Beginning in the 1970s, deposits began to decline as a proportion of funding for credit intermediation, as the separation of traditional lending and capital markets activities established by New Deal financial regulation began to break down. During the succeeding three decades, these activities became progressively more integrated, as credit intermediation relied more heavily on capital market instruments sold to institutional investors. Over time, these markets became--like traditional commercial banks--an important locus of maturity transformation, which in turn led to both an expansion and alteration of traditional money markets. Ultimately, there was a vast increase in the creation of so-called cash equivalent instruments, which were supposedly safe, short-term, and liquid.

When, in 2007, questions arose about the quality of some of the assets on which this intermediation system was based--notably, those tied to poorly underwritten subprime mortgages--a classic adverse feedback loop ensued. Investors formerly willing to lend against almost any asset on a short-term, secured basis were suddenly unwilling to lend against a wide range of assets. Liquidity-strained institutions found themselves forced to sell positions, which placed additional downward pressure on asset prices, thereby accelerating margin calls on leveraged actors and amplifying mark-to-market losses for all holders of the assets. The margin calls and booked losses would start another round in the adverse feedback loop. In short, the financial industry in the years preceding the crisis had been transformed into one that was highly susceptible to runs on the short-term, uninsured cash equivalents that funded longer-term extensions of credit.

Securities broker-dealers play a central role in many aspects of shadow banking as facilitators of market-based intermediation. To finance their own and their clients' securities holdings, broker-dealers tend to rely on short-term collateralized funding, often in the form of repo agreements with highly risk-averse lenders. The crisis revealed that this funding is potentially quite fragile if lenders have limited capacity to analyze the collateral or counterparty risks associated with short-term secured lending, but rather look at these transactions as nearly risk free. As questions emerged about the nature and value of collateral, worried lenders either greatly increased margin requirements or, more commonly, pulled back entirely. Borrowers unable to meet margin calls and finance their asset holdings were forced to sell, driving down asset prices further and setting off a cycle of deleveraging and further asset liquidation.

To monitor intermediation by broker-dealers, the Federal Reserve in 2010 created a quarterly Senior Credit Officer Opinion Survey on Dealer Financing Terms, which asks dealers about the credit they provide.

There are also a number of idiosyncratic sources of instability worthy of mention, some of which are unique to our particular system. One source of instability is the tri-party repo system that I discussed earlier. Another is the convention of tying collateral calls to credit ratings. In this case, if a firm’s credit rating is lowered, the firm may have to post additional collateral to its counterparties, eliminating this collateral as a potential source of funding. This phenomenon was a particularly important problem for AIG, which lost its access to the commercial paper market and was subject to increased collateral calls. Both factors caused the liquidity of the AIG parent company to be depleted very quickly. Finally, if asset volatility rises, haircuts can increase. This can lead to haircut spirals in which higher haircuts lead to forced asset sales, increased volatility and still higher haircuts.

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.

Just as public focus, experimentation, and policy debate have informed best practices with regard to loan modifications, we must also begin the work of developing responsible foreclosure and real estate inventory management protocols. Minimizing the amount of time that properties remain vacant and maximizing the price at which they are sold will serve the interests of both lenders and the communities. At this moment, lenders and communities alike are woefully under-resourced and unprepared for the volume of real estate that will need to be processed.

As the participants in this conference are keenly aware, I am sure, housing and housing finance played a central role in precipitating the current crisis.  As the crisis has persisted, however, the relationships between housing and other parts of the economy have become more complex.  Declining house prices, delinquencies and foreclosures, and strains in mortgage markets are now symptoms as well as causes of our general financial and economic difficulties.  These interlinkages imply that As the participants in this conference are keenly aware, I am sure, housing and housing finance played a central role in precipitating the current crisis.  As the crisis has persisted, however, the relationships between housing and other parts of the economy have become more complex.  Declining house prices, delinquencies and foreclosures, and strains in mortgage markets are now symptoms as well as causes of our general financial and economic difficulties.  These interlinkages imply that policies aimed at improving broad financial and economic conditions and policies focused specifically on housing may be mutually reinforcing.  Indeed, the most effective approach very likely will involve a full range of coordinated measures aimed at different aspects of the problem.

