I think for the next several month's there'll always be a chance that a shoe's going to drop. It induces portfolio shifts and financial
sector adjustments ... I don't think that the magnitude of shocks is likely to be big enough to threaten the financial system in a material way. And I think the magnitude of issues is likely to decline over time, if they occur. But you can't tell what you don't know. Unexpected stuff can always happen

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

Finally, our most powerful tool for addressing a liquidity crisis is monetary policy. In setting the stance of monetary policy, the Fed has a dual mandate: to help foster maximum employment and price stability. Monetary policy is concerned with mitigating financial market stress to the extent that the stress impedes fulfillment of this dual mandate. Broadly speaking, I see our response to a financial shock as similar to our approach for responding to other shocks to the economy: We gauge the most likely effects of the shock on the future paths for economic activity and inflation; we discuss less likely but more costly alternative outcomes that we may want to insure against; and, based on this analysis, we adjust policy to best fulfill our dual mandate.

In my view, the Federal Reserve has two related, but distinct, responsibilities. The first and primary responsibility is monetary policy, which involves ensuring price stability, which contributes to sustainable economic growth. The primary tool of monetary policy is the federal funds rate, and the FOMC meets about every six weeks to determine an appropriate target for the funds rate consistent with these longer-term goals. The Fed’s second responsibility involves promoting financial stability by ensuring that the payment system and financial system function effectively.

It is important to recognize that the Federal Reserve cannot resolve this price discovery problem. The markets will have to figure this out.  Arbitrarily lowering interest rates or providing liquidity to the market does not provide the answers the market seeks.  Indeed, in some circumstances, lowering interest rates may prolong the painful process of price discovery.

...

In the current environment, providing insurance through a reduction in the fed funds rate creates its own set of additional risks. It may exacerbate moral hazard problems as I suggested earlier.

When the Fed cuts its target for the federal funds rate, market participants know that the FOMCs decision at its next meeting will be either to leave the rate unchanged or to cut further. Barring unusual circumstances, the FOMC would not consider a rate increase just after cutting its fed funds rate target. This approach to policy is appropriate when market conditions are fragile because market participants must be confident that they can take positions without the risk that the Fed might raise rates, which would reduce asset values, in the near term.

What creates generalized financial turmoil out of a market problem is that investors flee riskier assets of all types, with little regard to whether the assets are connected to the original problem or not. However, a flight to quality typically does not last very long. Investors start to make the relevant distinctions as they search for good assets trading at distressed prices. That process is certainly observable today.

In my view, the most likely story line is one involving a moderate slowdown in economic activity over the coming quarters, with a return to growth near trend by late 2008 as the housing sector begins to recover. Underpinning this story is the view that our modern market economy has a keen ability to self-correct as opportunistic capital moves into depressed markets. Markets correct. And market solutions are preferable. This transition already is happening in the market for subprime mortgages. In this story, financial markets may endure some more weeks or months of volatility, but I believe they will find a restructured state of "normality," involving improved risk management practices, reduced leverage, and greater transparency.

An appropriate public policy posture is to be supportive of market solutions in the financial markets.

Over the last several decades we've seen an evolution from a bank-centered financial intermediation system to a market-centered system. As a result, lenders have become investors, loan spreads have become investment yields, and individual loans have become the feedstock of pools of like assets brought together through a process known as securitization. These changes have had significant implications both for loan underwriting and where in the system loans are ultimately held. In terms of underwriting, the old "banker-looking-borrower-in-the-eye" business model has been largely replaced by an "originate and distribute" business model.

The consequences of the liquidity shock of 2007 on the financial markets and the real economy are still playing out in real time. It is premature to delineate lessons learned with complete assurance. The facts, nonetheless, can perhaps be placed in some narrative context, drawing on the experience of prior bouts of financial instability. History, of course, is far from a perfect teacher. After all, history does not repeat itself; it only appears to do so. In that regard, the causes and consequences of market turmoil are still insufficiently understood for the end of history to be declared

The recent problems in financial and credit markets reflect a pulling back from what I would call surrogate securitization, whereby investors were willing to buy debt that had been assigned high credit ratings by the credit rating agencies, regardless of the underlying assets used in the securitization. In other words, investors basically delegated due diligence to the rating agencies. Utilizing ratings to help evaluate the riskiness of securities is a normal part of the securitization process. But when new securities arise, investors may need to exercise more caution as rating agencies themselves learn about the appropriate risk to attach to the new instruments.

