The unwinding of this global financial boom has caused a substantial degree of stress to the financial system. Was this preventable? I don’t believe that asset price and credit booms are preventable. They cannot be effectively diffused preemptively. There is no reliable early warning system for financial shocks.

First, some financial products were not well designed to withstand liquidity problems. To avoid paying banks fees to provide a liquidity backstop, many financial products of recent vintage included provisions to force liquidation when necessary to insure payment to the holders of the higher-graded securities (or slices of securities). This structure was used, for example, by structured investment vehicles (SIVs)

13. However, due to the recent financial stress, assets of SIVs could not be liquidated at prices felt to be reasonable. Broadly speaking, products should be structured to better weather periods of illiquidity, and ratings models should take better account of liquidity risk.

Securities that are consistent enough to trade on an exchange are more likely to have market prices that all participants can use.

the difficulties in obtaining market prices are likely to be significantly reduced, as are the consequent uncertainties like those we are currently facing.

In contrast to corporate securities, corroborating information on mortgage securities is not as readily available. There is no equivalent to equity analysts and equity prices to give investors updated market information. The information needed to analyze the individual mortgages in the pool can be expensive to obtain. So investors are more reliant on rating agencies than they are with corporate securities.

The problems in the mortgage market highlight the need for caution where there has been limited ratings history, where the underlying characteristics that drive the asset’s price may not be fully understood or anticipated, and where evaluations cannot be easily corroborated by others such as equity analysts.9 Certainly one way to highlight these differences is to differentiate ratings on corporate securities from ratings on assets like mortgage-backed securities.

I'm sure there'll be some other instrument that the market chooses to challenge. This is part of what I've described in the past as the price discovery process ... I'm guessing it will still be bumpy for a while to come.

From press Q&A, as reported by Market News International

I would characterize the current state of affected financial markets (those most affected by the subprime problem) as evolving positively but still fragile—in other words, unusually vulnerable to shocks. Affected markets are working through problems of counterparty mistrust, lower or no trading volume, reduced new origination, and plummeting market prices that may be well below eventual economic value. For instance, investors have been reluctant to roll over asset-backed commercial paper because of the linkages to subprime mortgage–backed securities purchased by structured investment vehicles, or SIVs. The asset-backed commercial paper (ABCP) market has shrunk over $400 billion since August of last year, and major investors have exited, possibly permanently.

I would argue that root causes of problems in the subprime market brought into question some fundamental practices, incentives, and even institutions of other markets. By fundamentals, I mean the integrity of origination (that is, the quality of assets that went into securitization pools), the structure of the securities into which loans and individual securities were packaged, and the value of these securities as collateral for margin financing.

Also, rating agencies had greatly underestimated the risk of many mortgage-backed securities. This led to a loss in confidence in the ratings assigned to other complex financing structures with further reductions in liquidity and increases in the volatility of prices across a variety of debt markets.

Through this spread of suspicion, subprime losses exposed related problems elsewhere, such as the syndication market for leveraged loans. Some leveraged lending underwriting was in its own way very aggressive in the period before the markets turned rocky starting last summer.

Finally, the subprime crisis generated a thicket of doubts concerning counterparties. Uncertainty about valuations of securitized debt fed uncertainty regarding the exposure of large banks and other market participants, which led to concerns about executing trades with these counterparties.

The credit rating agencies got it wrong. Badly. I think some of the investors didn't understand that a triple-A (rating) for a corporate bond really has a different meaning. A corporate bond that's triple-A will act in a different way than a triple-A tranche of subprime mortgages will act, and so when markets moved and markets changed, people got surprised by the extent to which there was downgrading.

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

The originate-to-distribute model for loans has been a successful model for some time; I think that's a very successful thing; it's worked very well in a number of areas -- consumer loans, auto loans, all kinds of things for a long time. In the case of mortgages, it just got too complicated. People made wrong assumptions. I think these instruments need to be simpler, more transparent. People need to be able to look through and make a judgment about whether the credit rating agency has done the right job or not.

From audience Q&A as reported by Market News International 

Market participants must ensure that they do not make valuation decisions based solely on excessive reliance on external ratings or evaluations, but that they also undertake their own assessment. And I would suggest that the value of independent due diligence on the part of market participants is especially high for newer and more-complex products.

As for the municipal bonds, Fisher said that market's woes do not appear to be having a significant liquidity impact on corporate financing. So far, corporate treasurers and cash managers aren't overly dependent on those instruments in their portfolio, he said. But it's a different story for the muni market itself.

"There's a short-term impact. I think the long-term impact of that will be mitigated by new financing methods that'll be discovered by issuers," Fisher said.

From press Q&A as reported by Market News International

My overall assessment is that the turbulence in financial markets is due to some fundamental problems that are not likely to be resolved quickly. The effects of these problems have now made credit conditions tighter throughout most of the economy’s private sector, and this will restrain spending going forward.

For the past few years, we have had a raucous party of economic growth fueled by an intoxicating brew of credit market practices that financed a housing boom of historic, and late in the cycle, hysteric, proportions. With the benefit of perfect hindsight, some have argued that the Fed failed to take away the punchbowl as the subprime party spun out of control, leaving rates too low for too long and not using our regulatory powers to restrain excessive complacency in the pricing and monitoring of risk. But that is beside the point.

Now we are faced with the consequences of a process that lawyers would call the “discovery phase”: As big banks and other financial agents confess their acts of fiduciary omission and excesses of commission, credit markets have effectively de-leveraged important segments of the economy, slowing growth suddenly and precipitously. Instead of taking the punchbowl away, the Federal Reserve is now faced with the task of replenishing the punch.

So, as we move out of the current turmoil, I see the U.S. markets headed toward a "new normal," not a return to normal. The recent turmoil has discredited the more dubious innovations of the past few years. But the foundation of earlier innovations over the past three decades delivered too much value for us to return to the "old-old" ways of finance.

I believe the contours of the new normal will be:

• a reformed, market-based system with a strong role for banks;
• the continuation of securitization more narrowly applied and with strengthened origination, structuring, and risk evaluation practices;
• better investor practices with more self-reliance, along with a substantially reformed rating agency industry;
• simplified and standardized instruments; and
• much refined risk management practices on the part of all market participants.

As I hope you detect, I am optimistic that the trauma of recent months will pass and our credit capital markets will be better for the lessons learned.

Lacker was asked whether the trading losses at French banking giant Societe General would impact the U.S. economy: "I don't think it's going to have an effect."

As to whether the scandal influenced the Fed's recent rate cuts, Lacker added, "I don't think it affected our policymaking at all."

From conversation with students and faculty, as reported by Market News International