It is natural to equate the problems in our financial system with the securitization of subprime mortgages. But the securitized subprime market happened to be the epicenter, and we now see that the fault line really ran for a very long distance and spanned many markets and many kinds of financial institutions – particularly those that were the most complex and the most interconnected.

Third, market participants have at times faced uncertainty about prospective public sector intervention.³ The disparate responses to potential failures at several high-profile organizations last year may have made it difficult for market participants to forecast whether official support would be forthcoming for any given counterparty. Speculation this year about the structure of possible government rescue programs may also be contributing to financial market uncertainty.

We knew from the beginning that we had a mess on our hands -- a very, very complicated mess we were going to have to work through. We were spending every minute, every molecule of oxygen, working to contain this big fire...

In during the Q&A session

Since August 2007, the FOMC's policy decisions have been calibrated to deal with the "adverse feedback loop" between disruptions to financial market stability and the real economy. This focus has influenced not only the setting of the funds rate, but also the implementation of several new policies aimed directly at the financial shocks, some of which I have discussed today.

I believe these initiatives will help in restoring the normal functioning of the financial system. They will also have a stabilizing effect on markets around the world and will therefore eventually help stimulate worldwide economic recovery.

Economic downturns historically are of two types. Most of those in post-World War II-America have been a by-product of the Federal Reserve’s efforts to control rising inflation. But an alternative source of recession comes from the spontaneous correction of financial excesses: the bursting of bubbles, de-leveraging in the financial sector, declining asset values, reduced demand, and reduced employment.

Unfortunately, our current situation reflects this latter, rarer kind of recession.

Like water seeking its level, saving flowed from where it was abundant to where it was deficient, with the result that the United States and some other advanced countries experienced large capital inflows for more than a decade, even as real long-term interest rates remained low.

The global imbalances were the joint responsibility of the United States and our trading partners, and although the topic was a perennial one at international conferences, we collectively did not do enough to reduce those imbalances. However, the responsibility to use the resulting capital inflows effectively fell primarily on the receiving countries, particularly the United States... In certain respects, our experience parallels that of some emerging-market countries in the 1990s, whose financial sectors and regulatory regimes likewise proved inadequate for efficiently investing large inflows of saving from abroad. When those failures became evident, investors lost confidence and crises ensued. A clear and highly consequential difference, however, is that the crises of the 1990s were regional, whereas the current crisis has become global.

Federal Reserve Board Chairman Ben Bernanke tried to assure Congress and investors that federal regulators are not grasping at straws in the response to the financial crisis.

"We're not making it up," Bernanke told the House Financial Services panel.

"We're working along a program that has been applied in various contexts," he said. "We're not completely in the dark."

As reported by MarketWatch.

The turmoil intensified in mid-September, and volatility has been elevated since. Financial market participants have faced three major categories of uncertainty. The first concerns the aggregate amount of losses on mortgage lending...

Second, financial market participants have faced uncertainty about where the losses will turn up...

Third, market participants have at times faced uncertainty about prospective public sector intervention.⁴ The disparate responses to potential failures at several high-profile organizations may have made it difficult for market participants to forecast whether official support would be forthcoming for a given counterparty. Shifts in expectations regarding official intervention may have added volatility to financial asset markets that already were roiled by an increasingly uncertain growth outlook. And uncertainty about the form of government support — asset purchases versus dilutive capital purchases, for example — may have hindered the provision of fresh equity capital.

Other than policies tied to current and expected future values of the overnight interest rate, the Federal Reserve has--and indeed, has been actively using--a range of policy tools to provide direct support to credit markets and thus to the broader economy.  As I will elaborate, I find it useful to divide these tools into three groups...

The first set of tools, which are closely tied to the central bank's traditional role as the lender of last resort, involve the provision of short-term liquidity to sound financial institutions.  Over the course of the crisis, the Fed has taken a number of extraordinary actions to ensure that financial institutions have adequate access to short-term credit.  These actions include creating new facilities for auctioning credit and making primary securities dealers, as well as banks, eligible to borrow at the Fed's discount window...

[T]he Federal Reserve has developed a second set of policy tools, which involve the provision of liquidity directly to borrowers and investors in key credit markets.  Notably, we have introduced facilities to purchase highly rated commercial paper at a term of three months and to provide backup liquidity for money market mutual funds...

The Federal Reserve's third set of policy tools for supporting the functioning of credit markets involves the purchase of longer-term securities for the Fed's portfolio.  For example, we recently announced plans to purchase up to $100 billion in government-sponsored enterprise (GSE) debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters... The Committee is also evaluating the possibility of purchasing longer-term Treasury securities.  In determining whether to proceed with such purchases, the Committee will focus on their potential to improve conditions in private credit markets, such as mortgage markets.

...

These three sets of policy tools--lending to financial institutions, providing liquidity directly to key credit markets, and buying longer-term securities--have the common feature that each represents a use of the asset side of the Fed's balance sheet, that is, they all involve lending or the purchase of securities.  The virtue of these policies in the current context is that they allow the Federal Reserve to continue to push down interest rates and ease credit conditions in a range of markets, despite the fact that the federal funds rate is close to its zero lower bound.

Confronted with a barrage of criticism from lawmakers, former officials and even some of his staff, Cox said he took pride in his measured response to the market turmoil.

"What we have done in this current turmoil is stay calm, which has been our greatest contribution -- not being impulsive, not changing the rules willy-nilly, but going through a very professional and orderly process that takes into account unintended consequences and gives ample notice to market participants," Cox said. This caution, he added, "has really been a signal achievement for the SEC."

