Until recently, the Bank of England (BoE)'s Financial Stability Reports (FSRs) warned about the dangers of underpricing risk, which led to excessive risk-taking by investors against a background of benign economic conditions. This was a key factor in last year's sub-prime meltdown.
However, its most recent FSR, published on May 1, argued that risk has been overpriced: estimates of sub-prime losses based on market measures seriously overstated the scale of ultimate losses.
The BoE's optimism contrasts with the IMF's claim that total financial system losses -- estimated at 945 billion dollars -- remain in excess of writedowns announced so far by banks and other financial intermediaries. It has therefore focused attention on the merit of the BoE's claims.
However, it is debatable whether current pricing methods have led to excessively depressed ABS valuations. Mark-to-market pricing, or 'fair value' accounting, is strongly endorsed by the accounting profession. The BoE's report offers a different approach, with interesting implications: · The BoE compares estimates of likely credit losses with losses on a market basis. It assumes that default rates of different vintages of mortgages rise with age but level off after four years, and that, upon default, the loan recovery rate is 50%.
· This would imply that credit losses reach a peak of 170 billion dollars, and AAA securities do not suffer from default, although there are still some losses from prime mortgages.
· In contrast, losses on sub-prime mortgages are currently computed by multiplying mortgages of different grades and vintages by the change in prices measured by the corresponding ABX price indices. This market value loss since early 2007 comes to 380 billion dollars -- more than twice the estimated losses computed from projected default rates.
· One of the most striking features is the fall in the price of AAA-rated securities, which has been steeper than for lower-ranking mortgages. Using its valuation model the BoE shows that the difference between actual and model-based prices is greater for AAA securities than for those with lower ratings -- ie that ABX-based prices may be far removed from credit fundamentals, particularly for AAA-grade mortgages. The BoE thus recommends that 'authoritative guidance' be sought on the application of mark-to-market pricing in disturbed markets, with banks disclosing their losses and explaining the assumptions on which the losses are computed.
By arguing that current mark-to-market pricing is overstating financial losses, the Bank of England appears to be seeking to restore confidence in increasingly risk-averse markets. However, its contrarian views have called to question its credibility. The wide acceptance of 'fair value' accounting makes it unlikely to be dropped as common practice.