Bank of England will swap gilts for RMBS

The Bank of England will step in to improve the balance sheets of UK banks by allowing them to swap illiquid mortgage-backed securities for treasury bills.

The swaps will allow the banks to use the treasury bills as collateral on loans, loosening up the interbank lending market and reducing banks' funding costs.

The swaps will last a year initially and may be renewed up to three years. The Bank said it would accept AAA-rated European covered bonds, AAA-rated tranches of European non-synthetic residential mortgage-backed securities (RMBS) and asset-backed securities, Aa3 or higher sovereign debt from G-10 nations, AAA-rated G-10 agency debt, and AAA-rated debt from US government-sponsored enterprises.

The banks will have to pay a fee of the spread between the three-month gilt repo rate and the three-month London interbank offering rate (Libor), which will not go below 20 basis points.

To prevent banks buying more RMBS cheaply and then flipping them through the scheme for treasury bills, the scheme is limited to securities already owned by the banks at the end of 2007.

The Bank said that it would take precautions to avoid being left with large amounts of worthless securities. "Banks will need, at all times, to provide the Bank of England with assets of significantly greater value than the Treasury Bills they have received. If the value of those assets were to fall, the banks would need to provide more assets, or return some of the Treasury Bills. And if their assets pledged as security were to be down-rated, the banks would need to replace them with alternative highly rated assets," it said.

Haircuts for collateral will vary from 1% for sovereign paper to 22% for long-term RMBS, with additional haircuts of 3% for foreign currency-denominated assets and 5% for securities with no available market price.

Initial use of the scheme should be about £50 billion, the Bank said, based on its discussions with banks. The Bank's earlier attempt to inject liquidity into the RMBS market in December saw it announce it would accept a wider range of securities, including RMBS, as collateral against three-month loans. About £25 billion of loans under this scheme are still outstanding, the Bank said, adding that it had failed to bring down interbank lending costs. "Reluctance [to lend] is evident in the interest rates charged on interbank lending, which have risen, even though Bank Rate has fallen". The spread between the overnight index swap rate and the three-month Libor rate, normally around 25bp, has widened to over 100 bp on three occasions since mid-2007, the bank added.

See also: Interbank lending rates soar
Fed will support securities market directly
Central banks act again to preserve liquidity
Central banks offer $20bn auctions to revive liquidity