Credit crunch may be half market estimates

The scale of losses and the economic fallout from the global credit crunch may not be as bad as feared and subprime losses could end up costing less than half market forecasts, the Bank of England said on Thursday.

The central bank is still concerned about the consequences of the credit crisis but Deputy Governor John Gieve said conditions could stabilise soon.

The crisis has frozen money markets and rattled consumers around the world, pushing the global economy to the edge of a sharp slowdown after banks lost confidence in each other due to defaults on low-end mortgages in the United States.

If the fallout from the crisis turns out not to be as drastic as many fear, the implications for global interest rate, and fiscal policy will be significant.

Current market estimates of subprime mortgage losses amount to nearly $400-billion and the IMF has said the wider cost to the financial sector could rise to $1-trillion.

“All of them are potentially significant overestimates of the losses within the wider economy associated with the financial market crisis,” the BoE said in its twice-yearly Financial Stability Report, estimating actual losses could be closer to $170-billion.

“Using a mark-to-market approach to value illiquid securities could significantly exaggerate the scale of losses that financial institutions might ultimately occur. It will exaggerate to an even greater extent the potential damage to the real economy.”

Unsympathetic line

The BoE has been criticised for taking an unsympathetic line on the lending squeeze. The United States Federal Reserve has drastically cut interest rates, most recently on Wednesday and, along with the European Central Bank, made cash much easier for banks to get hold of.

However, the BoE responded to pressure to ease the squeeze last week, announcing an unprecedented £50-billion swap scheme under which banks can trade in their hard to shift assets for risk-free government debt, which is now going to plan.

Gieve was cautiously optimistic.

“The unavoidable correction after the credit boom is proving protracted and difficult,” he said in comments alongside the report.
“While there remain downside risks, the most likely path ahead is that confidence and risk appetite will return gradually in the coming months.”

Analysts said the overview was surprisingly upbeat.

“The report seemed less pessimistic than I thought it might have been. I suspect the Inflation Report will echo that—it won’t be particularly dovish,” said Ross Walker, RBS economist.

“My sense is that there won’t be a particular shift among the middle ground members [of the BoE’s Monetary Policy Committee]. They have been making the case against more aggressive loosening and extolling the benefits of gradualism.”

The central bank publishes its quarterly inflation forecasts on May 14.

Moral hazard

BoE policymakers say they are wary of rescuing institutions from the consequences of their own risky behaviour and have to balance the real threat of rising inflation against the harder to gauge prospect of a decelerating economy.

“Losses recorded by financial institutions erode their capital, which may reduce their ability to offer finance to other households and corporations. This may have a detrimental impact on economic performance,” the BoE said in its report.

“But it is at least partly offset by the household sector being in a less weak state than if its mortgage debts had had to be repaid in full.”

Nonetheless, there is strong evidence to suggest the British economy is already suffering at the hands of the credit crunch, with house prices falling, home loan approvals at record lows and consumer confidence at 15 year lows.

BoE arch dove policymaker David Blanchflower warned this week aggressive action was needed to avoid the real risk of following the United States into a recession.

Other members of the MPC have been more sanguine. Governor Mervyn King said on Tuesday a period of slower growth would not be a “disaster”, saying it was not all doom and gloom. - Reuters

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