Bank of England signals worst is over

By Chris Giles and Gillian Tett in London
Published: April 30 2008 23:58 Last updated: April 30 2008 23:58

The correction in the credit markets has gone too far, the Bank of England says, in a signal that it believes the worst of the global crisis could be over.
The bank’s twice-yearly Financial Stability Report, issued on Thursday, says the credit markets “overstate the losses that will ultimately be felt by the financial system and the economy as a whole”. The view represents a big departure from its 2006 and 2007 warnings that risk was underpriced. It added that financial institutions would soon come to see that some assets now “look cheap”.
John Gieve, deputy governor, said: “While there remain downside risks, the most likely path ahead is that confidence and risk appetite will return gradually in the coming months.”
In becoming the first big official institution to offer a cautiously optimistic outlook for the financial sector, the bank shrugs off indications of falling house prices, noting that most households have lots of equity in their homes. Figures from Nationwide Building Society on Wednesday showed the first annual fall in house prices for 12 years, with values in April 4 per cent down on their peak six months earlier and 1 per cent lower than a year earlier.
The optimistic outlook also contrasts strongly with last month’s publications from the International Monetary Fund.
It estimated that financial sector losses so far had mounted to $945bn, a figure the Bank of England described as “misleading” because it “confuse[d] true credit losses and losses implied by market prices”.
Its report argues that if current market prices are to be believed, they imply “unprecedented” levels of default on mortgage-backed assets. Some 76 per cent of US subprime mortgages sold in the first half of 2007 would default with a loss of 50 per cent on each of these impaired mortgages if market prices were correct, the bank calculated.
Instead, it thinks there will be no defaults on triple A-rated subprime mortgage-backed securities even with a continued decline in US house prices, making these securities far too cheap in the market at the moment and causing banks to suffer unnecessary losses based on marked-to-market accounting. It said the market prices therefore reflected uncertainty about eventual losses, greater investor aversion to such uncertainty and illiquidity in the markets.
Rick Watson, head of the European Securitisation Forum, says: “This isn’t just a confidence issue, although that is an important issue, but is an institutional structure issue.”
The Bank of England’s insistence that assets are fundamentally mispriced will raise the question again of whether authorities should step in to buy up mortgage-backed securities themselves. The bank says that if investors do not reappraise risks and start buying again, there is a moderate risk of a much sharper slowdown.