The tier 1 capital ratios of major British banks would fall below the 6-7% minimum required by the Financial Services Authority if they were forced to write down the value of their mortgage portfolios in line with the market prices of mortgage-backed securities used by the Bank of England in its operation of the special liquidity scheme (SLS). However, actual losses are likely to be a fraction of those implied by these prices, illustrating the absurdity of mark-to-market assessments of capital adequacy.<\/p>\n
When the SLS closed on 30 January, the Bank of England held securities with a nominal value of £287 billion as collateral against Treasury bills lent under the scheme. The Bank’s valuation of these securities was £242 billion, implying a discount to par of about 16%. The collateral was mostly in the form of AAA-rated residential mortgage-backed securities and covered bonds. Since AAA tranches suffer impairment only after lower-rated tranches have been wiped out, a 16% discount suggests a much larger expected loss – of perhaps 25% – on the underlying pool of mortgages.<\/p>\n
Major banks held £496 billion of residential mortgages on their balance sheets at the end of 2008, according to the British Bankers’ Association. Ignoring additional exposure via off-balance-sheet entities, a write-down of 25% would reduce capital by about £125 billion – sufficient to cut banks’ current aggregate tier 1 ratio of over 11% by more than half.<\/p>\n
The chances of actual losses on this scale are miniscule. In the worst year of the early 1990s housing downturn – 1991 – 0.77% of mortgaged properties were repossessed, according to the Council of Mortgage Lenders. Even assuming a repossession rate of 0.77% sustained for 25 years, and a loss given default of 50%, the cumulative reduction in the value of mortgage principal would be less than 10%.<\/p>\n
The large deviation of market prices of mortgage-related securities from their likely economic value reflects extreme investor risk aversion and illiquidity. There is a strong case for the Bank of England to use its new asset purchase facility to buy such securities, in addition to corporate bonds and commercial paper. Targeting a wide range of assets would facilitate an early expansion of the facility – necessary if it is to have a meaningful impact on monetary growth.<\/p>\n","protected":false},"excerpt":{"rendered":"
The tier 1 capital ratios of major British banks would fall below the 6-7% minimum required by the Financial Services Authority if they were forced to write down the value of their mortgage portfolios in line with the market prices of mortgage-backed securities used by the Bank of England in its operation of the special […]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[3],"tags":[],"class_list":["post-2736","post","type-post","status-publish","format-standard","hentry","category-money-moves-markets"],"_links":{"self":[{"href":"https:\/\/mmm.9dotdigital.ca\/index.php?rest_route=\/wp\/v2\/posts\/2736","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/mmm.9dotdigital.ca\/index.php?rest_route=\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/mmm.9dotdigital.ca\/index.php?rest_route=\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/mmm.9dotdigital.ca\/index.php?rest_route=\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/mmm.9dotdigital.ca\/index.php?rest_route=%2Fwp%2Fv2%2Fcomments&post=2736"}],"version-history":[{"count":1,"href":"https:\/\/mmm.9dotdigital.ca\/index.php?rest_route=\/wp\/v2\/posts\/2736\/revisions"}],"predecessor-version":[{"id":5045,"href":"https:\/\/mmm.9dotdigital.ca\/index.php?rest_route=\/wp\/v2\/posts\/2736\/revisions\/5045"}],"wp:attachment":[{"href":"https:\/\/mmm.9dotdigital.ca\/index.php?rest_route=%2Fwp%2Fv2%2Fmedia&parent=2736"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/mmm.9dotdigital.ca\/index.php?rest_route=%2Fwp%2Fv2%2Fcategories&post=2736"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/mmm.9dotdigital.ca\/index.php?rest_route=%2Fwp%2Fv2%2Ftags&post=2736"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}