Fresh from Mervyn King’s slap down of avaricious bankers who failed to align their pay packets with the risks they were taking with other peoples’ money, the Bank of England is suddenly the investment bankers’ friend.
Remember that circular argument about whether banks should be writing assets to model or to stricken market prices? Well, Bank mandarins believe the former more clearly reflects reality.
What’s more, the Bank reckons all those forecasts putting total subprime losses at anything up to $1,000bn are somewhat fantastical - including the headline grabbing forecasts produced by the IMF.
Thursday’s Financial Stability Report contains a few basic lessons in economics. On the mis-match between forecasts that run into the hundreds of billions and the fact that banks have only taken write-downs of $100bn or so to date:
Ultimate losses to the economy depend on the impact on real assets, such as houses, factories, land and human capital. The financial crisis will only cause real losses to the extent that there is a reduction in the stock of these assets or a fall in the value of the goods and services they produce. Mortgage default does not necessarily imply real losses because a house that is transferred from one owner (a household) to another (a bank) in perfect condition at a lower price does not necessarily cause any reduction in the flow of economic benefits. This is simply a transfer of wealth from the old to the new owner of the property. The creation of financial contracts does not alter this underlying logic, although these contracts do determine who gains or loses from changes in the value of the house.
None of the headline-grabbing estimates of total losses take into account this off-setting effect and therefore greatly overstate the impact of the Crunch on the wider economy.
The picture becomes even more confusing, the Bank says, when these loss estimates confuse true credit losses and losses implied by market prices.
Using tested data on past mortgage delinquencies, the Bank puts cumulative losses on US subprime at about $170bn - noting, along the way, that holders of triple A tranches will probably avoid any losses at all:
Yet the loss in market value of subprime securities over the past year or so runs to a terrifying $380bn - which, the Bank asserts, largely reflects the fact that market prices have fallen for reasons other than expectations of increased credit losses, such as investors fleeing a market previously seen as relatively safe.
All of which has caused the Bank to apply its own collateralised debt obligation valuation model to the ABX indices and to assume that credit risk is the only factor determining prices - filtering out non-credit factors, such as market liquidity, in the process.
This approach shows that if the loss of market value of sub-prime securities had been calculated using the Bank’s model-implied values instead of actual ABX prices, the estimate of losses would be some US$64bn lower.
The Bank’s conclusion:
The above analysis suggests that using a mark-to-market approach to value illiquid securities could significantly exaggerate the scale of losses that financial institutions might ultimately incur. It will exaggerate to an even greater extent the potential damage to the real economy that these losses might inflict, since there are always winners and losers to financial contracts. This does not deny, however, the possibility of some adverse consequences for the real economy as a result of recent events — for example, due to a higher cost of capital for some borrowers.
Related links:
Financial Stability Report - Section One, Shocks to the System
BoE in search of the virtuous circle - FT Alphaville
Bank of England signals worst is over - FT.com
