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The Bank of England - swapping secure assets for `problem` debts

29/04/2008

Today’s money markets have too many debts, too many problems – and not enough cash. No-one knows how much money banks and other lenders will recoup from the loans and mortgages they’ve given out, and this is restricting lending.

Why? Each bank is reluctant to lend any more money to anyone, either individuals or banks. They know it would be hard to replace their funds by borrowing from another bank, as they’d need to show they have enough assets to act as security for the loan. Even if a bank is owed billions of pounds in mortgage debts, there’s a problem: after what happened to mortgages in the US, no-one will accept these debts as collateral for a loan. So although those ‘problem’ debts are assets, they can’t be turned into cash.

Solution to a debt problem?
To stop the financial system from freezing under the weight of these debt problems, the Bank of England (BoE) has a plan to make it easier for banks to lend to consumers and to each other. The BoE is offering to temporarily swap banks’ mortgage debts (and credit card debts) for secure government bonds, which other financial institutions will be willing to accept as security.

A few important points:

• Experts don’t expect this move to slash the cost of borrowing, but say it may stop the cost of borrowing from rising further.
• Banks can only trade mortgage debts which were on their books at the end of 2007 – the BoE wants to help banks use their existing mortgage assets, not encourage them to grant risky mortgages, knowing they can swap them for bonds.
• The BoE expects the banks to want about £50 billion of bonds to start with, but hasn’t fixed a maximum limit.

To protect itself, the BoE is only offering banks 70-90p of bonds for every £1 of these assets. Still, even 70p of secure assets is better than £1 of problem debts nobody wants.

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