The Bank of England has become the first major central bank to call the end to the credit crisis as it rejected the gloom contained in last month’s International Monetary Fund Global Outlook and Financial Stability Report.
The UK central bank said that the correction in the credit markets has gone too far.
In its own financial stability report, the BoE said at the start on the first page (to get the point firmly on the record):
"Rising US sub-prime defaults were the trigger for a broad-based repricing of risk and deleveraging in credit markets.
"An adjustment was needed after the credit boom and will inevitably have costs, but it is proving even more prolonged and difficult than anticipated.
"Prices in some credit markets are likely to overstate the losses that will ultimately be felt by the financial system and the economy as a whole, as they appear to include large discounts for illiquidity and uncertainty.
"Conditions should improve as market participants recognise that some assets look cheap relative to credit fundamentals."
That’s a big call and one the US Federal Reserve has avoided commenting on, as recently as its last interest rate statement yesterday; although it did omit any references about "downside risks to growth" for the US economy, a sign perhaps that it sees the worst being over.
The BoE’s stability report was issued yesterday and it’s a major change from the warnings in 2006 and 2007 that risk was under priced.
What interested commentators in Britain was the juxtaposition of this new view from the central bank, and the continuing concern about the health of the British housing sector.
It noted that despite falling house prices, most UK households have lots of equity in their homes (Something our Reserve Bank has tried to get people to focus on in the ‘mortgage stress debate’) so there’s a cushion there in the event of a sharp drop in values.
On Wednesday Britain’s Nationwide Building Society released figures showing the first annual fall in house prices for 12 years, with values in April 4% off the peak six months earlier and 1% down on the level in April 2007.
That’s nothing compared to the Standard &Poor’s/Case Schiller home price index which showed a 12.7% drop in house prices in the 20 major US markets in the year to February.
The Bank of England took issue with the forecasts from the International Monetary Fund last month in its global outlook and stability reports.
The IMF estimated that financial sector losses so far had mounted to $US945 billion, an estimate the Bank of England described as “misleading” because it confused true credit losses and losses implied by market prices”.
The Bank of England bases its newly found confidence on some logic. It argues that if current market prices are to be believed, there will be “unprecedented” levels of default on mortgage-backed assets.
It took issue with that saying that current market pricing meant there would be over three quarters of all subprime mortgages (so-called triple A included) sold in the first half of last year.
It argues that won’t happen and thinks there will be no defaults on triple A-rated subprime mortgage-backed securities even with a continued decline in US house prices.
The bank believes market prices are reflecting uncertainty about eventual losses, greater investor aversion to such uncertainty and illiquidity in the markets. They are not signalling a realistic level of actual losses.
This it says, indicates that such securities are being mispriced by the market.
That mispricing should produce buying support as investors spotted bargains: but it hasn’t happened as yet, leading to this warning from the Bank.
It said that if investors do not reappraise risks and start buying again, "there is a moderate risk of a much sharper slowdown".
So it’s really a test of confidence and down to someone to lead the way.
That’s why the $A1 billion in deals in Residential Mortgage Backed Securities done by the Reserve Bank last week and the week before was an important precedent. It clearly saw such a problem, with no eagerness from the private sector to do anything, so it stepped into the breach.
And yesterday GMAC, the US financier part-owned by General Motors, revealed plans to sell mortgage backed bonds here.
They will have to pay a high price: a margin of 2.50% to 3.0% over the overnight swap rate, but it will be the first deal since last December and a small win for the RBA. The bonds will be non-conforming mortgage backed securities.
In a series of potted summaries of chapters containing warnings the Bank of England looked at a number of flow on issues:
"Market participants overreact to market-based estimates of losses that likely overstate the ultimate costs of the turmoil;
• Inadequate information about key valuation assumptions and uncertainties around reported losses and exposures prolong concerns about counterparty credit risk and strains in money markets.
• In the near term, tight funding conditions mean banks are vulnerable to adverse news and rumours, as highlighted by the run on Bear Stearns in mid-March.
• Tight credit conditions can be expected to lead to a pickup in defaults among vulnerable borrowers, including a subset of households; parts of the commercial property sector, and some highly leveraged non-financial companies.
• Financing difficulties could emerge in some emerging markets, including countries in Central and Eastern Europe with large current account deficits," The BoE said in the report.
