By Frederic S. Mishkin It is a great pleasure to be back in Israel. I last was here in 1971 and can see that much has changed since then. And it is a great honor to be introduced by the professor who taught me monetary theory at the Massachusetts Institute of Technology in the 1970s.
Let me also say that over the past year, as we at the Federal Reserve have had to deal with the recent problems in financial markets, I have gained an even deeper appreciation for the many contributions you made as the first deputy managing director of the International Monetary Fund, guiding its response to the Mexican crisis, the Russian default, the Asian crisis, the collapse of Long-Term Capital Management, Brazil's devaluation, and the early stages of the Argentine crisis.
Your expertise in managing financial crises is surely unparalleled, and having you in the central banking world right now helps us all sleep better at night.
As you well know, financial markets in the United States and Europe have been under considerable strain for almost a year now. Speaking as a central banker soon to return to the relatively tranquil ivory tower of Columbia University, I don't think it is far off the mark to characterize the turmoil of the past year as one of the worst financial shocks that the United States has confronted since the Great Depression.
However, although the U.S. economy clearly has slowed, aggressive actions by the Federal Reserve and other central banks as well as fiscal stimulus have helped us weather the storm better than we would have otherwise. Let me start with a brief overview of the financial market turmoil, and then I'll briefly discuss what central banks have done to help restore health to the financial system. Finally, I'll turn to the implications for monetary policy and the economic outlook.1
The Financial Turmoil Well-functioning financial markets are crucial to maximizing sustainable economic growth because they channel funds to the people with the most productive investment opportunities. However, financial markets can do their job well only when they solve information problems that would otherwise impede the efficient allocation of credit to worthy borrowers.
The history of financial development can be characterized as a process in which innovation tends to lead to improvements in the quality of information, and this, in turn, enables new financial products and markets to develop. Indeed, in the past decade or so, technological innovations and financial market liberalization improved the flow of information and capital to broader groups of people. For example, the microfinance revolution in developing countries has made capital available to many poor, small entrepreneurs.
In the United States, financial innovation has recently manifested itself partly in the development of the market for subprime mortgages. While that market had serious weaknesses that eventually imposed large costs on many borrowers and their communities, it also brought considerable benefits to many others who were able to take advantage of responsible products never before available.
As a result, they found themselves far better off financially than they probably would have been otherwise. As this recent experience suggests, financial liberalization and innovation bring many benefits but can also create information and incentive problems that lead to mistakes. When mistakes of this nature become evident, financial markets can seize up, with potentially significant adverse consequences for the economy.
Advances in information technology and financial innovations in recent decades encouraged new lending products and faster securitization of debt. This lowered transaction costs and contributed to a "democratization of credit"--that is, the extension of credit to a wider spectrum of possible borrowers than in the past.
In the United States, a potential customer with an Internet connection could quickly fill out an online form, and a mortgage broker could rapidly price a loan with the help of credit-scoring technology. The resulting mortgages were bundled together to produce mortgage-backed securities, which could then be sold off to investors.
Advances in financial engineering took the securitization process even further by carving mortgage-backed securities into more-complicated structured products, such as collateralized debt obligations (CDOs), or even CDOs of CDOs, with an eye to tailoring the credit risks of various types of assets to risk profiles desired by different kinds of investors. All seemed well as long as the economy--particularly, the housing market--was booming, and credit became more and more available. But when the housing market turned down, substantial problems were exposed.
The subprime crisis exposed problems with the securitization of mortgages. In particular, it became painfully clear how poor the underwriting and credit-risk analysis were for a wide range of products. Some appraisers, brokers, and investment banks were motivated by transaction fees and had little stake in the ultimate performance of the loans they helped to arrange.
Many securitized products were complex, and the ownership structure of the underlying assets was opaque. Investors relied heavily on credit ratings instead of conducting due diligence themselves, and credit rating agencies failed to fulfill their raison d'etre. The result has been rising defaults, particularly in the subprime mortgage markets, with losses to both investors and financial institutions.
The ultimate losses from the recent residential mortgage-market meltdown have been estimated by Wall Street analysts at about $500 billion--less than 3 percent of the outstanding $22 trillion in U.S. equities.2 Why did a relatively small amount of losses on subprime mortgage loans lead to such broad-based financial disruption? After all, a 3 percent decline in stock market prices sometimes happens on a daily basis with hardly a ripple in the U.S. economy.
In part, the outsized impact of mortgage losses on broader financial markets probably stems from the fact that they exposed a more extensive set of problems in financial intermediation that were not limited to the original subprime loans. The liquidity shock that hit us in August has been described by one of my colleagues as a global margin call on virtually all leveraged positions.
The liquidity shock quickly brought an end to the credit boom that preceded it, as a striking loss of confidence in credit ratings and an accompanying revaluation of risks led investors to pull back from a wide range of securities, especially structured credit products. Along the way, the inadequacies of the business models of many large financial institutions were exposed, and these models are now in the process of significant re-examination and rehabilitation.
As has happened in the past, the long-run benefits of financial innovations were easier to anticipate than the problems. The originate-to-distribute model of securitization, unfortunately, created some severe incentive problems--or agency problems--in which the agent (the originator of the loans) did not have the incentives to act fully in the interest of the principal (the ultimate holder of the loan). Notably, the incentive structures often tied originator revenue to loan volume rather than to the quality of the loans being passed up the chain.
These agency problems resulted in lower underwriting standards, giving borrowers with weaker financial positions access to larger loans than they should have had. Investors in mortgage-backed securities apparently ignored the importance of these agency problems and did not adequately understand the risk characteristics of the securities they were holding. The practices in place to align the incentives of the originators, securitizers, and resecuritizers with the underlying risks proved to be woefully inadequate.
