Central banks float rescue ideas

By Chris Giles and Krishna Guha in London

Central banks on both sides of the Atlantic are actively engaged in discussions about the feasibility of mass purchases of mortgage-backed securities as a possible solution to the credit crisis.

Such a move would involve the use of public funds to shore up the market in a key financial instrument and restore confidence by ending the current vicious circle of forced sales, falling prices and weakening balance sheets.

The conversations, part of a broader exchange as to possible future steps in battling financial turmoil, are at an early stage. However, the fact that such a move is being discussed at all indicates the depth of concern that exists over the health of the banking system.

It shows how far the policy debate has shifted in recent weeks as the crisis has spread to prime mortgage assets in the US and engulfed Bear Stearns, the investment bank.

The Bank of England appears most enthusiastic to explore the idea. The Federal Reserve is open in principle to the possibility that intervention in the MBS market might be justified in certain scenarios, but only as a last resort. The European Central Bank appears least enthusiastic.

Any move to buy mortgage-backed securities would require government involvement because taxpayers would be assuming credit risk. There is no indication as yet that the US administration would favour such moves. In the eurozone it would require agreement from 15 separate governments.

One argument among policymakers and bankers has been that new international rules have exacerbated the credit squeeze by requiring assets to be valued at their current record lows rather than at face value.

But a strongly held view at one European central bank is that it is not “mark-to-market” accounting that is to blame for severe weaknesses in banks’ balance sheets but that prices of MBS securities have fallen to levels that imply unrealistically high rates of default.

If public authorities were to buy and hold sufficient mortgage-backed securities – rather than simply lend against them as they have until now – at prices well below face value but above current prices, they would set a floor in the MBS market.

The Fed does not believe that the point has yet been reached when such drastic action is necessary and considers the discussions it has had with its counterparts to represent “blue-sky thinking” rather than the formulation of a definitive policy proposal.

Fed officials are monitoring the impact of the latest barrage of Fed liquidity moves and interest rate cuts. They also believe the US has not exhausted all the options short of wholesale public intervention and further intermediate steps are available to them.

These could include still more aggressive use of the Fed’s own balance sheet to boost liquidity in the markets.

Analysts say the US government also has plenty of scope to boost support for the markets indirectly through the Federal Housing Administration or Fannie Mae and Freddie Mac.

The UK lacks these institutions, which could be one reason why the Bank of England is keenest to explore outright intervention. The UK government has already become heavily involved in buying mortgages since September with the recent nationalisation of Northern Rock, the mortgage lender.

Michael Coogan, the director-general of the UK’s Council of Mortgage Lenders, said this week: “Demand for mortgages remains strong but cannot be fully met from existing funding sources.” He predicted higher prices and reduced lending.

It is not just central banks that think the MBS market prices are too low and imply a unrealistic level of mortgage default. Some US states’ pension funds are investing small sums in the mortgage market.

Robert Gentzel, a spokesman for the Pennsylvania State Employees’ Retirement System, told the AP news agency: “Some of the securities that have dropped in value were really very solid securities.”