4/28/2008: BOE Financial Stability Report, Issue 23

Excerpts from Bank of England's Financial Stability Report, April 2008, Issue 23 :


While realised losses in sub-prime markets have been small to date, large complex financial institutions (LCFIs) have announced substantial write-downs ... These estimates of expected future losses have been based on a range of indicators, including internal models and market prices such as the ABX. There has been considerable variation in reported valuations across products by different financial institutions ... And disclosures have often provided only partial information on the assumptions underlying valuations and the uncertainties around reported point estimates of losses.

Falls in indices such as the ABX have led to increasing estimates of system-wide mark-to-market losses ... The gap between these estimates and reported write-downs to date by firms have fuelled expectations that further losses are in store but have yet to be revealed. This has added to the mood of uncertainty and pessimism in financial markets, which is retarding the recovery of confidence and risk-taking.

But 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 and uncertainty that have emerged as markets have adjusted but which 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.

...

[One] respect in which the loss estimates may be misleading is because they confuse true credit losses and losses implied by market prices. These two approaches can differ markedly at times when market prices deviate significantly from credit fundamentals — for example, when illiquidity and uncertainty discounts in market prices are large, as at present.

...

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.

...

ABX prices are often used to estimate mark-to-market losses on sub-prime securities. These loss estimates have also risen, to around US$380 billion. These losses have often acted as a benchmark for public commentary on possible bank write-downs. But as [our analysis] explains, estimates based on projected credit losses are considerably lower, suggesting there are large illiquidity and uncertainty premia in the ABX market. So although ultimate realised losses on sub-prime mortgage securities could be high, market prices appear to be giving an overly pessimistic impression of their eventual scale. This may be one important factor weighing on market confidence and retarding the recovery of risk appetite.

...

Under fair-value accounting (FVA) rules, firms are required to mark to market when an active market exists and a price is observable. This is the appropriate way to ensure that those parts of the balance sheet that are subject to FVA reflect current market values. But difficulties can arise when markets suffer [certain types of dislocation] — that is, when prices may be distorted by temporary factors, such as poor or no liquidity. In these circumstances, accounting standards setters need to provide authoritative guidance on the valuation of financial instruments when markets are no longer active and on what constitutes an active market. And audit standards setters need to provide robust guidance that promotes consistent auditing practices.