Bank of England says that the financial crisis is over - 1-May-08 - Generational Dynamics

According to the Bank's new "Financial Stability Report," credit fears have been overstated, and banks have overstated their exposure to mortgage-linked investments.

"Rising US sub-prime mortgage defaults were the trigger for an inevitable and broad-based repricing of risk and deleveraging by banks and other financial market participants. This process is proving even more prolonged and difficult than anticipated. Banks have been unable to sell or secure funding on assets in which markets have closed. That has increased uncertainty about banks’ financial positions, contributing to continued stress in money markets and tighter credit availability. In these conditions, adverse news and rumours can lead to a sudden loss of market confidence, as was shown by the collapse of Bear Stearns in mid-March.

An adjustment in both the price and quantity of risk-taking was clearly needed after an extended credit boom and was bound to have costs. But estimates implied by prices in some credit markets are likely to overstate significantly the losses that will ultimately be felt by the financial system and the economy as a whole, as they appear to include unusually large discounts for illiquidity and uncertainty. In effect, risk premia in some markets have swung from being unusually low to temporarily too high relative to credit fundamentals. That may be contributing to the delay in the return of confidence and risk-taking.

The most likely path ahead is that confidence and risk appetite turn gradually as market participants recognise that some assets look cheap on a fundamentals basis."

First off, if you look at the BBC story on the report, the headline is "Bank says credit fears overstated," and the story quotes a business analyst as saying, "Financial institutions are currently assuming that losses on sub-prime will be on a scale without any precedent. The Bank of England thinks their fears are exaggerated. It now believes that the market price of sub-prime investment products overstates likely future losses on sub-prime lending by about 100%."

However, the ironic part of the BBC story is that, as of this writing, there is a sidebar right next to the above analyst quote, providing links to related stories. Here's the text of that sidebar this morning:

Financial market liquidity. Liquidity collapsed with the credit crunch that began in August, 2007 (Source: Bank of England)

Next, if you look into the details of the Bank of England's report, you find the adjoining graph. This graph of the "liquidity index" points to the heart of the problem: That banks are still unwilling to lend money, and that the trend is, if anything, accelerating.

So how does the BoE conclude, "The most likely path ahead is that confidence and risk appetite turn gradually as market participants recognise that some assets look cheap on a fundamentals basis"?

The answer is obvious: The BoE report ignores the trend and resorts to wishful thinking.

Actually, the report itself contains warnings of more serious scenarios, but you have to dig deep into the report to find them:

"But there is a risk of a more severe scenario.

Although the most likely outcome is that markets recover over time, there is a possibility that the current disruption to the financial system continues for a more prolonged period. Table 3.A shows the Bank’s assessment of changes in the probability and impact of financial stability tail risks. ...

There is some risk of events over the past six months repeating themselves. Asset prices and financial market activity might persist at low levels, prompting further risk reduction by banks and other market participants. Such actions could generate significant selling pressure, leading to further falls in asset prices, and potentially disrupting wider market functioning. Amplifying mechanisms in financial markets could reduce asset prices further.(1) These factors have increased concerns about the vulnerability of the financial system to high risk premia, compared to the assessment in the October 2007 Report, when uncertainty in risk pricing was seen as a greater threat."

What the BoE is concerned about is a "self-fulfilling prophecy." The fear is that banks and investors will be too fearful of the future, and remain as risk-averse as they've become since August, as a result of which the fears will come true.

The problem is there's no way to stop that from happening. As I've said many times, investors are shifting from a historic, secular risk-ignoring attitude to a historic, secular risk-averse attitude. Furthermore, that's a generational shift that will last for decades.

Like many analysts, the Bank of England is assuming that the credit bubble was "normal," and what's happening now is "abnormal," and that with a few nice words and a little encouragement, investors will return to the credit bubble.

But that's clearly impossible, as anyone can see from the liquidity graph above. You can see the huge liquidity bubble that lasted from 2002 through August 2007 right on the graph. Now the liquidity bubble has collapsed, and by the Law of Mean Reversion, the liquidity level is going to have to remain low for a long time, for roughly as many years as liquidity was way above average.

And so it's absolutely certain that the Bank of England's optimistic conclusions are simply wrong.

Generational Dynamics Web Log for 1-May-08
Bank of England says that the financial crisis is over

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Generational Dynamics Web Log for 1-May-08 Bank of England says that the financial crisis is over

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Generational Dynamics Web Log for 1-May-08
Bank of England says that the financial crisis is over