Shares bounce despite Bank's gloomy forecast

SHARES rose sharply today as the City appeared to shrug off the continuing world economic turmoil and a gloomy assessment of Britain's prospects from the Bank of England.

In a positive morning of trading, the FTSE 100 jumped by nearly 3.5 per cent to 3,986 - up 134 points - reversing some of the sharp losses of recent days. This came despite new figures showing rising negative equity and in the amount of "toxic debt" held by financial institutions worldwide.

The new statistics on house prices and bad debt, which has now hit a staggering £1.8 trillion, were revealed in the Bank of England's latest Financial Stability Report setting out the state of the world and British economies.

It says 500,000 homeowners are facing negative equity, with the total potentially rising to 1.2 million if price falls continue. It also warns that the huge scale of losses faced by financial institutions is likely to cause a downward spiral as credit conditions for businesses and consumers tighten in response.

Despite the downbeat prognosis, shares rallied today on the back of a similar surge in the Far East, where Hong Kong's Hang Seng rose by 12 per cent overnight, and strong figures from BP.

TOXIC DEBT

Today's Financial Stability Report says that the amount of toxic debt held by the UK's financial institutions has doubled in the last six months to a mammoth £1.8 trillion.

It says that these potential losses racked up on loans and other financial products that have subsequently collapsed in value could be reduced by a between a third and a half if conditions ultimately improve.

Despite this, however, it warns that estimated paper losses by UK banks and financial institutions alone currently stand at £122.6 billion and that widespread actual losses are likely to occur. The £1.8 trillion losses currently faced by the world amount to more than three times the UK's entire annual public spending.

NEGATIVE EQUITY

The Bank warns that 500,000 homeowners are already facing negative equity because of a 15 per cent slump in prices since last summer but says that the total could rise by 1.2 million. That would mean that one in 10 of the country's 11.7 mortgage holders would be suffering from negative equity.

Today's report also warns that the price drop that has occurred so far is "already nearing the total fall of the early 1990s". It also warns that buy-to-let investors, in particular, face a tough time as lenders become increasingly reluctant to offer loans or good rates. It suggests that the result is likely to be more repossessions

CONSUMER CONFIDENCE

A "self-fulfilling spiral of failing confidence" is identified by the Bank as one of the key problems facing the British economy. It says the danger is that as banks tighten their lending terms then businesses and consumers will struggle to obtain the cash they want.

REGULATION

Today's report says that "a fundamental rethink" of how to protect banks from suffering future financial problems is now needed to curb risk-taking and to provide a stronger safety net when things turn sour.

One key option mooted is to insist that banks retain a bigger capital base upon which to base their lending so that institutions rely much less heavily on raising funds from the money markets. This would also mean that the banks had more cash available to cope with any future losses and reduce the risk of them effectively running out of money. A similar idea that is also raised is "dynamic provisioning" under which banks could be required to protect against losses by taking out insurance .

THE BANK'S CHANGING ASSESSMENT

Only six months ago, when its last Financial Stability Report was published, the Bank of England's deputy governor Sir John Gieve struck an optimistic tone and suggested that the economy was more likely to head upwards, rather than down. The inability of Sir John to foresee the potential problems ahead is likely to lead to renewed questioning of his abilities.