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BoE votes for mark-to-model

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:

1164.jpg

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.

1166.jpg

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.

1168.jpg

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

This entry was posted by Paul Murphy on Thursday, May 1st, 2008 at 10:23 and is filed under Capital markets, People. Tagged with , . You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.

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Comments

  1. May 12   20:48 Posted by PrefBlog » Blog Archive » Bank of England Financial Stability Report: April 2008 [report]

    […] More extracts with light commentary are provided by FTAlphaville. […]

  2. May 02   4:23 Posted by Anonymous [report]

    What planet is BoE on with this nonsense:
    “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.”

    In those U.S. markets where housing prices are falling and will continue to fall for another year at least, a mortgage default is a real loss. To think otherwise is nonsensical, and a denial of the time value of money or assets. Since when does transferring a house from one owner to a bank “at a lower price” not reduce economic benefits?

  3. May 01   17:39 Posted by Anonymous [report]

    Personally, I think the problem is the Bank has to figure out how to constantly value the SLS collateral without engendering further issues and is finding that task rather daunting. Hence, the desire to rely on models. Needless to say, that’s part of what got us here in the first place. Reading these carefully parsed phrases, I can’t help but be reminded of the 90’s comedy “Yes Minister.”

  4. May 01   15:42 Posted by Research Recap » Blog Archive » BoE says Marking to Market Overstates Subprime Losses [report]

    […] FT Alphaville provides further analysis of the Bank’s report. […]

  5. May 01   13:22 Posted by PhilA [report]

    Granted.

    Not all the predictions of large final losses are using the ABX as a base, so complaining that the ABX is out of whack & then positing a model of future defaults based on past default rates as being the ‘true value’ might be putting the cart before the horse: If the market doesn’t believe that those past default rates have predictive value any more, then the ABX may be relecting that lack of faith rather than any price dislocation due to liquidity issues.

  6. May 01   13:03 Posted by D Clark [report]

    The point is that the ABX index, like any non-deliverable index, can be distorted when participants rush to short it to hedge their positions. Cash and carry traders will find it hard to arbitrage particularly when market liquidity dries up. Perhaps it needs some redesigning.

  7. May 01   12:50 Posted by PhilA [report]

    Quite. Oh, and as per my comment on the earlier post, they appear to be using historical US default rates to model the expected future losses. I personally do not believe that these are going to apply going forward: the US has never had a nationwide fall in nominal house prices since records began & home owners who are in negative equity can walk away without direct penalty in many states, including Califormia where the mismatch between house prices and fundamentals was huge.

    For people who’ve bought a house with no money down (100% mortgages) & where house prices around them have already fallen 30% with no sign of stopping, then the temptation to just walk away and start over must be very strong, especially if they can cut their housing costs in half (by renting at market rates rather than paying the mortgage) as a result.

    See http://www.youwalkaway.com/ for the gory details. It’s not going to be pretty.

  8. May 01   10:43 Posted by JP [report]

    Maybe the Bank should suggest to the Government that it move to ‘Level 3′ counting of election results in order to curb excessive volatility in election results. the government should simply make a poll based on what it though voters might actually vote in an election and simply mark all ballot papers to that model.

  9. May 01   10:41 Posted by PC [report]

    The inflections in Chart A are still in the future for all tranches. The cynic in me still sees the hand of the wishful thinking statistician…

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