Investment Management Blog - Montague Capital

The detailed terms of what is now officially named the Special Liquidity Scheme (SLS) represent a successful limited rearguard action, by the Bank of England at least, against “moral hazard”.  If banks want to play at all then they have to take a minimum amount of funding as dictated by the Bank.  The fee for funding is the 3-month LIBOR gilt repo rate spread.  If banks want cheaper money then they had better start lending to each other once again and help to drive the LIBOR part of that spread down.  But even when they do, the Bank will still charge a minimum of 0.2%.  The fee is set at the start of a drawdown period and only re-set after three months, so even if spreads do come down banks will take a hit.  As for the assets that qualify as collateral, “synthetics” based on derivative contracts are out.  But – and the authorities may live to regret this – credit card debt securities are in.  (The current propaganda, disseminated as part of the highly successful flotation of Visa, is that credit card debt is OK.  But will mortgage holders, faced with the threat of repossession or considering unilateral default, not have reneged on their credit cards already?  Credit card debt, like monoline insurers, is just something we find it easier to ignore in the hope that it will just go away.)

The Mortgage Master Trust

One important detail of the SLS was not successfully back-briefed in advance.  The cut-off date for residential mortgage backed securities to qualify as capital is 31^st December 2007.  Mortgages issued after that date, but which reside within a Master Trust, do not count but nor do they disqualify the Master Trust.  Rather, the pre-31^st December 2007 element will qualify, but on a declining balance basis as the SLS progresses.  So, all the toxic waste is “in”.  The Bank of England has no interest in supporting the creation of new mortgage products, just in freeing up the liquidity logjam.  Indeed, in a comment that puts it at odds with the Treasury, the Bank said that it would be relaxed to see “some adjustment in the housing market and [that the SLS] is not designed to impede this adjustment… it is not designed to send the mortgage market back to the rather wild lending before the turmoil began last summer.”

 How does one value their collateral?

It is in the valuation of collateral that the fun really starts.  Only AAA-rated collateral will qualify.  There are no US-style concessions on “quality”.  Independent, publicly available market prices will be used and if these do not exist the Bank of England will determine the price.  “Haircuts” on qualifying G10 sovereign or government agency debt, or bonds issued by the likes of Fannie Mae and Freddie Mac, are modest, ranging from 1% for sovereign debt with less than three years to maturity out to 14% for Fannie Mae 30-year paper.  The haircut spectrum for residential mortgage or credit card debt collateral starts at 12% and goes out to 22%.  To all of these must be added a surcharge of 3% if the collateral is not sterling-denominated, 5% when there is no observable price and 5% if the debt “assets” are in the borrowing bank’s own name rather than another institution’s.  The maximum possible “haircut” is therefore 35%.  This will cause the banks considerable pain and not before time too.  As the value of collateral declines (which it will do if the UK housing market keeps falling) margin calls will be made to protect the Bank’s exposure.  The detail of the SLS speaks volumes for the authorities’ assessment of the quality of UK banks’ balance sheets and the need to protect the UK taxpayer from any fall-out.  It also shows the mountain the banks have to scale before they can even think about things getting back to what passed for normal.  The SLS has a halfway decent chance of getting UK banks to behave normally again, but the interbank market as a whole will need to see a return of US institutions before we regain previous levels of excess.  Those institutions have got far bigger problems of their own at home than to be bothered with helping us.  Just look at Bank of America with its latest US$4.8bn increase in provisions against loan defaults and actual US$1.5bn write-off on mortgage positions, all for just FY08Q1.  Winston Churchill was way ahead of the game in his Mansion House speech of 10^th November 1942 after the Battle of El Alamein.  “Now this is not the end.  It is not even the beginning of the end.  But it is, perhaps, the end of the beginning.”  NB: “perhaps”.