The ongoing capital injections under the TARP are continuing to bring stability to the banking system and have reduced some of the pressure on banks to deleverage, two critical first steps toward restarting flows of new credit.  However, overall, credit conditions are still far from normal, with risk spreads remaining very elevated and banks reporting that they continued to tighten lending standards through October.

It's a tough, tough choice as a policy maker. It's always tempting to think, ``Well, I know where this is going to go, let's just smooth out the path and get it there.'' Or to come to the judgment that things are overshooting and they've really gone too far. But I tend to have some respect for market processes in times like this. And I like to approach this with some humility about policy makers' ability to asses where mortgage backed securities should trade, just as we were genuinely humble about what we could say about where tech stocks should trade through.

Unless we take steps to deal with it, the long-term fiscal situation of the federal government will be unimaginably more devastating to our economic prosperity than the subprime debacle and the recent debauching of credit markets.

From Q&A as reported by Bloomberg News

We saw a debauching of the credit system. To correct that, financiers, whether they be banks or homeowners, will be more cautious as they proceed.

As reported by Market News International

Consistent with Munger's admonition, the Fed saw it necessary to expand our toolkit beyond the proverbial hammer of the policy rate in the last nine months. And as I discussed in remarks last month, the Fed's nontraditional policy response included the use of innovative liquidity tools to counter the market turmoil and improve the functioning of financial and credit markets.⁴

In my remarks today, I would like to discuss the use of the hammer--the setting of the federal funds rate--particularly in extraordinary times. Of course, determining the proper level of the federal funds rate is rarely simple, given typical imprecision on key economic variables and relationships. It is far more challenging still when the financial architecture is in the early stages of redesign, the economy is adjusting to the aftermath of a credit bubble (witnessed most acutely in the housing markets), and inflation risks are evident.

The Federal Reserve has employed the hammer with considerable force in the last nine months, lowering the federal funds rate by 3-1/4 percentage points, with wide-ranging implications for the economy. Of substantial import, we have filled the toolkit with other implements to provide liquidity and improve the provisioning of credit during the turmoil. But now, policymakers may be well served encouraging a new financial architecture to emerge, aided, in part, by the actions we have taken. Even if the economy were to weaken somewhat further, we should be inclined to resist expected, reflexive calls to trot out the hammer again.

Policy actions should reinforce the notion with stakeholders that further hammering needs to be done, but it needs to be accomplished by the financial institutions themselves in retooling their businesses and rebuilding the credit channel to help ensure a stronger, more durable economy.

In the extreme, the interaction between asset prices and the health of financial institutions following the collapse of an asset price bubble can endanger the operation of the financial system as a whole.⁶

To be clear, not all asset price bubbles create these risks to the financial system. For example, the bubble in technology stocks in the late 1990s was not fueled by a feedback loop between bank lending and rising equity values; indeed, the bursting of the tech-stock bubble was not accompanied by a marked deterioration in bank balance sheets. But potential for some asset price bubbles to create larger difficulties for the financial system than others implies that our regulatory framework should be designed to address the potential challenges to the financial system created by these bubbles.

Just as doctors take the Hippocratic oath to do no harm, central banks should recognize that trying to prick asset price bubbles using monetary policy is likely to do more harm than good.

Extreme losses have occurred much more frequently than we would have assumed four or five years ago ... When we were
first seeing billion dollar losses, people would say those are thousand year events ... but we need to think more about them now.

From Q&A as reported by Market News International

What steps should market participants take to restore their disciplinary role in the financial system and prevent the depth of problems we have recently experienced? In the near term, investors can be expected to show a preference for simpler and more readily understood financial instruments, while showing a reluctance to put their money in the types of markets and investment vehicles that have caused much of the recent turmoil. They can also be expected to exert more “due diligence” and to favor the originators, rating agencies and fund managers that demonstrate a reputation for providing sound credit analysis and accurate disclosures. These are certainly some of the most apparent “lessons to be learned,” and it will take some time for our financial markets to regain the confidence of investors and meet this revised set of expectations.

Experience tells us, however, that as time passes and memories fade, market participants will always be tempted to relax their ongoing disciplinary role, particularly as any corrective steps begin to appear outmoded in a more prosperous time and as new and seemingly more profitable opportunities and investment vehicles are developed.

Because many of our current financial problems can be tied to asset-backed securities, beginning with the subprime market, we should ask ourselves what can be done to strengthen the regulatory framework surrounding securitization and to address the asymmetric information problems in this market. This is a particularly important question given the benefits that securitization can bring to our credit markets in terms of attracting new funding sources and distributing risk across a broader marketplace.

Among the ideas now being suggested are: (1) tighter registration requirements for loan originators; (2) improved disclosures by originators and securitizers on the underlying loans; (3) new limits on the types of asset-backed securities regulated institutions can hold; (4) greater liability, risk exposure or equity positions for originators and securitizers; and (5) new regulations for the agencies rating these securities.

Other regulatory steps may be necessary.

There is a real difficult issue here, because the incentives are out of line. I'm a rating agency, you're going to pay me to rate you. So how do you deal with that? Should we open the market? ... Either get those incentives aligned or you're going to have to oversee them.

From Q&A as reported by Market News International

Clear disclosures of loan modifications will not only make it easier for regulators, the mortgage industry, and homeowners to assess the effectiveness of foreclosure-prevention efforts, but they will also foster greater transparency, and hence greater confidence, in the securitization market.

It is appalling where we are right now. [The Fed has introduced] a backstop for the entire financial system.

There is a striking parallel with the challenges for the re-emergence of the subprime mortgage market and the adoption of innovations in the community development investments market. To overcome the unease of the current financial markets and attract a new source of capital, new market entrants must make particular efforts to reduce the uncertainty associated with their investment opportunities. For the CDFI industry, the challenges that need to be addressed are improving information about these products, developing models of risk and pricing, and standardizing these contracts. Addressing these issues will be critical to jump-start sustainable private CDFI investments as well as to revive the subprime mortgage market.

The migration toward sustainable mainstream capital sources is important in light of budgetary challenges facing governmental and philanthropic funding sources. For CDFIs to expand the scope and volume of their financing activities, they need to develop new products and innovations that tap more predictable sources of funding. Accessing the broad depth of the capital markets as a self-sustaining funding source for community development would yield enhanced benefits, such as more-efficient delivery of capital, greater funding and underwriting discipline, and reduced finance costs.