Bank of England Takes on Mortgage Debt

The following post first appeared on Minyanville.

Mimicking recent moves by the Federal Reserve, the Bank of England announced today a plan to trade $100 billion in government Treasury bills for mortgage-backed securities.

The Wall Street Journal reports the lending facility will allow British banks to swap AAA-rated assets backed by U.K. and European mortgages for government bonds. Although it will also accept highly rated credit card debt, the central bank said specifically it won't take securities backed by U.S. mortgages.

Similar to the Fed's Term Auction Facility and Term Securities Lending Facility, the Bank of England claims the asset swaps won't result in increased credit exposure for the central bank itself. If securities are downgraded, banks must replace them with new AAA-rated assets. Unlike the Fed's swap arrangements -- which last only 28 days at a time -- the new British facility will last one year and is renewable for up to three.

Banks in the U.K. have been slower to write down asset values than U.S. financial institutions, partly because British borrowers have kept up on mortgage payments better than their American counterparts.

Although the move may alleviate concerns of big bank insolvency, it's unlikely to jumpstart credit markets. The Bank of England will learn what the Fed has learned: Handing banks like Citibank (C), Bank of America (BAC), and Merrill Lynch (MER) taxpayer money in exchange for questionable mortgage debt doesn't mean they'll turn around and lend it out.

The capital markets operate on trust, a characteristic noticeably missing from today's environment. Whether they're lending to a grocery store, homeowner or another bank, financial institutions don't offer loans without the expectation of being repaid - unless of course they're able to offload the risk to another party. That ability, so prevalent during the credit boom, is now gone.

Faced with the choice of providing loans to borrowers increasingly struggling under the weight of inflation and an uncertain employment outlook, financial firms are keeping capital close to home. Recent fears about data integrity in the bank-to-bank lending markets evidence just how little trust currently exists in the system.

Market turmoil resolves itself as a function of either time or price. Central banks are hoping to resolve the credit crisis by removing the price side of that equation. Unfortunately for them, the market was a long time in creating this problem. It will be a long time fixing it as well.

Reprinted by Permission copy write 2008 Minyanville Publishing and Multimedia