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Because developments in the housing sector have become so interlinked with the evolution of the financial markets and the economy as a whole, both macro and micro policies have a role in addressing the strains in housing.  At the macro level, the Federal Reserve has taken a number of steps, beginning with the easing of monetary policy.  To the extent that more accommodative monetary policies make credit conditions easier and incomes higher than they otherwise would have been, they support the housing market.

The Federal Reserve has also implemented a series of actions aimed at restoring the normal functioning of financial markets and restarting the flow of credit, including providing liquidity to a range of financial institutions, working with the Treasury and the Federal Deposit Insurance Corporation (FDIC) to help stabilize the banking system, and providing backstop liquidity to the commercial paper market...

Another lesson of the current crisis is that central banks need to improve their understanding of the workings of the financial system, its vulnerabilities, and its links to the real economy.  We must try to find ways to discern more quickly if financial innovation and other factors are leading to a buildup of destabilizing forces, such as rapidly rising asset prices or excessive leverage.  Moreover, the unexpectedly rapid resonance of financial turmoil through global markets signals a need for further study of the complex cross-country linkages among lenders and borrowers, and the ways in which those linkages are influenced by such factors as leverage, interdependent counterparty relationships, and backup liquidity agreements.  Finally, more effort needs to be spent on further investigation of the financial accelerator and other credit-channel effects, given the accumulating evidence that such effects can give rise to an adverse feedback loop between financial markets and the real economy.

We are in the grip of an “adverse feedback loop” in which a credit crunch exacerbates economic weakness, which in turn weakens financial institutions, intensifying the credit crunch.  Moreover, as I have explained, the efforts of the private sector to fix itself through deleveraging and other means are only making matters worse. This is why government action was urgently needed.

Overall, I anticipate that real GDP growth in the second half of this year will come in below the growth of potential output which implies that the unemployment rate will rise. On its own, this obviously is not good news. And its interaction with the housing and financial markets raises the potential for worse news—a deepening of the adverse feedback loop I've been describing: more unemployment causing more people to fall behind on their mortgage payments, leading to further delinquencies and foreclosures, tighter credit conditions and further downward pressure on activity and employment. This kind of process represents a downside risk for the economy, especially if it intensifies the sagging consumer and business confidence we've seen.

The balance-sheet pressures, and broader financial market dislocations, are likely to be with us for some time. My expectation is that market functioning will improve markedly by 2009. But things could get worse before they get better. For example, home prices could fall more than markets expect, leading to larger losses for financial institutions and further impairing their ability to make new loans. The credit crunch could then lead to further declines in house prices. The resulting decline in household wealth could then further reduce spending, leading to additional knock-on effects. So an adverse feedback loop could develop, with consequences for both financial markets and economic activity.

The outlook is indeed really sensitive to real estate prices. [Lower prices could cause a downward cycle and] that kind of adverse feedback loop is a real downside risk for the economy.

From audience Q&A as reported by Market News International.

Mr. Fisher was concerned that an adverse feedback loop was developing by which lowering the funds rate had been pushing down the exchange value of the dollar, contributing to higher commodity and import prices, cutting real spending by businesses and households, and therefore ultimately impairing economic activity.

One of the concerns that I have is that there is some interaction between the credit market situation and the growth situation. That is, if the economy slows considerably, which reduces credit quality, that worsens, potentially, the condition of credit markets, which then may tighten credit further in a somewhat adverse feedback loop, if you will.

 From the Q&A session

My baseline forecast envisions weakness in the first half of 2008 followed by improvement in the second half, with inflation moderating from recent levels. The liquidity injections and easing of monetary policy should help housing and financial markets stabilize and avoid an "adverse feedback loop" in which a decline in housing prices fuels financial market volatility with spillover to the broader economy.    

I see the growth risks as skewed to the downside for the near term. In circumstances like these, we can’t rule out the possibility of getting into an adverse feedback loop—that is, the slowing economy weakens financial markets, which induces greater caution by lenders, households, and firms, and which feeds back to even more weakness in economic activity and more caution. Indeed, an important objective of Fed policy is to mitigate the possibility that such a negative feedback loop could develop and take hold.