Bank of England sounds alert on credit crisis's impact on economy
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Monday, 17 March 2008
The Bank of England will warn today that credit markets have "deteriorated again" and that there is a serious danger of further writedowns by the banks, with the difficulty of securitising loans and mortgages posing a particular problem for the property market and the economy as a whole.
The Bank's latest Quarterly Bulletin was compiled prior to last Friday's rescue of Bear Stearns by the United States Federal Reserve and JP Morgan, but highlights the parlous state of the US housing market. It warns of "considerable uncertainty" over the "ultimate scale and location of the losses across the global financial system, not least because of further increases in delinquency rates on the underlying mortgages in the United States."
Once again, the Bank voiced its worries about how the credit crisis will affect the wider UK economy, and how the problems might lead to a vicious circle. "This could act as a drag on economy activity and in turn could prompt further deterioration in the quality of banks' assets and limit their ability and willingness to lend."
Charles Bean, chief economist of the Bank, said he had hoped for better times after the co-ordinated injection of liquidity by the world's leading central banks last December, but had been disappointed by how the new year had panned out.
"There were some signs of improvement in sterling money markets around the turn of the year, but during February conditions deteriorated again and wider funding markets remained impaired," Mr Bean said. "Furthermore, UK equity markets fell quite sharply in January and became more volatile."
A further co-ordinated injection of liquidity by the Fed, the European Central Bank, the Bank of England and others last week only partially succeeded in reassuring markets fearful of the near certainty of a recession in the American economy.
The Bank also drew attention to concerns about so-called "monoline" firms, which insure banks against potential losses on debt instruments. The Bulletin states: "A particular source of uncertainty was banks' exposures – both direct and indirect – to financial guarantors, and the potential losses associated with further credit rating downgrades to these institutions. Banks have various contractual exposures to financial guarantors (also known as monoline insurers)."
The Bank added that this danger had not yet passed. "Some of the major financial guarantors remained on review for downgrade by the ratings agencies," it said. "In the event of further downgrades, the value of the guarantees provided against the underlying assets would fall. This could lead to additional marked-to-market losses on banks' asset portfolios and in turn to further writedowns."
Looking ahead, the Bank also warned that the spread of portfolio insurance to protect investors' returns could prove self-defeating. It said: "Portfolio insurance could, in certain circumstances, interact with market frictions, such as illiquidity or imperfect information, to increase market volatility."
