Press reports suggest that the planned facility to allow banks to swap mortgage assets for gilts could be as large as £100 billion. If true, this would make it much more significant that the Federal Reserve’s equivalent scheme – the term securities lending facility (TSLF).

The TSLF is currently capped at $200 billion, of which $100 billion had been used as of Wednesday 9 April. $200 billion is equivalent to 1.8% of the US broad money supply (expanded M2). The same percentage of UK broad money M4 would be £29 billion.

The UK scheme arguably needs to be larger because the Fed has introduced a range of other measures to help markets. Total Fed support amounts to $470 billion* or 4.1% of broad money. The equivalent UK sum would be £69 billion. From this should be subtracted the £25 billion of three-month funding the Bank of England has offered to banks against AAA-rated asset-backed securities. This suggests the UK swap facility should be £44 billion to equate total UK and US support. (An earlier post suggested additional aid of about £40 billion was necessary to ease mortgage market strains.)

Demands for a £100 billion facility seem excessive. The success of the scheme will depend as much on the precise collateral rules and term of the swap as its size.

* Breakdown: TSLF $200 billion, term auction facility $100 billion, additional term repos $100 billion, swap facilities with ECB and Swiss National Bank $36 billion, primary credit discount window lending $7 billion (9 April), primary dealer credit facility lending $26 billion (9 April).

Today’s Wall Street Journal argues that three-month dollar LIBOR fixings compiled by the British Bankers’ Association (BBA) may understate true interbank borrowing costs by as much as 30 basis points. The suggestion is that some banks on the BBA panel are failing to report actual borrowing rates for fear of alerting markets to financing difficulties.

The chart below shows the spread between three-month dollar and sterling LIBOR fixings and an average of offer rates quoted by the interdealer brokers ICAP and Tullett Prebon – these should reflect actual borrowing costs The BBA dollar fixings do indeed look low relative to broker rates, although the divergence is smaller than suggested in the WSJ article – 14 basis points yesterday. However, the issue is much less significant for sterling rates, with a gap of just 1 bp yesterday.

The divergence in dollar rates is puzzling but seems unlikely to reflect BBA banks deliberately understating borrowing costs, since this would be expected to affect sterling rates by a similar amount.

I have been tracking the path of annual industrial output growth in the Group of Seven (G7) major economies against “soft landing” and “hard landing” scenarios, based on average experience in prior downswings over the last 40 years. Despite the credit crisis, my bias has been to expect an outcome closer to the soft landing path, for reasons explained here.

The first chart below updates the comparison to include February industrial output data. Activity held up reasonably well in early 2008 and continues to track the historical soft landing path closely. Supportive factors have included solid export gains to emerging markets and modest stock levels in late 2007.

I still think a hard landing will be avoided but further credit tightening and commodity price gains in early 2008 may result in growth moving slightly below the soft landing path over coming months. As the second chart shows, business surveys are consistent with the annual output change falling close to zero.

UK net mortgage lending last year totalled £108 billion (see here). Of this, only £27 billion ended up on the books of banks and building societies. The other £81 billion was assumed by “other specialist lenders” – often bank subsidiaries largely funded in wholesale markets.

Reflecting the shut-down of wholesale funding, these specialist lenders reduced their mortgage book by nearly £5 billion in the first two months of 2008. Assume – optimistically – that their net lending is zero for the year as a whole. If mortgage demand remained at £108 billion, and banks and building societies planned again to lend only £27 billion, this would imply a “funding gap” of £81 billion.

The actual gap is likely to be significantly lower, for three reasons.

First, banks funded £10 billion of the £81 billion advanced by specialist lenders in 2007. This £10 billion will be available to finance their own lending in 2008, reducing the estimated funding gap to £71 billion.

Secondly, mortgage demand would have fallen as a result of Bank rate rises and a slowing economy even in the absence of the recent tightening of lending standards. In the last housing slowdown in 2004/5, when supply conditions remained generous, the 12-month running total of net mortgage lending declined 22% from peak to trough. A drop in mortgage demand on this scale in 2008 would cut the implied funding gap from £71 billion to £47 billion.

Thirdly, a portion of the funds that last year were invested in wholesale markets will this year end up in bank and building society deposits, creating extra lending capacity.

