Green Budget: Funding Issues and Debt Management January 30 th 2008

1. Green Budget: Funding Issues and Debt ManagementJanuary 30th 2008 David Miles, Chief UK Economist David.Miles@morganstanley.com Laurence Mutkin, Head of European Interest Rate Strategy Laurence.Mutkin@morganstanley.com Morgan Stanley does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.Please see important disclosures at the end of this report.

2. Summary • Government is again likely to borrow more than forecast. But the gilt issuance environment is still favourable as yields are very low. • Yields on shorter dated gilts have fallen a lot. Issuance could now be less skewed towards longer dated bonds. • One factor behind such low gilt yields is the “credit-crunch” – which, if it continues, poses significant difficulties for mortgage lenders. • Mortgages where repayments are linked to consumer or house prices could be attractive and commercially viable.

3. The scale of gilt issuance

6. Table 6.5. Gilt issuance and gilt yields Gross (Net) 15 - year 15 - year issuance (£bn) nominal yield real yield 2001 – 02 14 ( – 5) 4.86% 2.37% 2002 – 03 26 (9) 4.71% 2. 21% 2003 – 04 50 (29) 4.70% 2.04% 2004 – 05 50 (35) 4.57% 1.78% 2005 – 06 52 (38) 4.24% 1.44% 2006 – 07 63 (32) 4.41% 1.37% 2007 – 08 58 (29) 4. 75 % 1.5 0 % 28 Jan 2008 4.5% 1.0% Notes: 15 - year real and nominal yields are funding year averages of Bank of England estimated spot yields. 2007 – 08 estimates are calculated using spot yields up until 11 January 2008. Sources: Bank of England; Debt Management Office.

7. 6% Average long-term real interest rates 5% Long-term average (1700-2006) 4% 3% Real yield 2% 1% 0% 1700- 1750- 1800- 1850- 1900- 1960- 1970- 1980- 1990- 2000- 2006 2007 1749 1799 1849 1899 1939 1969 1979 1989 1999 2005 Figure 6.4. Long term real interest rates on UK conventional debt Notes: Nominal 2.5% consol rate less long - term inflation expectations. 1940 – 59 is omitted from the graph [but not from the long - run average, which otherwise would rise further to just under 3.6%] because rationing during this period made price data unreliable, leading to a ne gative real long - term interest rate. Source: Morgan Stanley Research. Estimates of real yields are based on the nominal yield on consols net of a measure of expected inflation over the coming 10 years. For a detailed description of the method used to const ruct the real yields, see D. Miles, M. Baker and V. Pillonca, ‘Where should long - term interest rates be today? A 300 year view’, Morgan Stanley Research, March 2005.

9. Issuance strategy

10. Table 6.6. Breakdown of gilt issuance by maturity and type Conventional Other % Total 0 – 7 7 – 15 15+ Floating Undated Index - years years years linked 72.5 2000 – 01 38.9 16.1 17.4 1.1 1.1 25.3 73.2 2001 – 02 36.7 17.0 19.5 0.0 1.2 25.6 72.2 2002 – 03 35.6 17.7 19.0 0.0 1.1 26.7 73.9 2003 – 04 34.3 18.6 21.0 0.0 1.0 25.1 74. 3 2004 – 05 37.2 14.1 23.0 0.0 0.8 24.8 73.5 2005 – 06 32.8 15.4 25.2 0.0 0.7 25.8 72 2006 – 07 28 19 25 0.0 1 27 74.3 2007 – 08 17.2 17.1 40.0 0.0 0.0 25.7 Notes: Floating - rate gilts have coupons set in line with short - term interest rates. The redemption of undated gilts is at the discretion of the government. Source: Debt Management Office.

11. Figure 6.9 The Gilt yield curve 6.0 UK 2Y UK 30Y 5.5 5.0 4.5 4.0 3.5 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 60.0 40.0 UK 30Y-2Y 20.0 0.0 -20.0 -40.0 -60.0 -80.0 -100.0 -120.0 -140.0 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Source Morgan Stanley

13. 4.5 UK 30Y BEI 4.0 UK 30Y Real Yield 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Jan-97 Jul-98 Jan-00 Jul-01 Jan-03 Jul-04 Jan-06 Jul-07 Figure 6.10 30-year Index Linked real yield and Break Even Inflation (BEI) Source Bloomberg

14. The credit crunch, funding issues and the mortgage market

16. The design and funding of mortgages poses several policy issues • In the short-term, problems in the wholesale funding markets for lenders are creating strains • There is a longer standing set of issues about the types of mortgage lending in the UK • The advantages of index-linked mortgages could be substantial

17. Table 6.8 Bank Securitisation of Mortgage Loans Total mortgage loans outstanding Securitised Securitised 2006 (£bn) (£bn) (%) HBOS 219.0 72.7 33 Abbey 101.7 29.1 29 Lloyds TSB 95.3 14.9 16 Northern Rock 77.3 47.2 61 RBS 69.7 15.7 23 Barclay s 61.7 12.6 20 HSBC 37.4 3.7 10 Alliance & Leicester 38.0 3.4 9 Bradford & Bingley 31.1 6.7 22 Total 731.2 206.0 28 Source: Company data, Morgan Stanley Research