Taking a swipe at the shifting response of the Treasury and Fed in addressing the financial crisis, he said: "When these gale-force winds hit our markets, there were panicked cries to change any and every rule of the marketplace: 'Let's try this. Let's try that.' What was needed was a steady hand."

Cox said the biggest mistake of his tenure was agreeing in September to an extraordinary three-week ban on short selling of financial company stocks. But in publicly acknowledging for the first time that this ban was not productive, Cox said he had been under intense pressure from Treasury Secretary Henry M. Paulson Jr. and Fed Chairman Ben S. Bernanke to take this action and did so reluctantly. They "were of the view that if we did not act and act at that instant, these financial institutions could fail as a result and there would be nothing left to save," Cox said.

As reported by the Washington Post.

Our lending to other major central banks, who in turn re-lend dollar funding to banks in their own jurisdiction.  As I have mentioned before, that has created liquidity provision around the world that has made the Federal Reserve in some sense the lender of last resort for dollar markets around the world.  That’s important because we have a globalized financial system. If dollar markets are disrupted in the U.K. or in Europe or in Asia, that will have effects on our markets here in the United States.  

…

I guess I would also emphasize – some people have worried about the credit issues. As I mentioned in my remarks, all of those programs are very safe from a credit perspective. The loans to banks and dealers are over-collateralized and with recourse to the firms. The loans to central banks are collateralized with currency of the foreign country and the good faith and credit of those central banks.  The loans in our credit markets are also well-protected and well-collateralized.  So we’re not putting money at risk – in fact, we expect probably to make some money in this – but the purpose of this is to put cash out in order to get this markets working, functioning better – getting credit flowing more freely to help the economy recover.

From the audience Q&A

Indeed, a significant feature of the recent financial market stress is the strong demand for dollar funding not only in the United States, but also abroad. Many financial institutions outside the United States, especially in Europe, had substantially increased their dollar investments in recent years, including loans to nonbanks and purchases of asset-backed securities issued by U.S. residents.¹ Also, the continued prominent role of the dollar in international trade, foreign direct investment, and financial transactions contributes to dollar funding needs abroad. While some financial institutions outside the United States have relied on dollars acquired through their U.S. affiliates, many others relied on interbank and other wholesale markets to obtain dollars. As such, the recent sharp deterioration in conditions in funding markets left some participants outside the United States without adequate access to short-term dollar financing.

The emergence of dollar funding shortages around the globe has required a more internationally coordinated approach among central banks to the lender-of-last-resort function. The principal tool we have used is the currency swap line, which allows each collaborating central bank to draw down balances denominated in its foreign partner’s currency. The Federal Reserve has now established temporary swap lines with more than a dozen other central banks.² Many of these central banks have drawn on these lines and, using a variety of methods and facilities, have allocated these funds to meet the needs of institutions within their borders.³ Although funding needs during the current turmoil have been the most pronounced for dollars, they have arisen for other currencies as well. For example, the ECB has set up swap lines and repo facilities with the central banks of Denmark and Hungary to provide euro liquidity in those countries. The terms of many swap agreements have been adjusted with the changing needs for liquidity: The sizes of the swaps have increased, the types of collateral accepted by these central banks from financial institutions in their economies have been expanded, and the maturities at which these funds have been made available have been tailored to meeting the prevailing needs. Notably, in mid-October, the Federal Reserve eliminated limits on the sizes of its swap lines with the ECB, the Bank of England, the SNB, and the Bank of Japan so as to accommodate demands for U.S. dollar funding of any scale. Taken together, these actions have helped improve the distribution of liquidity around the globe.

This collaborative approach to the injection of liquidity reflects more than the global, multi-currency nature of funding difficulties. It also reflects the importance of relationships between central banks and the institutions they serve. Under swap agreements, the responsibility for allocating foreign-currency liquidity within a jurisdiction lies with the domestic central bank. This arrangement makes use of the fact that the domestic central bank is best positioned to understand the mechanics and special features of its own country’s financial and payments systems and, because of its existing relationships with domestic financial institutions, can best assess the strength of each institution and its needs for foreign-currency liquidity. The domestic central bank is also typically best informed about the quality of the collateral offered by potential borrowers.

While housing may well have been the trigger for the onset of the broader financial turmoil, I have long believed it is not the fundamental cause.⁵ Indeed, recent financial market developments strongly indicate that housing, as an asset class, does not stand alone. Indeed, the problems associated with housing finance reveal broader failings, including inadequate market discipline, excessive reliance on credit ratings, and poor credit and liquidity risk-management practices by many financial firms.

Over the past year or so, the FOMC has cut its federal funds rate target by 425 basis points to its current level of 1 percent.  Nonetheless, most private-sector borrowing rates are higher now than at the beginning of this crisis in August 2007. In pointing this out, I don’t mean to imply that the rate cuts did no good: borrowing rates in my view would be substantially higher absent the reduction in our base lending rate. It’s just that the effects of the growing credit crunch have outpaced the easing of policy, and, indeed, every major sector of the economy has been adversely affected by it.

The proximate cause of the financial turmoil was the steep increase and subsequent decline of house prices nationwide, which, together with poor lending practices, have led to large losses on mortgages and mortgage-related instruments by a wide range of institutions.  More fundamentally, the turmoil is the aftermath of a credit boom characterized by underpricing of risk, excessive leverage, and an increasing reliance on complex and opaque financial instruments that have proved to be fragile under stress.