Should The Government Take On Questionable Mortgage Debt From The Banks ?

Today's morning news highlighted some further developments in the current catalogue of economic woes: Firstly, a meeting with 'the banks' at No 10. Secondly the reporting of a 'widespread fall' in house prices. To quote 'Private Eye': Are they by any chance related?

The BBC has reported this morning that there is the most 'widespread' fall in house prices, according to the 'RCIS Survey', that has occurred over the past thirty years. This is obviously bad news, but the 'small print' does bear some examination. In particular, this headline does not relate to the size of the falls, but simply to the fact that they have fallen consistently across a range of geographic locations.

It has also been reported that one of the items on the agenda for the meeting with bankers at No 10 will be the issue of whether banks should be able to use their mortgage debt to obtain additional financing from the authorities. This is an interesting idea, and one that parallels earlier developments in the US. However, there are pros and cons. The main arguments for and against are:

• In Favour: By helping the banks and easing liquidity, the banks would have much more room for manoeuvre, and so benefit us all.

• Against: Is that banks that have leant irresponsibly would be able to offload some of their risks, ultimately onto the taxpayer. However, both of these arguments are superficial, and bear closer examination.

It is undoubtedly true, as we have commented in the past, that some very unwise strategic positioning and lending decisions have been made, particularly since the turn of the millennium.

If we look at this from the 'portfolio risk' perspective. Many banks and other financial institutions have a large proportion of their exposures in a combination of mortgage debt, and also 'inter-bank' loans. In risk-speak, this situation is known as a 'concentration', and is normally something that a good portfolio risk manager would either avoid or 'price in' carefully.

Such 'concentrations' are bad for a number of reasons. If we use sensible ways of measuring risk, rather than simplistic methods (such as 'Expected Loss'), then the effect of such concentrations is starkly reflected in the behaviour of these risk measures.

However, mortgages are a vital part of the financial framework of the country, and are always likely to be a significant part of the portfolio of exposures of our banks. Therefore, it is worth considering whether there are any sensible ways of addressing this situation, and reducing some of these systemic risks that are inherent in this situation.

In the present context, there are two main factors that could make a bad situation much worse, and to some extent, unnecessarily so. Firstly, market psychology - which tends to create a momentum, even when it is not necessarily justified. Secondly the overall reduction in liquidity means that banks are unable to oil the wheels of the economy to help remedy the situation. These two factors are also strongly inter-related, a lack of liquidity drives, both directly and indirectly, negative market sentiment.

Unfortunately the term 'liquidity crisis' comes from the language of banking, and will strike most people as rather divorced from everyday life. In essence, the banks do not currently want to lend to one-another, partly because they fear that their counterparties may suffer serious losses, and they may not get their money back.

However, such a crisis, if sustained, could act as a major force that would throttle back the economy and precipitate a much worse situation in the longer-term. This would drive increasingly negative market sentiment, and set up a self sustaining vortex of financial destruction.

It is particularly important to address this problem in the UK at the present time. For the moment at least, there are a number of relatively positive factors in our economic situation - which tend to be eclipsed by the mounting bad news. This means that, although a significant ammount of pain is inevitable, some of the most dire projections can probably be avoided, given the right action now.

In particular, one of the most important considerations should be to make sure that businesses, and particularly small and medium businesses, which are always particularly vulnerable to economic fluctuations, and are regarded by lenders as 'risky', are sustained.

So how does all of this relate to the banks using mortgage debt to raise finances from the authorities? Like the rest of us, banks decide how much they can afford to risk (and particularly lend) according to how much they can afford to lose, which is based on their available capital, and how much they can themselves borrow.

This problem is fuelled by the fact that, in a market, the value of an asset - for example a share in a company, a house, or a package of mortgage debt - is only what someone is prepared to pay for it - regardless of what we might think it is 'really' worth in a rational objective sense.

So, should the government allow the banks to raise finances using their mortgage debt ? The answer to this would depend on the extent and on the mechanism used.

If the banks were to use mortgage debt as collateral against loans from the authorities, then the government would not actually own the mortgage debt, but could be able to claim it in the event that the bank did not meet their payment obligations.

This raises the rather obvious point that - under the circumstances where the banks could not meet their obligations - the value of the mortgage debt is likely to be worth rather less than they had hoped for - so correct risk-based pricing of such transactions would be crucial.

In our opinion the government should be very careful about taking on this mortgage debt, and ensure that any such transactions are structured and priced appropriately. Failing to do so could have a number of unforeseen longer term consequences, which could be ultimately counterproductive.

If the government did not manage this properly, the large amount of risk and debt that it would accrue would ultimately make it more difficult (and expensive) for them to borrow money in the money markets to fund government spending. So the taxpayer would end up footing the bill indirectly a second time at a later date.

Some measure of asset swap between mortgage debt and government bonds could be a worthwhile exercise to loosen liquidity constraints, but there are some important issues that would need to be settled:

• How big would this exchange be ?
• What pricing and valuation metrics would be used ?
• What terms and conditions would be put in place ?
• Could this turn out to be just the thin end of a rather expensive wedge ?

Special conditions could be placed on the valuation of these assets for collateral purposes, so that they would be valued at a significant discount. This would mean that this mechanism could be used to ease market liquidity, but there would be unlikely to be used excessively, and would not be taken as a sign of government weakness by the markets.

A suitable valuation metric would though, of course, have to be agreed.