Why £50bn isn’t enough to make banks cut mortgage rates

Despite the £50bn injection, it doesn’t matter how much money the government tries to force through the system - mortgage rates won't be coming down anytime soon...

Well, as I suspected, it doesn't look like the Bank of England's £50bn injection is going to bring down mortgage rates any time soon.

Mervyn King has been broadly applauded for the way he's put this package together. £50bn which can rise, depending on demand of short-term government bonds will be available to banks in exchange for high-quality mortgage debt.

But the banks will take a large haircut' in other words, they'll have to pay the price. This will range from 1% to 35% of the asset's value.

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So it seems that Mr King has attached enough conditions to these loans to make the risk to the taxpayer much smaller than it might have been. He's also helped to make life easier for banks with genuine liquidity problems.

Problems with actual solvency are quite another matter however

No get out of jail free' card for the banks

Mervyn King seems to have avoided bailing out' the banking sector.

His conditions for swapping quality government debt for mortgage-backed debt seem sufficiently onerous enough that it's tough to describe them as a get out of jail free' card for the banks.

JP Morgan credit strategist Ben Ashby summed it up well in The Telegraph, when he said: "Banks will give their best assets at unattractive rates and keep all the risk. It's not exactly a compelling trade unless your fairly desperate."

But banks are fairly desperate, it seems. The general consensus is that the facility will be used enthusiastically in fact, some believe up to £100bn will end up being drawn down.

So there's now an outlet for banks with genuine liquidity issues, making another Northern Rock-style situation unlikely. But the underlying problem that too much money was loaned against overpriced houses, which are now heading lower hasn't gone away.

We are unlikely to see a cut in mortgage rates

And that's why it doesn't matter how much money the government tries to force through the financial system. Banks realise they've messed up. They now think that housing has a way to fall. And that's why, even if they were up to their eyeballs in cash, we wouldn't see anyone keen to return to the loose lending standards of a year ago.

As Michael Coogan of the Council of Mortgage Lenders said: "The improved liquidity is unlikely to reverse the trend to higher mortgage costs we have seen in recent weeks there are other considerations such as the cooling housing market."

In other words, even if Libor comes down (the inter-bank lending rate which has been much blamed for rising mortgage costs), lenders might not follow suit. What most people still don't fully understand is that banks are under no obligation to track the base rate, or Libor, or any other rate.

If you own a factory, you want to get your raw materials as cheaply as possible, and then charge as much as the market will bear for the end product. That's how you make a profit. How much you can charge the end user depends very much on how much demand there is for your product, and how competitive the market is.

Banks are exactly the same. All that Libor represents is the cost of money to the bank in the wholesale markets (savings rates are the cost to attract money from depositors). So that's the price of raw materials, if you like.

So what the banks want to do, is to sell the end product their mortgages at a price as high as the market will bear. Now when banks were competing for mortgage business any mortgage business at all - there was good reason for lending rates to pretty much track the base rate. If bank A wouldn't give you a 100% interest-only mortgage at 5%, then bank B definitely would.

Negative equity is bad for banks too

But now, banks don't really want the business. House prices look set to fall, and lending money against a depreciating asset is of course much riskier than lending on an appreciating one. After all, negative equity is bad for banks too. You don't want to repossess a house only to find out that it's worth far less than you loaned out against it.

That's why banks are now demanding 25% deposits if you want to be in with a hope of getting a good rate. That's a huge amount of money given current house prices. So, of course, for most people the availability of decent mortgage loans has dropped like a stone. Suddenly neither bank A nor bank B want your business. And that means that bank C can charge as much as it wants.

Banks are in business to make a profit. That's it. They're not there to help people get onto the housing ladder, and they're not there to help the Government cling on to power. And those that can will milk the current situation for all it's worth, while their weaker counterparts retreat to lick their wounds.

Turning to the wider markets

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The FTSE 100 dipped 3 points to close at 6,053. The banking sector slipped back after the Bank of England's bail-out' conditions were more stringent than expected.

Across the Channel, the Paris CAC-40 fell 51 points to end the day at 4,910. And in Frankfurt, the DAX-30 fell 56 points to 6,786.

On Wall Street, US stocks slipped back as Bank of America's earnings disappointed. The Dow Jones fell 24 points to end at 12,825. The broader S&P 500 closed 2 points lower at 1,388, while the tech-heavy Nasdaq gained 5 points to close at 2,408.

In Asia this morning, Japanese stocks fell as broker Nikko Citigroup downgraded carmakers. The Nikkei 225 fell 148 points to 13,547.

Crude oil was trading at around $117.26 this morning. Meanwhile Brent spot was trading at $113.61.

Spot gold was trading at around $918 an ounce this morning, while silver was trading at $17.41.

Turning to forex, sterling was trading at 1.9781 against the dollar, and at 1.2439 against the euro. The dollar was last trading at 0.6299 against the euro and 103.16 against the Japanese yen.

And this morning, as expected, Royal Bank of Scotland has announced a record £12bn rights issue. It wrote down its balance sheet by £5.9bn. It plans to keep its core tier 1 capital above 6%, compared to the current ratio of below 5%.

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John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.