The elevated defaults we have already seen on recent vintages of subprime mortgages have resulted in losses for the highest risk tiers, and have caused investors to sell higher quality securities at a discount, reflecting uncertainty surrounding the accuracy of the investment-grade rating. If the ratings were accurate, highly rated securities containing subprime debt would have only a remote chance of default similar to investment-grade securities containing prime mortgages, home equity loans, or student loans. Unfortunately, underlying assumptions for the subprime market were inaccurate for several reasons I'll describe.

First and most importantly, most parties involved in the process assumed that house prices would continue rising nationally. This assumption seems to have had the biggest impact on the situation we see today. ... Second, the subprime market has grown very rapidly in recent years, so such widespread use of subprime mortgages is a relatively new phenomenon. This limited history made it difficult to assess the likelihood of defaults if underlying economic conditions changed. And third, the increased reliance on mortgage brokers who originated the loans but had little stake after they were securitized was a departure from the traditional buy-and-hold strategy of many financial institutions. These brokers typically are compensated based on volumes of loans made and sometimes on the rates and fees as well; as a result, the brokers have few incentives to worry about the longer-term viability of the mortgage.

Defaults in the subprime market have resulted in even the most secure tranches of subprime securitizations selling at a sizable discount. Investors are now questioning the appropriateness of surrogate securitization, contemplating more independent analysis of the securities and underlying assets and the need to distinguish between securitizations with different underlying assets. These are appropriate considerations, to be sure, but until they are more confident, investors have been shying away from even investment-grade securitization. The problems in securitization are highlighted by the impact on jumbo mortgage loans. Because of difficulties in securitization, the cost of these loans has risen significantly. This is particularly a problem in New England where the price of housing is quite high.

In our research, we looked at what happened to homeowners who used subprime loans to buy their homes and found that five years later, 90 percent were either still in their house or had profitably sold it.  While our research also shows that number will likely be lower for the most recent vintages, which already exhibit elevated defaults, most subprime buyers have a positive experience with homeownership. So, perhaps the most critical issue is that financing that supports responsible subprime lending continues, despite recent problems. Since the broker channel has been disrupted, as described earlier, I believe there is an opportunity for commercial and savings banks to help provide liquidity in this market. Most commercial and savings banks were not involved in originating subprime mortgages and are well capitalized, and may have profitable opportunities to explore in this market.

I am hopeful that financial institutions will play an important role in providing financing for many of the borrowers facing higher rates as their mortgages reset. In the past, rate-resets may not have been as problematic as they could be now, because borrowers had an easier time refinancing or selling. As we look at the situation now, we want to see borrowers continue to have the option to refinance, and want to see lenders continue lending so that resets do not become an increasing problem. As I said a moment ago, perhaps the most critical issue is that financing that supports responsible subprime lending continue.

Should we view the current developments and concerns in credit markets as a wholesale reassessment (or repricing) of risk by investors, and are the recent problems related to securitizing assets likely to have a longer lasting impact on the economy or financial markets?

I think the answer is no, investors are not reassessing risk in a wholesale way. Consider that a variety of assets that normally are impacted by investor desire for risk reduction have shown little reaction to current problems. For example, if one looks at emerging market debt, or stock prices in emerging economies, the current problems have left little trace in the data. Prices for stocks in many emerging markets are close to or at their highs for the year.

By contrast after September 11, 2001 and during the problems triggered by Long-Term Capital Management, stocks in many emerging markets fell sharply. Similarly, emerging market debt has shown only a modest widening of spreads. Following the September 11 attacks and during the Long-Term Capital Management problems, emerging market interest rates rose sharply.

Short-term debt markets, where relatively low risk financial assets are traded primarily between large financial institutions, are experiencing significantly reduced volumes and unusually large spreads. This is consistent with liquidity problems rather than a change in the willingness to hold risky assets in general.