Of course, any contraction of specialist lenders’ mortgage books would offset these factors, boosting the funding gap.

I think the authorities need to offer about £40 billion of additional funding assistance to mortgage lenders this year. The previous post discussed detailed proposals.

Markets are awaiting details of new measures promised by the Bank of England to ease banks’ difficulties obtaining longer-term funding, particularly to finance mortgage lending. What form could they take?

In principle, the Bank can offer relief in three main ways:

1. Increase the average term of its lending to the banking system.
2. Widen the definition of eligible collateral against which loans are made.
3. Increase the total volume of lending.

Under 1, the Bank has already moved a long way. Longer-term lending (i.e. for three months or longer, including the loan to Northern Rock) now accounts for an estimated 80% of funds advanced to the banking system, up from 30% in September last year. A further increase is possible but is unlikely to have a significant beneficial impact.

Under 2, the Bank has allowed some widening but continues to operate stricter rules than the Fed and ECB. It still requires government collateral for its normal weekly operations and a portion of its longer-term lending. Banks have been allowed to use AAA-rated asset-backed securities in special auctions of three-month funds in December and January, which have been rolled over and expanded in March and April. Last September, the Bank offered to auction three-month funds against a broad range of collateral including mortgages and corporate bonds as well as ABS but imposed a high minimum bid rate, resulting in no take-up. Applying this broad collateral definition to all longer-term lending, without enforcing a penal rate, would be helpful in both widening access to official funds and allowing liquidity-short banks to borrow in greater amounts.

A significant improvement in funding conditions is, however, also likely to require measure 3 – an increase in aggregate lending to the banking system. This presents a technical issue: any such expansion requires offsetting sterilisation measures to prevent banks’ reserve balances with the Bank rising above target. (An overshoot of reserve balances would result in very short-term interest rates falling below Bank rate, undermining MPC policy.) Two possible measures for achieving a rise in lending without boosting banks’ reserves are as follows. First, the Bank could ask the Debt Management Office to repay immediately the government’s remaining “ways and means” borrowing from the Bank, releasing funds for market operations. Secondly, the DMO could issue an additional quantity of Treasury bills or gilts relative to its current plans, placing the proceeds on deposit at the Bank for onward lending to the banks.

The tables below illustrate how the Bank of England’s balance sheet and the size and composition of its lending to the banking system might change if these proposals were implemented. Specifically, the following assumptions are made:

1. A further reduction of £3 billion in short-term lending in favour of longer-term loans (measure 1 above).
2. Application of the broad September definition of eligible collateral (i.e. including mortgages) in all longer-term operations (measure 2).
3. Full repayment of the remaining £7 billion “ways and means” advance to the government.
4. Placement of a £20 billion special deposit by the DMO at the Bank, financed by additional issuance of gilts and / or Treasury bills.

Changes c and d would allow an increase in the Bank’s aggregate lending to the banking system from its current level of £65 billion to £93 billion. Within this total, changes a and b would permit new longer-term lending of £38 billion against mortgage collateral. This is a significant sum in the context of the overall mortgage market – sufficient to finance five months worth of net lending at its recent pace.

In addition to these measures, the authorities should also consider emulating the Federal Reserve’s “term securities lending facility”, under which banks are able to swap mortgage-backed securities for Treasuries held on the Fed’s balance sheet, with the Treasuries then used as collateral to obtain funds in the market. The Bank of England holds few gilts on its balance sheet so such a facility would require the DMO to create extra gilts specifically for this purpose.

The purchasing managers’ surveys are reasonable coincident indicators of economic activity. The charts below show quarterly GDP growth together with a weighted average of PMI new business indices covering the manufacturing and services sectors for the US, Eurozone, UK and Spain.

Somewhat surprisingly, the UK PMI indicator has held up best in early 2008, suggesting growth of about 2% annualised. The Eurozone indicator has also been relatively resilient, while US surveys look consistent with a flat economy, supporting other evidence that a fall in GDP may have been avoided in the first quarter.

The stand-out, however, is the collapse in the Spanish PMI indicator. The government plans significant fiscal stimulus but can the ECB continue to ignore a developing recession in the Eurozone’s key locomotive economy of recent years?