Old Lady could relax collateral rules

Suggestions of the move follow pleading from the City of London for the Bank to follow the Federal Reserve and European Central Bank's lead in lending against mortgage collateral.

The Financial Times, a newspaper, reported on Wednesday that the Bank had almost finalised plans to accept some forms of mortgage collateral for loans made before the end of last year.

Such a move would represent a marked shift in stance for the Bank. The European Central Bank (ECB) has always accepted some forms of mortgage-backed securities, with the Fed doing so since March this year. The Bank, however, has until now appeared reluctant to follow suit.

"If the rumours are true, the Bank will have done a 180-degree turn from the position that it held in the summer," Danny Gabay, a director at Fathom, a financial consultancy, told Central Bank News. "In terms of moral hazard, this is the kind of thing that makes the Bank quite nervous: taking on illiquid assets for government bonds."

"[The rumoured move] underscores that countries with heavily indebted consumers are having to resort to extraordinary measures, which are certainly questionable from a moral hazard perspective," Marc Ostwald, an economist at Insinger de Beaufort, a consultancy firm, told Central Bank News. "On the other hand, a hard line on moral hazard may well engender systemic risk and dislocation."

Senior bankers from the City of London met with Mervyn King, the governor of the Bank, late last month and Gordon Brown, Britain's prime minister, on Tuesday to appeal for the Bank to accept mortgage-backed securities as collateral.

"The credit crunch has been unfolding since the summer but something has changed this week around Downing Street," said Gabay. "It is important from a political perspective that the Bank is engaging with the problem, though it is clear it is doing so quite reluctantly."

By enabling banks to clear mortgages from their balance sheets, the move could narrow spreads between interbank rates for three-month sterling loans and overnight index swap (OIS) rates.

The London Interbank Offered Rate for three-month sterling loans has hovered at about 100 basis points above the OIS rate in recent weeks. Costs for three-month dollar and euro loans have stood at roughly 75 basis points above their respective OIS rates.

"[Accepting mortgage-backed securities] hasn't obviously worked in the US or in Europe so I'm not sure it will alleviate the problem in the UK," said Gabay. "But it is certain that it will not do any harm."

"I would assume that the haircuts applied to the mortgage backed assets will be harsh, and rightly so, but it will be better than having non-performing assets [on balance sheets], which tie up already other very scarce capital assets," Ostwald said. "Probably more important, is how much of an injection of capital such a move will entail. £10 billion-£20 billion ($19.7 billion-$39.4 billion) will barely touch the sides. Anything closer to £100 billion would imply a seismic shift, which should see sterling Libor fall sharply along with credit spreads."