Markets are increasingly of the belief that the bottom of the credit market crisis has been reached and on a fundamental basis, some assets are now cheap.
Some sense of normality has returned to global equity markets with recent stability aided by belief that the threat of inflation has abated somewhat. Major indices in the US have recovered to their highest point since January and the US dollar has made some recent headway against the euro. Against a basket of major global currencies, it is now at a seven-week high.
Market confidence was boosted by the 25 basis point cut in interest rates by the Federal Reserve and more importantly by the suggestion by the Reserve that end of interest rate cuts may be near.
Through its actions, the Fed also signalled some belief that the worst of the credit crisis has now passed.
The Bank of England (BoE) also largely confers with the view that the extreme effects of the credit crisis have been reached. The BoE's view is that rising US sub-prime defaults triggered a broad-based re-pricing of risk and de-leveraging in credit markets. The subsequent adjustment was needed after the credit boom, both domestically and globally, and was bound to have costs, but it is proving even more prolonged and difficult than anticipated. The Bank of England considers that prices in some credit markets are now likely to overstate the losses that will ultimately be felt by the financial system and the economy as a whole. Assets and yields are including large discounts for illiquidity and uncertainty.
The BoE believes that conditions should improve as market participants recognise that some assets look cheap relative to credit fundamentals. Market investors and traders are on the whole in agreement with the belief that there is value in the credit markets now. Nevertheless, despite its view of some light at the end of the tunnel, the BoE has implemented a scheme to improve the liquidity position of the banking system and to increase confidence in financial markets. The BoE also sees a threat by banks, which have moved from granting credit too easily and pricing credit risk too low to now be overly cautious, which may turn out to be a double-edged sword.
There remain downside risks but the most likely route ahead is that confidence and risk appetite will return gradually during the course of 2008.
Moreover, the BoE believes that asset valuations and pricing is now possibly too pessimistic.
The bank in its analysis compares aggregate market prices for sub-prime securities globally, with an estimate of their fundamental value. Using mainstream but very cautious assumptions on defaults and loss rates, the BoE believes that sub-prime securities with an aggregate par value of about $900 billion (Dh3.3trn) 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, sub-prime securities are worth about 58 per cent of par, a variance of more than 30 per cent.
Asset writedowns by financial institutions have overshot slightly too, implying sub-prime securities are worth 80 per cent of face value. If the BoE analysis is correct, banks could actually see small provision write-backs as losses have been overstated, while there may be a profit opportunity for sub-prime investment.
However, although very important and critical, sub-prime exposure and write-downs is only one part of a group of factors that are affecting banks and financial institutions. Banks have obviously plain vanilla credit assets and defaults are rising as economic conditions slow. Credit granting in previous years was also overly aggressive with lax standards and these factors may exacerbate the position going forward. Funding costs are still high and there remains difficulty in tapping the interbank market.
Many securities are trading below their fair value due to uncertainty and weak liquidity. Until the whole interbank funding market improves, institutions and traders are likely to carry on demanding risk premiums to hold collateralised bonds. On the opposite side, there is still significant weight behind the argument that the credit crisis is far from over. Some investors believe that the cycle has some way to run yet and will take years and not months to recover.
Others have warned that many of the problem financial instruments were still hidden and the total amount of debt attached to them largely unknown. Housing and credit card defaults will rise significantly, which in turn will negatively impact the economy. The use of sub-prime debt structures was also a feature of other markets, such as private equity, where $300bn in loans were due to be refinanced in the next two years. Some investors believe that another $1trn to $5trn of assets would have to come back on to US bank balance sheets as a result of defaults on housing and other debts. It is unclear how banks could fund them – issuance of preference shares by US banks was already at a record high.
Although the worst of the sub-prime crisis may be over, other variables are still in play. It is inevitable banks will remain cautious over the short term, de-leveraging balance sheets and restricting credit growth. Nevertheless, prices may have overshot and there may be opportunities for long-term investors in either the credit or equity markets.