Generational Dynamics: Forecasting America's Destiny Generational
 Forecasting America's Destiny ... and the World's


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

Web Log - May, 2008

Bank of England says that the financial crisis is over

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

According to the Bank of England's report:

"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."

There's a great deal of irony in these conclusions.

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:

  • 'Tough conditions' hit Barclays
  • Credit Suisse bank loses billions
  • RBS sets out £12bn rights issue
  • Citigroup sees second giant loss
  • Write-downs add to Merrill woes
  • Brown 'standing firm' on economy
  • G7 passes plan to ease credit woe
  • IMF slashes world growth forecast

Financial market liquidity. Liquidity collapsed with the credit crunch that began in August, 2007 <font size=-2>(Source: Bank of England)</font>
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.

In particular, the stock market is still way overpriced by a factor of close to 250%, same as in 1929.

I've estimated that the probability of a major financial crisis (generational stock market panic and crash) in any given week from now on is about 3%. The probability of a crisis some time in the next 52 weeks is 75%, according to this estimate. (1-May-08) Permanent Link
Receive daily World View columns by e-mail
Donate to Generational Dynamics via PayPal

Web Log Pages

Current Web Log

Web Log Summary - 2016
Web Log Summary - 2015
Web Log Summary - 2014
Web Log Summary - 2013
Web Log Summary - 2012
Web Log Summary - 2011
Web Log Summary - 2010
Web Log Summary - 2009
Web Log Summary - 2008
Web Log Summary - 2007
Web Log Summary - 2006
Web Log Summary - 2005
Web Log Summary - 2004

Web Log - December, 2016
Web Log - November, 2016
Web Log - October, 2016
Web Log - September, 2016
Web Log - August, 2016
Web Log - July, 2016
Web Log - June, 2016
Web Log - May, 2016
Web Log - April, 2016
Web Log - March, 2016
Web Log - February, 2016
Web Log - January, 2016
Web Log - December, 2015
Web Log - November, 2015
Web Log - October, 2015
Web Log - September, 2015
Web Log - August, 2015
Web Log - July, 2015
Web Log - June, 2015
Web Log - May, 2015
Web Log - April, 2015
Web Log - March, 2015
Web Log - February, 2015
Web Log - January, 2015
Web Log - December, 2014
Web Log - November, 2014
Web Log - October, 2014
Web Log - September, 2014
Web Log - August, 2014
Web Log - July, 2014
Web Log - June, 2014
Web Log - May, 2014
Web Log - April, 2014
Web Log - March, 2014
Web Log - February, 2014
Web Log - January, 2014
Web Log - December, 2013
Web Log - November, 2013
Web Log - October, 2013
Web Log - September, 2013
Web Log - August, 2013
Web Log - July, 2013
Web Log - June, 2013
Web Log - May, 2013
Web Log - April, 2013
Web Log - March, 2013
Web Log - February, 2013
Web Log - January, 2013
Web Log - December, 2012
Web Log - November, 2012
Web Log - October, 2012
Web Log - September, 2012
Web Log - August, 2012
Web Log - July, 2012
Web Log - June, 2012
Web Log - May, 2012
Web Log - April, 2012
Web Log - March, 2012
Web Log - February, 2012
Web Log - January, 2012
Web Log - December, 2011
Web Log - November, 2011
Web Log - October, 2011
Web Log - September, 2011
Web Log - August, 2011
Web Log - July, 2011
Web Log - June, 2011
Web Log - May, 2011
Web Log - April, 2011
Web Log - March, 2011
Web Log - February, 2011
Web Log - January, 2011
Web Log - December, 2010
Web Log - November, 2010
Web Log - October, 2010
Web Log - September, 2010
Web Log - August, 2010
Web Log - July, 2010
Web Log - June, 2010
Web Log - May, 2010
Web Log - April, 2010
Web Log - March, 2010
Web Log - February, 2010
Web Log - January, 2010
Web Log - December, 2009
Web Log - November, 2009
Web Log - October, 2009
Web Log - September, 2009
Web Log - August, 2009
Web Log - July, 2009
Web Log - June, 2009
Web Log - May, 2009
Web Log - April, 2009
Web Log - March, 2009
Web Log - February, 2009
Web Log - January, 2009
Web Log - December, 2008
Web Log - November, 2008
Web Log - October, 2008
Web Log - September, 2008
Web Log - August, 2008
Web Log - July, 2008
Web Log - June, 2008
Web Log - May, 2008
Web Log - April, 2008
Web Log - March, 2008
Web Log - February, 2008
Web Log - January, 2008
Web Log - December, 2007
Web Log - November, 2007
Web Log - October, 2007
Web Log - September, 2007
Web Log - August, 2007
Web Log - July, 2007
Web Log - June, 2007
Web Log - May, 2007
Web Log - April, 2007
Web Log - March, 2007
Web Log - February, 2007
Web Log - January, 2007
Web Log - December, 2006
Web Log - November, 2006
Web Log - October, 2006
Web Log - September, 2006
Web Log - August, 2006
Web Log - July, 2006
Web Log - June, 2006
Web Log - May, 2006
Web Log - April, 2006
Web Log - March, 2006
Web Log - February, 2006
Web Log - January, 2006
Web Log - December, 2005
Web Log - November, 2005
Web Log - October, 2005
Web Log - September, 2005
Web Log - August, 2005
Web Log - July, 2005
Web Log - June, 2005
Web Log - May, 2005
Web Log - April, 2005
Web Log - March, 2005
Web Log - February, 2005
Web Log - January, 2005
Web Log - December, 2004
Web Log - November, 2004
Web Log - October, 2004
Web Log - September, 2004
Web Log - August, 2004
Web Log - July, 2004
Web Log - June, 2004

Copyright © 2002-2016 by John J. Xenakis.