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The Bank of England appeared to be doing more earthly financial types a favour earlier on Thursday, taking issue with recent apocalyptic estimates of subprime losses and suggested that the credit markets as a whole might well be in “overshoot” territory.

One (seemingly elementary) point the Bank seemed keen to stress in the Financial Stability Report was that a mortgage default did 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.

Which has clearly caused a mini-explosion at the desk of UBS strategist Meyrick Chapman, who spat out a quick note to clients:

Now, the fact that a party to a contract can win by defaulting is not a universally applauded notion among societies based on contract law, even if it occasionally happens. Moreover, banks are in the business to lend money, not to own houses. If banks end up owning a large stock of houses, due to past loans and probably in lieu of making future loans, this suggests they have changed their economic function. There is also a large capital impairment problem to deal with among the banking system. If households end up with the cash difference, instead of a house, it suggests they, at least, no longer adhere to the American Dream.

Indeed. But the stickier issue with the FSR analysis picked up later on Thursday was over the Bank’s insistence that its modelling on the likely eventual losses that would crystallise from the subprime debacle
suggested indices like the ABX had fallen far too far - hit by panic investor sales as much as pricing in likely future defaults.

Back to Chapman at UBS:

The FSR identifies “a second respect in which the loss estimates may be misleading is because they confuse true credit losses and losses implied by market prices.” Professionals differ in their interpretation of mark-to-market losses, but the central thesis of the FSR seems to be that the market is in ‘overshoot’. Colleagues involved in mortgages here suggest that this may have been true in February, but is much less true now. The difference between estimated losses by market-prices (US$381 billion) and model-implied losses (US$317 billion) is significant, argues the FSR. It seems to us close to a rounding error. At US$64 billion the difference is approximately 20% less than the estimate losses given by market prices. This amount is less than the change in the market value of losses since March 2008, as is shown by a chart in the FSR.

The second serious issue we have with the ‘mark-to-model’ approach taken by the Bank of England is detailed in their previous FSR, released in October 2007. In it they say “the key finding (of attempting to model sub-prime RMBS tranche prices) is that plausible variations in assumptions about the future performance of sub-prime mortgages can make a very significant difference to the fundamental values of RMBS. CDOs of ABS, which often take RMBS as collateral, can be even more sensitive to such variation. This sensitivity in, and hence uncertainty about, fundamental value may help to explain the shortage of market liquidity in these instruments at present, and the significant volatility in their prices over the past few months.” Who is right? The Bank in October 2007, or the Bank in April 2008?

Finally, the bank argues there may be a 20% liquidity premium for sub-prime assets in market prices compared to model prices, which will disappear. Oddly this is fairly close to the liquidity premium currently paid by 3 month Libor rates (5.83%) compared to the Bank of England’s Bank Rate (5.00%). Of course, the UK is a different country, with its own problems. It seems fair to compare the liquidity premium of US sub-prime with the liquidity premium of US Libor rates. USD 3-month Libor rates yesterday fixed at 2.785%, compared to yesterday’s (not today’s) Fed Funds target rate of 2.25%. The difference of 58.5bp was equal, yesterday, to 23.77% premium of 3-month Libor.

Purists would argue that the difference is a credit premium not a liquidity premium, but that seems to be splitting hairs when the average life of a sub-prime mortgage product is 4-years and so seems, from FSR, to have a smaller liquidity premium than the interbank market over a much shorter horizon. No-one is suggesting that the Libor liquidity premium is not material to the real economy, so what makes the sub-prime liquidity premium so different?

Related links:

BoE votes for mark-to-market - FT Alphaville

BoE in search of the virtuous circule - FT Alphaville

Financial Stability Report - Bank of England