The tier 1 capital ratios of major British banks would fall below the 6-7% minimum required by the Financial Services Authority if they were forced to write down the value of their mortgage portfolios in line with the market prices of mortgage-backed securities used by the Bank of England in its operation of the special liquidity scheme (SLS). However, actual losses are likely to be a fraction of those implied by these prices, illustrating the absurdity of mark-to-market assessments of capital adequacy.

When the SLS closed on 30 January, the Bank of England held securities with a nominal value of £287 billion as collateral against Treasury bills lent under the scheme. The Bank’s valuation of these securities was £242 billion, implying a discount to par of about 16%. The collateral was mostly in the form of AAA-rated residential mortgage-backed securities and covered bonds. Since AAA tranches suffer impairment only after lower-rated tranches have been wiped out, a 16% discount suggests a much larger expected loss – of perhaps 25% – on the underlying pool of mortgages.

Major banks held £496 billion of residential mortgages on their balance sheets at the end of 2008, according to the British Bankers’ Association. Ignoring additional exposure via off-balance-sheet entities, a write-down of 25% would reduce capital by about £125 billion – sufficient to cut banks’ current aggregate tier 1 ratio of over 11% by more than half.

The chances of actual losses on this scale are miniscule. In the worst year of the early 1990s housing downturn – 1991 – 0.77% of mortgaged properties were repossessed, according to the Council of Mortgage Lenders. Even assuming a repossession rate of 0.77% sustained for 25 years, and a loss given default of 50%, the cumulative reduction in the value of mortgage principal would be less than 10%.

The large deviation of market prices of mortgage-related securities from their likely economic value reflects extreme investor risk aversion and illiquidity. There is a strong case for the Bank of England to use its new asset purchase facility to buy such securities, in addition to corporate bonds and commercial paper. Targeting a wide range of assets would facilitate an early expansion of the facility – necessary if it is to have a meaningful impact on monetary growth.