The Old Lady put

Remember the "Greenspan put"? That's how Wall Street described the situation in the early part of this decade, when it seemed as though the Greenspan Fed was willing to cut rates whenever there was a wobble in the stock market. No need to worry about getting overextended in the equity market -- if things went pear-shaped, Greenspan would come to the rescue with a rate cut.

Does the Bank of England's plan to "unfreeze" UK credit markets by allowing banks to swap some of their asset-backed debt for gilts amount to a UK version of the Greenspan put? Early in the credit crisis, Bank of England Governor Mervyn King was steadfast in his opposition to doing anything that might create a moral hazard in the financial system, by appearing to bail out imprudent lenders. Arguably, this stance delayed the search for a solution to the plight of Northern Rock, at great expense to all concerned.

King has been less vocal about moral hazard lately, but it seems unlikely that he would have come up with this swap scheme of his own volition. It must be the Government that has initiated it, prompted by fears that a prolonged slump in the housing market would put paid to its reputation for prudent economic management and scupper its chances of re-election in one fell swoop. Yet almost everyone agrees that the credit excesses of the last half-decade have raised housing prices to unsustainable levels, while making first-time home ownership near-impossible. A period of falling house prices would start to address both of these problems, yet the launch of the swap scheme seems designed to prevent that from happening.

Of course, all bets would be off if the credit crisis caused more institutions to go the way of Northern Rock; in that case the Bank and the Government would be forced to act. So the swap scheme is likely to be presented as a preventive measure. It certainly seems to have been set up to avoid giving the appearance of a bailout. Banks will have to overcollateralise the gilts they receive (i.e. put up a larger face value of asset-backed paper in exchange -- possibly 10 to 30% more). This will limit the risk of the scheme winding up costing the taxpayer money, though that could still happen if the fall in underlying asset vales (house prices) becomes sufficiently severe.

Still, I'm not sure that the apparent goal of getting banks back to business as usual in the mortgage market is the right one -- that's how we got into this mess. Far better for banks to take their lumps and rein in a bit while they rebuild their balance sheets. That's what RBS seems to be intent on doing, with its proposed rights issue and asset sales. Interestingly, though, that has the firm's shareholders up in arms. Presumably they think that the taxpayer should be on the hook for past management mistakes, so they at least must be happy with today's announcement from the Old Lady.