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.

The problems in the mortgage-related sector reverberated throughout the financial system and particularly in the market for asset-backed commercial paper (ABCP)... The problems intensified in the second week of August after the announcement by a large overseas bank that it could not value the ABCP held by some of its money funds and was, as a result, suspending redemptions from those funds. Some commercial paper issuers invoked their right to extend the maturity of their paper, and a few issuers defaulted. In response to the heightening of perceived risks, investors fled to the safety and liquidity of Treasury bills, sparking a plunge in bill rates and a sharp widening in spreads on ABCP.

The retreat by investors from structured investment products also affected business finance. In particular, issuance of collateralized loan obligations (CLOs) and collateralized debt obligations (CDOs), which in turn had been major buyers of leveraged syndicated loans, fell off significantly during the summer. Demand for leveraged loans slowed sharply, reducing credit access for private equity firms and other borrowers seeking to finance leveraged buyouts (LBOs).

The past two months have been quite unusual for financial markets. Short-term liquidity has been disrupted for almost two months, as investors have reevaluated the securitization process. I am hopeful that with appropriate underwriting, the securitization process and the ABCP [asset-backed commercial paper] will continue to be a source of financing for a wide range of assets.

As questions have been asked on ratings of securities, many investors have chosen not to roll over commercial paper that was not backed by solid assets and did not have liquidity provisions provided by banks. This freeze-up, of course, means problems for financing a variety of assets, including mortgages, student loans, and home-equity loans.

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The alternative to securitizations and financing assets with commercial paper is financing by commercial banks. Fortunately, most banks are very well capitalized and have the ability to finance these assets. In fact, bank balance sheets did expand in both August and September, reflecting in part banks holding assets on their balance sheet that have been difficult to securitize. However, while banks have the capacity to finance many of these assets, it is likely that the cost of financing for these assets will increase if they are done by banks rather than through financial markets.

My expectation is that over time, investors will gain more confidence in their ability to evaluate the quality of ratings, and that conservatively underwritten securitizations and asset-backed commercial paper will find acceptance by investors. A reevaluation of ratings and the models used to determine ratings, and a greater onus on investors to understand the underlying assets and securities they are purchasing is likely to make these markets more resilient. However, this process of evaluation may take some time. While we have seen improvement in financial markets over the past month, we continue to observe wider spreads and reduced volumes on securitized products, which may remain until investor confidence has been restored.

Recently, we have watched the deterioration in financial conditions extend beyond the subprime market.  Investors appear to have reassessed their outlook and their tolerance for risk, especially for structured financial products and for securities of highly leveraged firms.  Bond spreads--especially those for speculative-grade debt--widened substantially in June and July, and the volatility of equity prices increased as well.  In mid-August, following several events that led investors to believe that credit risks might be larger and more pervasive than previously thought, the functioning of financial markets, including short-term and interbank funding markets, became increasingly impaired.  Notably, many asset-backed commercial paper programs found rolling over their paper increasingly difficult.  To help restore orderly conditions, the Federal Reserve in recent weeks has increased the provision of reserves, cut the discount rate, and changed its usual discount-window lending practices in order to facilitate term borrowing, together with other measures. 

The spike in delinquencies has affected not only the mortgage holders but also other segments of financial markets, including the market for asset-backed commercial paper. As background, the commercial paper market links investors directly with corporate borrowers without intermediation by banks. About half the current commercial paper market is so-called SIVs that invest in financial assets. Holders of the asset-backed commercial paper obligations of SIVs came to recognize the increased risk and, in many cases, refused to roll over or refinance the short-term debt of these borrowers.

In turn, the securities that included significant amounts of the subprime mortgages became hard to value. The secondary market for these securities shrank dramatically. I would describe this development as a closed loop. Valuation uncertainty reduced secondary market trading. Little or no trading made it even more difficult or impossible to value the securities by market price.

Faced with these valuation difficulties, broader market participants have become wary of classes of structured debt securities beyond subprime. For instance, markets for jumbo prime mortgages also experienced liquidity problems.

Investment funds believed to be heavily exposed to subprime mortgage—backed securities and other structured debt securities have faced some redemptions and cancellation of borrowing facilities used to acquire the securities in the first place. This development forced sales of other classes of securities in their portfolios, and institutional sponsors of these investment funds have been called upon to support their distressed funds.

Many investment funds bought these securities "on margin" (using debt), and this fact is important. By employing leverage, many funds pursued enhanced returns. Efforts by investment funds to improve their liquidity and reduce exposure to risky assets involved reducing the amount of outstanding debt. This process—called deleveraging—appears to be widespread across the financial system.

The recoiling from risk in general is affecting an unrelated market—the leveraged loan market used by private equity deal sponsors. This market has backed up markedly—loan commitments intended to be syndicated have not been able to close because of weak distribution prospects. By some estimates, more than $400 billion of such financings are in backlog.

The markets for asset-backed commercial paper and for lower-rated unsecured commercial paper market also have suffered from pronounced declines in investor demand, and the associated flight to quality has contributed to surges in the demand for short-dated Treasury bills, pushing T-bill rates down sharply on some days. Swings in stock prices have been sharp, with implied price volatilities rising to about twice the levels seen in the spring. Credit spreads for a range of financial instruments have widened, notably for lower-rated corporate credits. Diminished demand for loans and bonds to finance highly leveraged transactions has increased some banks' concerns that they may have to bring significant quantities of these instruments onto their balance sheets. These banks, as well as those that have committed to serve as back-up facilities to commercial paper programs, have become more protective of their liquidity and balance-sheet capacity.