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The UK Government has announced that it will guarantee AAA RMBS, precisely as I had proposed the Australian government should do in some detail last week...

I argued that a government guarantee of Australian AAA residential mortgages (and possibly commercial mortgages) on arms-length terms would help create a level playing field amongst all lenders including banks, building societies, credit unions, and non-bank lenders.

By guaranteeing the assets, and not necessarily the institutions, government can in turn vouchsafe specific lending and credit outcomes.

Furthermore, since these assets are AAA rated, the risk to which taxpayers are exposed is considerably less than guaranteeing far riskier AA, A and BBB rated banks (and then not being able to control what those banks do with the government guaranteed funds they raise).

Based on the government guarantee of State government debt, the cost of a guarantee of AAA RMBS should be around 30 basis points.

Secondary market AAA RMBS is currently pricing at more than 400 basis points over the swap rate and is completely non-economic as a funding source for lenders (break-even pricing for lenders is about 100 basis points over the swap rate).

A government guarantee would slash the cost of funding home loans for all smaller banks, building societies, and non-banks. It would also help solve the funding challenges faced by the regional banks in their core mortgage business (since the cost of funding would be broadly the same irrespective of the institution’s size).

Applying the guarantee to AAA rated commercial property loans might also reduce the need for RuddBank.

This initiative is entirely consistent with Professor Joshua Gans and my recommendation in March 2008 that the government needed to develop a specific policy approach to supporting the liquidity of the RMBS market, which historically supplied the funding for up to 25 per cent of all home loans.

The government embraced this by investing $8 billion into the RMBS market via the Treasury’s AOFM, as we had proposed.

However, the subsequent government guarantee of bank debts created a new super-class of AAA-rated securities that has supplanted the traditional AAA RMBS market. This resulted in spreads blowing out from 130 basis points over before the government announced the bank term funding guarantees to more than 200 over today (in the primary market and double that in the secondary market). Everyone agrees – including the RBA – that current pricing makes no sense and is a function of genuine market failure.

As I outlined in my article last week, there is also a clear empirical precedent for this initiative in the highly successful (government guaranteed) Canadian securitisation market, which has continued to function effectively throughout the crisis.