Why is the Bank of England acting now?

The mortgage market has nearly ground to a halt because lenders cannot get funding as they used to. Banks and building societies with spare cash are nervous of lending to rivals after massive losses sparked by the sub-prime fiasco in the US.

Borrowing between banks has become increasingly expensive, forcing lenders to pass on these higher costs to borrowers in the form of increased interest rates. Several lenders have increased the rates on new home loans by as much as 1 per cent in recent weeks.

Lenders are also cherry-picking the best customers and refusing to lend to those who do not have large deposits, making it nearly impossible for first-time buyers to get on the property ladder. This is causing downward pressure on house prices.

Sliding house prices coupled with increased pressure on borrowers’ wallets could lead to a slowdown in consumer spending, sparking a vicious spiral which could lead to a severe downturn in economic growth or even a recession.

What is happening?

Before the credit crunch, most major lenders raised money to lend to homebuyers by selling IOUs, or securities, backed by existing home loans. Since the sub-prime crisis in the US, investors have been reluctant to accept this type of asset as a guarantee. Now the Bank of England is set to offer Treasury bills — special bonds backed by the Government — in exchange for lenders’ assets. The theory is that lenders will be able to attract funding by using the government-backed bonds as a guarantee. The government backing is important as investors know that they will always be able to cash in the bond to get their money back.

Will taxpayers foot the bill?

The billions of pounds the Bank is offering in bonds is taxpayers’ money. It is offering bonds for a maximum of three years, after which time lenders must return them.

The taxpayer is bearing a risk. If house prices fall sharply and many borrowers default on their loans the mortgage-backed assets will fall in value. The Bank of England is expected to mitigate against this by demanding extra assets in exchange for the bonds. For example, it could demand £120 million in mortgage-backed securities in exchange for £100 million in bonds.

The Bank says that any additional shortfall in assets will have to be covered by the lender, although if the lender runs into financial trouble the taxpayer will be left with the bill

Will this lower mortgage rates?

The Government and the Bank hope that their move will kick-start lending between banks. There is no guarantee this will happen. If the plan is successful, the cost of borrowing is likely to fall. While this is good news for homeowners, there is no guarantee how quickly lenders will cut their mortgage rates, if at all.

The Treasury has admitted that it cannot force lenders to use the money to the benefit of customers.

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