UK mortgage plan won't end credit famine

The Bank of England has agreed to swap at least £50bn of banks' risky mortgage and other assets for easy to liquidate government debt, its latest and most radical attempt to break the back of the credit crunch.

The plan has its uses; it makes another Northern Rock or Bear Stearns far less likely and it may well bring down interbank lending rates, though this is far from clear on the early evidence.

What it is, in short, is liquidity. What it isn't is capital, which is the true constraint on British mortgage lending.

While banks theoretically could take the government bonds, turn them into cash and lend the money out to homeowners, gearing up their already very big exposure to British housing, it would be a risky move by an industry now rediscovering risk controls.

"I don't think it gives the banks a green light to go through an enormous lending programme," said Mike Amey, the fund manager at Pimco in London responsible for sterling portfolios. "While it will free up some liquidity, how much we would see in mortgage rates coming down is less clear cut."

To be sure, the plan does reduce the chances of a blow-up in interbank lending and the damage that would do to the mortgage market, but it will not end what amounts to a credit famine in Britain.

Approvals for British mortgages hit a record low recently, according to data from the Council of Mortgage Lenders, falling by almost half compared with a year ago.

The reasons for this are straight forward and not fundamentally changed by the Bank of England plan. In recent years, the amounts Britons could borrow to buy houses, and the costs, were turbo charged by a hot market for loan securitisations.

That market accounted for something in the order of 35 percent of all loans in the year to July 2007, when the storm broke and the market shut.

The competition from the securitisation market forced all lenders to cut their prices and standards. According to Bank of England data, the effective mortgage spread, essentially the extra interest above their funding costs banks charge mortgage borrowers, fell steadily and precipitously in recent years, from about 100-120 basis points in 2003 to about 40 basis points last year.

In retrospect, given that some loans go bad and it costs money to run a bank, it wasn't much of a business model.

That spread is now rising and can be expected to go back to its traditional peaks, if not beyond. At least half of all mortgage deals available earlier this year are gone, and it is now all but impossible to borrow the full amount of a house purchase.

The solution to the situation will be lower house prices, less lending and a better capitalised banking system.

British banks are more thinly capitalised in many instances than their international peers, and what is needed now is time for them to raise capital, sell assets and cut lending ratios. That process has clearly begun with Royal Bank of Scotland's record £12bn rights issue, and it's reasonable to expect similar moves from several of its peers.

But while that will help over time, a sharpish fall in house prices in the UK seems inevitable, and self-fulfilling. Few banks will want to be terribly aggressive into a falling market: buyers will feel much the same.

"There is no guarantee that increasingly risk-averse lenders will reverse the recent tightening in lending criteria, meaning that mortgaged borrowers will still find their purchasing power reduced," Capital Economics analyst Seema Shah wrote in a note to clients.

"Add a weak economic backdrop to the mix and the housing market outlook is certainly not looking up. We now think house prices will fall by eight percent this year."

Morgan Stanley estimates that a two-year decline in house prices of 15 percent, which is not beyond reason, would leave 1.2 million households, or about 10 percent of all people with a mortgage, carrying a total £164bn of negative equity.

There are important differences between America and Britain, of course, not least that borrowers in Britain are on the hook personally for their debts and therefore less likely to default.

Even so, if a substantial fall in housing brings leaves many owing more than their houses are worth, 2008 will not be the last difficult year in Britain.