Financial markets have been overreacting to their fears, TD Bank says. The most likely outcome is that the global economy holds up and markets recover their footing, it says, although volatility is likely to remain high.

“Early August was extremely tough on global markets, which were gripped by pronounced volatility and a correction in major equity indices. The catalyst was mounting concern about defaults on U.S. Sub-prime loans that were used to back billions of dollars of collateral debt obligations,” TD says in a research note.

Markets had become aware of the increased financial risks posed by CDOs in June when problems became apparent at two Bear Stearns hedge funds. The anxiety mounted in August when BNP Paribas announced that they would freeze 1.6 billion euros of funds due to sub-prime problems – and this came just days after saying it did not have a significant exposure, TD added.

“The fears limited the willingness to lend and dampened demand for many debt products, putting upward pressure on overnight borrowing costs that forced the ECB, the Federal Reserve and the Bank of Canada to provide additional liquidity to markets. The message from the central banks was ‘don’t panic’. Regrettably, the natural reaction was to panic,” it observes.

And, TD says that the bad news is likely far from over. “It traditionally takes 20 to 25 months before the peak in sub-prime delinquencies occurs. Thus, the tide may only turn on the 2006 loans in mid-2008,” it says. “Many U.S. mortgages also have an adjustable rate feature that provides an initial low borrowing cost that jumps higher after a limited time, and a large number are poised to reset in late 2007 and early 2008. This is bound to raise default rates — including some backing CDOs.”

“The CDOs have been purchased by a wide array of global investors and holdings are spread across banks, insurers, asset managers, and hedge funds. Financial markets should be braced for more companies reporting exposure to these products and this may continue to limit the appetite for private debt issues,” it adds. “There is also a repricing of risk going on by jittery markets that is likely to weigh on financial conditions.”

However, TD also maintains that in this environment of uncertainty, markets are probably being overly negative about the extent of future default rates. “Some small firms and heavily leveraged firms may be hard hit by the revaluation in these assets, but the impact on earnings for the major diversified financial players should prove limited,” it says. “The central banks are also monitoring conditions closely and stand ready to provide additional funds or cut interest rates if necessary. At this time, we do not believe that an easing in policy will be required. But if the central banks are forced to act in reaction to further liquidity pressures, financial markets would surely rally, as they did in the wake of similar circumstances in 1987, 1998 and 2001.”

“The downside risks to the economic outlook have clearly risen, but default rates on non-subprime loans have not risen significantly and are unlikely to do so,” TD concludes. “This suggests that financial markets may have overreacted. If fears subside, the most likely scenario is that the global economy will weather the fallout from the U.S. Sub-prime mess and the repricing of risk, but investors should be braced for continued volatility.”