The worst of the credit crunch is over - or it could be.  According to the Bank of England, the financial markets have become too cautious and have exaggerated losses from the sub-prime markets.

In its latest Financial Stability Report the Bank says that: ‘The most likely path ahead is that confidence and risk appetite gradually return.....That could generate a virtuous cycle of rising asset prices and improving bank balance sheets, reversing the cycle of the past six months'.

If the Bank is right, mortgage interest rates should gradually move closer to the Bank's official base rate and lenders will be able to increase the amount they lend to homeowners and buyers. In the context of a 24 per cent fall in the number of mortgages approved in March (compared to the same time last year), any change is unlikely to re-ignite the property market.  But it would help to stabilise a market that is being hit by limited access to mortgage funds. 

The financial markets have frozen because investors have been unwilling to invest in mortgage backed assets. Until recently, banks have been able to raise more money for lending by selling mortgages they have arranged to investors.  Mortgages were seen as a good investment because they generated income (the interest we all pay on our mortgage) backed by a valuable asset - property.  But now, demand for ‘asset-backed securities' such as mortgages has fallen dramatically with the value of mortgages sold to investors down from £42 billion in the last three months of 2006 to just £0.4 billion in the first three months of 2008. Without investors who will put money into mortgage lending, lenders have less cash to turn in to mortgages.

But the Bank of England now says that investors and The City have become too cautious. The price of mortgages on the markets implies much higher losses than are likely to be the case.  As the Bank puts it: ‘There is little evidence to support...projected loss rates, particularly as arrears rates remain at low levels'.

In short, the Bank believes that: ‘Prices in some credit markets have become detached from credit fundamentals', and argues that: ‘Unless there is a significant deterioration in the economic outlook, well beyond that currently anticipated, financial institutions.....are unlikely to suffer losses on anything like the scale implied by market prices'.

As a result, it argues that the situation will gradually improve: ‘As uncertainty falls and market liquidity improves, it should become clearer that some assets appear cheap relative to credit fundamentals, which should in turn encourage a recovery in confidence and risk appetite by......investors'.  It is even possible that some losses reported by banks will be reversed as the value of mortgages that they own increase in value.

The Bank also points out that, if lenders remain cautious, their unwillingness to lend might actually have the adverse effects on the economy that The City hopes to avoid.  But, as Deputy Governor, John Gieve says: "The most likely path ahead is that confidence and risk appetite will return gradually in the coming months."