In retrospect, it is clear that investors were too reliant on credit ratings: Because many of the securities were rated very highly by the credit rating agencies, investors did not understand the underlying risk and had a false sense of safety. Many structured finance products experienced multiple-tier downgrades, a development that is unheard of for more traditional securities such as corporate bonds. This episode was a jarring wake-up call to investors regarding the risk properties of all structured finance products. The credit ratings agencies' failure to correctly assess these underlying risks further undermined investor confidence and worsened market worries about when the next shoe might drop.
When these problems came to light, investors--including leveraged financial institutions--took large losses as the values of mortgage-related assets were marked down in anticipation of higher defaults on the underlying collateral. The market for newly issued subprime and alt-A mortgage-backed securities virtually closed, and the availability of jumbo mortgages dried up. Banks were caught with assets they couldn't securitize, which put further pressure on their capital positions.
Central Bank Actions As the liquidity crisis began in August, central banks immediately responded by pumping large amounts of funds into overnight markets. The Federal Reserve conducted several large operations in the federal funds market, and the European Central Bank (ECB) conducted special operations to inject overnight liquidity at the same time, as did the Bank of Japan, the Bank of Canada, and many other central banks.
The Federal Open Market Committee also began to ease monetary policy in September as it grew concerned about the impact that the contraction in housing activity and a possible credit crunch could have on economic growth more broadly. These actions quickly brought overnight interest rates down, but financial institutions remained reluctant to lend to each other for any but the very shortest maturities, prompting central banks to take several extraordinary steps to help support longer-term funding markets.
Many central banks increased their longer-maturity lending and expanded the set of assets they accepted as collateral to further help banks that found themselves with suddenly illiquid assets. The ECB, which had regularly auctioned longer-term funds, increased both the size and frequency of those auctions. The Bank of England and the Bank of Canada conducted similar term funding operations in their own currencies. The Federal Reserve announced the creation of the Term Auction Facility (TAF) to provide secured term funding to eligible depository institutions, and it also established swap lines with the ECB and the Swiss National Bank, which provided dollar funds that those central banks could lend in their jurisdictions.
As market conditions once again worsened in March and investors pulled back from lending against all but the safest assets, the Federal Reserve established the Term Securities Lending Facility, which allows primary dealers to swap a range of less-liquid assets for Treasury securities in the Federal Reserve's portfolio for terms of about one month. The Bank of England introduced a similar type of facility in April as the U.K. mortgage market showed increasing signs of stress, unveiling a plan to swap securities backed by mortgages for government bonds for a period of up to three years.
Finally, when the liquidity position of Bear Stearns deteriorated rapidly in mid-March, the Federal Reserve, in close consultation with the Treasury Department, judged that it was appropriate to use its emergency authority to provide secured funding to Bear Stearns through JPMorgan Chase.
To address liquidity at other primary dealers, the Federal Reserve again used its emergency lending authority to create the Primary Dealer Credit Facility (PDCF), which provides a backstop source of liquidity to primary dealers similar to that available to depository institutions through the discount window. Borrowing from the PDCF to date has been fairly substantial. Weekly-average borrowing levels peaked at about $37 billion in late March but have subsequently declined.
In sum, the Federal Reserve and other major central banks have taken aggressive actions that have helped us through some uncharted territory. Well-functioning, liquid financial markets are essential to economic prosperity. Had the Federal Reserve and other central banks not stepped in and acted with appropriate vigor to provide liquidity, the consequences for the real economy very likely would have been quite severe.
Public liquidity, however, is only an imperfect substitute for private liquidity. Although it is critical that the Federal Reserve acts as a lender of last resort when financial stability is threatened, the efficient allocation of capital is best promoted by competitive financial markets and institutions. However, the flow of credit has been impeded by the developments I outlined previously. Financial markets and institutions will be able to resume their proper roles in allocating capital and supporting economic growth only when confidence in them recovers.
And it is clear that financial institutions have some way to go toward reforming business models and practices. Large financial institutions in the United States and Europe have reported credit losses and asset write-downs amounting to more than $375 billion and have been working to repair their balance sheets by raising new capital from a wide range of sources. This process will take time, but at least we can see some progress.
This discussion brings us up to the present moment. The period of extreme stress seems to have abated, and financial markets are showing some tentative signs of revival. Reflecting pressures in short-term bank funding markets, London interbank offered rates over comparable-maturity overnight index swap rates rose to near record highs in March and April; although these spreads remain high by historical standards, they have narrowed somewhat over the past two months, one indication that conditions may be improving.
Spreads between yields on corporate bonds and yields on Treasury securities have also narrowed since March, as have spreads on credit default swaps for nonfinancial firms across a wide range of industries. However, significant strains persist. Banks are tightening their lending standards, and conditions could worsen again should the economic outlook deteriorate further.
The Economic Outlook Let me now turn to a brief discussion of the current economic outlook and how the financial turmoil we have recently been experiencing has affected it. Unfortunately, just as the problems in financial markets have begun to abate, commodity prices have reached new heights, which clearly could take a toll on the U.S. economy as well as on the economies of our major trading partners.
U.S. inflation has risen recently, largely because of these sharp increases in global commodity prices. However, thus far, the high costs of energy and other primary commodities have not led to much increase in core inflation, partly because of slackening domestic demand, and there is little evidence that these costs are feeding a wage-price spiral. Nevertheless, the latest spike up in energy and food prices has raised the upside risk to inflation and inflation expectations, which we are closely monitoring and seeking to contain.
Continued...
