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The search for liquidity

Paul Thomas reports on the predicament facing banks as the special liquidity scheme is wound up

Funding problems are still restricting the mortgage market and look likely to continue to do so as banks struggle to raise sufficient liquidity to fund lending.

Banks are due to repay the special liquidity scheme this year. The SLS has allowed banks to swap their high-quality mortgage-backed securities for Treasury bills for up to three years. With the scheme about to close, the need for a replacement source of funding has become increasingly apparent but so far the search for a solution has been fruitless.

In a speech in September, at the Loan Market Association Syndicated Loans Conference, Bank of England executive director for markets and monetary policy committee member Paul Fisher said the main challenge for lenders is to find new sources of income.

He said: “As these schemes come to an end, the challenge for the banks is not so much the sourcing of an additional quantity of funding, it is to roll over that existing market funding into different funding instruments.

“More generally, a central bank should not allow its liquidity operations to become, or even to be perceived, as a source of sustained funding for banks or for any other form of medium-term lending.”

Some have suggested that institutions such as insurers, pension funds and asset managers could become a source of funding for lenders as the Government looks to wind down support schemes.

These institutions have billions of pounds worth of gilts which lenders could trade mortgage-backed securities for, offering a fresh source of funding for lenders when they are traded in the repo markets.

But Home Funding chief executive Tony Ward does not believe pension funds would find the idea attractive. He says: “I do not think it is going to happen. There have been many times over the years where this has become a hot topic and it has never worked.

“I do not think you are going to see long-term fixed-rate mortgages launched, and therefore long-term fixed-rate bonds, which would make them more attractive for pension funds.”

Ward does not see the attraction for pension funds in this type of mortgage investment.

He says: “Can pension funds pick up the whole of the refinancing requirement? No, they cannot. If you are a pension fund and are investing in a gilt and have to protect the liquidity of your funds, you know you can always sell it. Unless the UK economy completely bombs out, UK sovereign debt is AAA risk, so you are always going to be able to sell it.

“If you invest in a mortgage-backed security or a covered bond paper, we have now seen over the last three years that the market is not so liquid, which makes these investments less attractive to pension funds.”

However, Ward believes pension funds would be more attracted to the idea if they were offered guarantees from the Bank of England.

He says: “We would be likely to see much greater take-up by pension funds if they had some liquidity back-stop facility that they could place paper with, provided by the Bank of England.”

The Bank of England has recently offered lenders a short-term funding safety net by adjusting the terms of its discount window facility.

The facility offers lenders liquidity insurance and cover against system-wide shocks, acting as a kind of temporary overdraft facility. It is designed as a short-term solution where banks and building societies may borrow gilts for a fee, at the Bank of England’s discretion, for 30 or 364 days, against a wide range of less liquid collateral.

The Bank of England has recently extended the criteria of the scheme to allow loan portfolios to be used as collateral, where it had previously only accepted residential mortgage-backed secur-ities and covered bonds.

Precise Mortgages managing director Alan Cleary thinks the extension will prove to be important for lenders as liquidity continues to be a constraint in the near future.

He says: “Virtually all banks and societies will be using this as an insurance policy in case of liquidity issues later in 2011/12. I can also see it being tapped heavily, not least as a replacement to the SLS.

“Liquidity is going to be even tighter in 2011 because not only is there a requirement to start repaying the SLS but there is also going to be fierce competition for retail deposits. All banks and building societies should be hyper-sensitive about liquidity this year.”

But Ward does not believe the extension will be that significant and thinks only smaller lenders will make use of the facility. He says: “I think this is an attempt to allow smaller, less sophisticated lenders – in brackets, the building societies – who do not have holdings of triple A mortgage-backed securities but do have mortgage portfolios, to access pre-clear funding.”

“Are we going to suddenly see the DWF being used by many more people on a longer-term basis because they have put loan tranches in there? No. The big banks will not bother to go down that route.”

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