Bank of England calls the bottom

Is the financial sector now so dependent on central banks that it must be told when assets are cheap? That is one possible conclusion from the Bank of England’s latest Financial Stability Report. The key piece of analysis is a comparison of aggregate market prices for subprime securities globally, with an estimate of their fundamental value. Tricky though this calculation is, it cuts to the heart of whether the world’s banking system is through the worst.

The Bank, using mainstream, fairly pessimistic, assumptions on defaults and loss rates, thinks that subprime securities with an aggregate par value of about $900bn now have a fundamental worth of about 81 per cent of face value. Market prices, as implied by credit derivative indices, are far more pessimistic, suggesting, in aggregate, subprime securities are worth 58 per cent of par. Writedowns taken by financial institutions (banks, insurers and investors mainly) have overshot slightly too, implying subprime securities are worth 80 per cent of face value. If the analysis is right, banks could actually see small writebacks, while there may be a $211bn profit opportunity for anyone brave enough to pile into subprime. Is the analysis right? The Bank has a strong analytical track record on subprime losses, having produced one of the first accurate assessments in October. The real question is whether the judgment that credit derivative subprime prices show an overreaction justifies the Bank’s wider assessment that the worst is over.

There are two reasons to be hesitant. First, subprime securities (at par value) are equivalent to only 3 per cent of European and US bank assets. On the basis of their performance in subprime, the risk that these institutions have behaved foolishly on other products appears quite high, particularly as economic conditions slow. Second, in spite of far more transparency on subprime exposures, major bank capital raisings, and generous central bank policies, interbank lending rates remain oddly high. It is hard to feel comfortable about banks when they do not trust each other.

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