BoE says Marking to Market Overstates Subprime Losses
Mark-to-market loss estimates overstate the damage wrought by the subprime crisis and may even result in some “writebacks” in the future, the Bank of England believes. In its latest Financial Stability Report the Bank weighs in on the “fair value” issue, warning that strict marking to market in illiquid markets risks overstating potential losses.
The Bank says “credit losses from the turmoil are unlikely to ever rise to
levels implied by current market prices unless there is a significant deterioration in fundamentals, well beyond the slowdown currently anticipated. That is because prices are likely to reflect substantial discounts for illiquidity anduncertainty that have emerged as markets have adjusted butwhich should ease over time.”
While market-based estimates and the write-downs announced by firms may be unduly pessimistic, if such concerns persist there is a risk they could become self-fulfilling.
The Bank says that the most likely outcome is that market conditions improve in the period ahead, supported by measures to improve market functioning and to bolster confidence in financial institutions. “Indeed, there are some signs of an improvement in credit market sentiment in recent weeks.”
“As uncertainty falls and market liquidity improves, it should become clearer that some assets appear cheap relative to credit fundamentals, which should in turn encourage a recovery in confidence and risk appetite by speculative and long-term investors.”
In that environment, firms may find that previous mark-to-market loss estimates have been overstated and some writebacks of reported losses may occur.
Over a longer horizon, better pricing of risk and stronger risk management and
supervision should strengthen financial institutions’ balance sheets, the Bank says.
Still, the Bank sees several areas of rising financial stress:
- Parts of the commercial property sector, where prices have fallen and where weaker economic growth could lower rental income growth.
- Leveraged non-financial companies, including those taken private in recent years, where default rates are expected to rise.
- Highly indebted households, adverse credit borrowers and buy-to-let investors, as the housing market slows.
- Emerging markets, particularly in countries in Central and Eastern Europe with large current account deficits and rapid domestic credit growth.
FT Alphaville provides further analysis of the Bank’s report. The Economist adds a caution to the Bank’s optimism:
Yet even if the report is right in suggesting that the self-inflicted financial wounds may gradually be starting to heal, the worry now is the damage that has already been done to the economy. The bigger that turns out to be, the greater the potential for a second round of financial pain through defaults arising from a slowdown or recession.
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