possibly, as a matter of political reality, endorse the thought that such enormous problems were a possibility. Hence if the Bank of England were to attempt to offer such a large discount, the banks would simply refuse to take up the scheme - even if that discount were between current Market rates and the "equilibrium" level - knowing that, at a later stage, the government would be bound to offer much lesser discounts. Whatever the Market's true expectations are of house price falls and repossessions, the government will feel able to endorse only a much lower figure.
Hence in practice the banks will able to exploit the government's political difficulties in admitting to any material housing market problems in order to secure much lesser discounts than the equilibrium market level, and taxpayers will end up with huge losses - effectively buying the banking system's bad mortgage debt, leading to huge problems of moral hazard in the future and the need for massive additional financial regulation. As a rough estimate of the scale of these things, the superior financial development of the UK compared to other parts of Europe probably adds something like 0.2-0.4% to the UK's sustainable growth rate. My guess is that we'll lose about half of that because of the additional financial regulation that will the inevitable concomitant of the various bailouts being offered (and which have been and will be offered) to banks as part of recent market turmoil - something like 0.1-0.2% off the UK's sustainable growth rate over the next couple of decades. That's quite a price to pay. And that is before we take account of the (much smaller) effect of the losses taxpayers will bear - let's say, something like £3bn on Northern Rock (it would be more, but the scheme described above will be to the particular benefit of Northern Rock) and something like a further £10bn out of the bailout above (obviously the latter is very hard to guess until one sees the specifics of the discount offered).
The alternative path would be to really believe in light-touch regulation, instead of just repeating the mantra. For light-touch regulation implies that we let people make their own mistakes - and make losses if they get it wrong. But of course, it's a lot easier to believe in light touch regulation when times are good...
