King pledges more cash to help banks' liquidity
Nick Clark, The Independent, 27 Mar 2008View original article
The Governor of the Bank of England yesterday pledged to continue supporting liquidity-starved banks, but stopped short of promising to buy worthless mortgage-backed securities.
Mervyn King told the Treasury Select Committee that following last week's summit meeting with leading banks, he was in continuing talks with the sector over finding a "longer-term solution" to the credit crisis.
Mr King promised that the central bank would "provide the liquidity assistance that the system needs in order to restore confidence". However, while the Governor confirmed that in December, January and March the Bank had broadened the range of collateral it accepted on repurchase agreements to include certain residential mortgage-backed securities, he denied any plans to begin buying unwanted mortgage-backed securities.
Such a move would be hugely controversial, with critics claiming that it would amount to taxpayers bailing out the City. "We are taking some mortgage securities as collateral on repo agreements," he said. "That is very different from offering to buy all mortgage-backed securities."
Last week, the Bank again pumped billions of pounds into the money markets in addition to the weekly funds offered to commercial banks. However, the extra liquidity has failed to bring down the cost of borrowing, with the Libor rate at which banks lend to each other touching 6 per cent yesterday.
Mr King said the offer of funding assistance was only a temporary measure, adding "we are discussing with the banks how a longer-term resolution of the problem might be reached".
He warned it was too soon to say where the discussions would lead, but the Bank later refused to give any further details on the talks.
The financial crisis has moved into a new and different phase worldwide, Mr King added. "Across the world confidence in financial markets is fragile," he warned. "It stems from an 'overhang' on banks' balance sheets of assets in which markets have closed. These assets cannot now be sold or used to secure funding in the market – they are difficult to finance. That has created uncertainty about the strength of banks' financial positions."
In addition to fresh liquidity, MPs on the committee were also told that the further deterioration of the markets meant the chances of an interest rate cut next month had increased.
Mr King said that the weakening market conditions meant the Monetary Policy Committee, which sets the UK's interest rates, was more likely to consider a cut. Last week, the MPC minutes for March's meeting revealed that the Governor's deputy, Sir John Gieve, had voted to cut rates. The vote went eight to two to remain at 5.25 per cent.
Sterling fell against the euro yesterday in the wake of bearish sentiment on the short-term prospects for the currency from the central bank.
Charles Bean, the chief economist to the Bank of England, told the Treasury Select Committee that regarding the currency "the risks are balanced on the downside", sending the pound lower in the afternoon.
Andrew Sentance, another member of the MPC, added that he expected consumer spending to weaken in the next few months. However he called outright recession a "remote risk for the UK economy at present".
Last year’s ‘bêtes noires’ were private equity funds. They had seen the light in terms of leverage and were using debt to fund major acquisitions, taking advantage of ridiculously low credit spreads and getting tax relief on their interest payments into the bargain. The Danish government’s corporation tax revenues fell by an estimated 12% when a consortium of private equity firms bought the Danish telecom operator, TDC for over Euros10bn. Too late, the Danish – and German – governments have introduced legislation to limit corporate tax relief on debt interest.
But other market players have been using leverage in a big way. Hedge funds leveraged with cheap short-term debt to make money out of the yield curve. Building societies spurned retail deposits for cheaper money-market funding of long term lending. Banks and building societies took loans off balance sheet, turning over capital more often for a higher return.
There are two common threads in all this. The first is regulation, or the lack of it. One of the attractions for investors in private equity was the lack of disclosure compared with listed companies. Hedge funds have replaced conventional investment institutions such as mutual funds, without the same regulatory framework. International banking regulation, such as Basel II, became less restrictive, as banks boasted that their risk management controls were cast iron. In the UK, the tripartite regulatory split between the Treasury, the Bank of England and the FSA meant that no-one’s eye was on the ball when Northern Rock’s business model failed.
The second common thread is the under-pricing of risk. This boom and bust has echoes of the junk bond era. No-one realised then, and no one realised this time, least of all the credit rating agencies, that if you multiply the number of corporate fixed interest securities by a huge multiple, the amount of risk in the system has to go up, not down. It doesn’t matter that a small proportion of the bonds are backed by real real estate.
Unwinding these leveraged positions has meant volatility in markets far removed from money market instruments. For example, hedge funds have been forced to sell equities to meet margin calls on loans. The Bombay stock exchange has fallen 20% in the past few months in response to such sales, despite a booming local economy. Now, commodities are feeling the heat. The sub-prime crisis has led to a volatile dollar, directly feeding the oil price.
The more volatile a market, the more attractive it is to speculators. Lots of hedge funds, with fingers burned on money markets, bonds and equities are looking for pastures new – preferably uncorrelated with their other investments. Even pension fund trustees are being encouraged to invest part of their funds in commodities. Low interest rates – seen as a solution to the banking liquidity crisis – have made speculation in commodities cheaper to fund. Analysis of past returns shows that the oil price is poorly correlated with bond and equity market returns. But oil is currently negatively correlated with the dollar and that makes it even harder for European investors. One thing is sure, whichever way the oil price goes, investors need to be on the right side of oil price volatility to make money.