UK banks may mark down holdings of commercial mortgage-backed securities by as much as £1.6 billion ($3.2 billion) after the credit market slump made investors unwilling to buy the loans, the Bank of England said.
British financial institutions held about £16 billion of "highly rated" CMBS at the end of 2007, the BOE said in its latest Financial Stability report published today.
The securities may be valued in secondary markets at about 90 per cent of face value, it said. The collapse of the US subprime-mortgage market and rising credit costs have weighed on bank earnings globally.
The world's biggest financial companies have posted $319 billion in asset writedowns and credit losses in the past year.
A decline in commercial property values and an increase in loan default rates may also erode the earnings of UK banks. The BOE's "baseline" analysis suggests that a loan default rate of 1.5 per cent may dent pre-tax profits by 3 per cent.
"A very large increase in default rates would be needed to have a material impact on UK banks' average profits,'' the central bank report said.
"Contacts report no increase in default rates associated with the recent fall in commercial property values so far, although there have been some breaches of loan-to-value covenants,'' it said.
UK banks have pared their holdings of leveraged loans to about £9 billion on their balance sheets from £15.5 billion in the third quarter last year, according to the report.
"This has only been achieved by offering investors significant inducements," it said.
Banks having to value holdings of illiquid securities at market prices may "significantly exaggerate" the losses they may ultimately take on the assets, the central bank said.
Prices for the ABX derivative index tied to US subprime asset-backed securities imply "unprecedented" losses of 50 per cent after default and a 76 per cent likelihood of default, suggesting that prices have become detached from credit fundamentals, the Bank of England said.