As expected, the Bank of England announced a major intervention in the banking system last week, allowing mortgage lenders to swap some of their mortgage assets for what is effectively cash.  The scheme is design to ease lending in the mortgage markets and to stop the rise in interest rates charged on mortgages.  But will it work?

Until recently, banks have been able to raise more money for lending by selling mortgages to investors.  Mortgages were seen as a good investment because they generated income (the interest we all pay on our mortgage) backed by a valuable asset - property.

Now that investors are no longer buying mortgages, the banks have had difficulty raising more cash to lend to homeowners and buyers.  And given their losses in the US sub-prime market, they have been reluctant to lend money to each other.  The deal with the Bank of England should mean that they can effectively ‘sell' mortgages to the Bank and so raise more cash.  

Not that there will be a stampede of lenders to claim the extra money - the Bank of England insists that it will only accept the mortgages as payment at a discount to their face value.  Individual lenders will have to accept that the mortgages they ‘sell' to the Bank will be worth less than they thought.  The Bank estimates that lenders will want to raise about £50 billion under the scheme but says that more could be available if required.  Bank of England Governor, Mervyn King, said that there was no arbitrary limit on how much the lenders could raise from the Bank.

The key question, however, is what the banks will do with the money.  If they lend it to homeowners and buyers, it should make it easier to get a mortgage.  That in turn should halt the rise in interest rates charged on mortgages.  On the other hand, if they hoard it so that they have more cash to cover possible losses in the future, the impact will be muted at best. 

So far there has been few clear sign of how the banks will use the extra funds.  CML director general Michael Coogan said: "The Bank's actions should ease funding conditions for mortgage lenders over time to help to ensure the continued availability of a wide range of mortgages for potential borrowers at competitive prices," but added: "The improved liquidity is unlikely to reverse the trend to higher mortgage costs we have seen in recent weeks."  Mervyn King was reported as saying that it would take two months before the Bank could judge whether the scheme had worked. 

The announcement by the Royal Bank of Scotland that it was going to raise £12 billion from asset sales and issuing more shares suggested that the banks might seek to increase the amount of capital they hold in other ways. But there is still uncertainty about how lenders will use the money made available.

Nevertheless, there is huge political pressure on The City to start lending again.  Chancellor of the Exchequer, Alistair Darling, told major mortgage lenders that they had to pass on the extra funds in mortgage lending at a meeting last week and Prime Minister, Gordon Brown said: ""We will make sure that there is enough liquidity in the economy so that we can continue to lend money for businesses and lend money for people to buy their own houses."