May 1 (Bloomberg) -- The Bank of England said the credit crisis has left investors too pessimistic about asset prices, raising the prospect of respite for Britain's financial system in coming months.
``The pricing of risk in credit markets seems to have swung from being unsustainably low last summer to being temporarily too high relative to fundamentals,'' said John Gieve, the bank's deputy governor for financial stability. ``While there remain downside risks, the most likely path ahead is that confidence and risk appetite will return gradually in the coming months.''
The central bank's semi-annual financial stability report shows the probability and threat of more shocks to the economy have risen. It still marks officials' first signal of hope that market turmoil may ease as banks take up an offer to swap mortgage securities for government bonds and Royal Bank of Scotland Group Plc and HBOS Plc sell shares to repair depleted balance sheets.
``To reinforce those prospects of recovery, we need to restore confidence in the banking system,'' Gieve said in a statement today. ``That is why we have launched the special liquidity scheme and why I welcome the steps taken by some banks to strengthen their capital positions.''
The U.K. central bank delayed the release of the report until today after announcing its swap plan on April 21. Governor Mervyn King pledged then to meet demand from banks even if it exceeds an estimate of 50 billion pounds ($99 billion).
Share Sales
HBOS, the U.K.'s biggest mortgage lender, plans to sell 4 billion pounds of shares to bolster capital, while Royal Bank of Scotland Group will sell 12 billion pounds of stock.
As confidence returns to credit markets, the risk premiums investors demand for liquidity risk will shrink, the bank said. It said losses assessed now may underestimate what investors will be able to obtain once they sell the securities later.
``As uncertainty falls and market liquidity improves, it should become clearer that some assets appear cheap relative to credit fundamentals,'' the report said. ``Financial institutions in aggregate are unlikely to suffer losses on anything like the scale implied by market prices.''
The bank said that credit losses from U.S. subprime mortgage- backed securities will be about $170 billion. David Greenlaw, Morgan Stanley's chief economist, said in February that the total may reach as high as $400 billion.
There are signs of improvement in credit markets, suggesting a return of investor confidence, the central bank said.
Leveraged Loans
Financial institutions including Citigroup Inc. and Deutsche Bank AG have moved some leveraged loans off their balance sheets, paring liabilities to about $91 billion from a peak of $237 billion in August, Bank of America Corp. strategists led by Jeffrey Rosenberg in New York said last month.
Josef Ackermann, Deutsche Bank's chief executive officer, said April 29 that ``we have seen some encouraging developments,'' while ``the near-term outlook is highly uncertain.''
The Bank of England raised its assessment of the threat to financial stability posed by company and household debt, wider credit-risk premiums and an institution falling into distress.
Investors may face pressure to sell assets if prices stay low and markets remain illiquid, the report said. The central bank warned that could raise the chances of another large institution facing difficulties and further dent confidence.
``There is some risk of events over the past six months repeating themselves,'' the bank said.
Some economists have warned that the turmoil in credit markets is deepening and will damage the economy.
Recession Concern
David Blanchflower, the policy maker who wanted a half-point interest-rate cut this month, said April 29 that the bank needs to take ``aggressive action'' to avert a recession. Nigel Lawson, who served as finance minister from 1983 to 1989, said on April 9 that Britain is headed for a ``prolonged'' recession.
The majority of policy makers opted for a quarter-point interest-rate cut to 5 percent, noting that economic growth has been more resilient than they forecast, while they also have concerns that faster inflation may persist.
The bank said today that more permanent changes to improve financial stability should include requiring rating companies to give more information on the complex products they assess, while financial institutions should improve risk management.
``With sentiment still weak and de-leveraging continuing, downside risks remain,'' the report said. ``The most likely outcome for financial stability in the United Kingdom in the period ahead is that conditions improve gradually.''
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