With respect to impaired assets, experience reveals that programs to remove nonperforming loans from the balance sheets of financial institutions have proven helpful in resolving a number of earlier financial crises in both industrial and developing countries... To the extent that the prices that the government pays through auctions exceed the fire-sale prices now used to value them, some institutions will see an improvement in their capital.

I think that today's circumstances align, although not perfectly, with the experience of the early 1990s. There is no doubt that a variety of potential borrowers are finding funding more difficult and expensive to obtain. Moreover, while there was a significant contraction in residential construction activity in the late 1980s and early 1990s, the recent correction in this sector has been more severe, especially with the decline in housing values, and is continuing.

It is important to bear in mind, however, that many “initial conditions” prevailing prior to this financial shock were perceptibly better than in the early 1990s. Unemployment, interest rates, and inflation were all lower at the outset of the latest period of turmoil than in the previous headwinds episode. Equally important, the financial condition of both most banking and nonfinancial businesses was relatively healthier at the onset of recent problems.

In my judgment, the 1990s headwinds episode continues to provide a valuable reference point for thinking about economic prospects. For the near-term, I think that this framework suggests further declines in employment and likely softness in consumer spending, with a diminution of inflation, absent a resurgence in energy and other commodity prices.

In view of what we have seen at some large financial institutions and in some funding markets, the need to address TBTF through a framework which reduces spillovers is critical, and we propose systemic focused supervision as a constructive first step in this process...Given the headwinds associated with the financial shock, the economy appears likely to be restrained until these conditions improve, and that will take some time.

Our preference is to allow market forces to handle any required restructuring in the financial services industry. However, in some cases this is not possible when the risks to financial stability are too high.

Regardless of our intentions, we need to recognize that by taking these actions, we create expectations about future interventions and who will have access to central bank lending. These expectations, in turn, can create moral hazard by influencing firms' risk management incentives and the types of financial contracts they write, which may ultimately increase the probability and severity of future financial crises.

Going forward, just as we should avoid setting unrealistic expectations for monetary policy, we should also avoid encouraging unrealistic expectations about what the Fed can do to combat financial instability. As I have argued, in times of financial crisis, a central bank should act as the lender of last resort by lending freely at a penalty rate against good collateral. Yet, recent experience suggests we need to clarify what the Fed can and cannot be expected to do in today's complex financial environment.

The events of the past year underscore the importance of carefully assessing the current financial regulatory structure. Regulatory reforms should aim to lower the chances of financial crisis in the first place, for example, by setting capital and liquidity standards that encourage firms to appropriately manage risk. We should consider market structures, clearing mechanisms, and resolution procedures that will reduce the systemic fallout from failures of financial firms. Indeed, it would be desirable to be in an environment where no firm was too big, or too interconnected, to fail.

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I believe that the central bank should clearly state objectives and set boundaries for its lending that it can credibly commit to follow. Clarifying the criteria on which the central bank will intervene in markets or extend its credit facilities is not only essential but critical.

I would note one -- two things. First, as a minor point, that one of the things that this program being discussed could do would be to purchase second liens, which have proved to be a very significant barrier to the resolution of -- of foreclosures.

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Well, second liens are selling for a few cents on the dollar. I wouldn't expect them to be worth much more than that.  But I was only pointing out that -- I know this from Governor Duke, who's on the Hope for Homeowners board, that the problem with second liens is a big issue right now, because it prevents renegotiations of the first mortgage.  So I was just saying that a side effect, if we do buy them at market value, a few cents on the dollar, would be to help free up this -- this other issue.

From the Q&A session

Let me say that looking only at the Federal Funds rate during periods of significant economic headwinds will, in my view, provide a misleading gauge of the degree of monetary stimulus that the Federal Reserve has put in place.  At such times, a low Federal Funds rate does not signal a particularly accommodative monetary policy, but rather offsets some of the contraction that would otherwise occur as financial institutions tighten credit standards and offer borrowing rates with a spread over the Federal Funds rate that is larger than usual (in other words, larger than would be the case outside of credit crunch conditions).

That said, make no mistake: in my view, credit conditions would likely be much worse if the Federal Reserve had not lowered the Federal Funds rate and taken several innovative steps to enhance liquidity in the marketplace – steps like opening our new Term Auction Facility and other facilities that complement our traditional “Discount Window” for banks.

One day, a little Dutch boy was walking home when he noticed a small leak in a dike that protected the town. He started to stick his finger in the hole. But then he remembered the moral hazard lessons he had learned in school.  "Wait a minute," he thought.  “The companies that built this dike did a terrible job.  They don’t deserve a bailout, and doing so would just encourage more shoddy construction. Besides, the dumb people who live here should never have built their homes on a flood plain.” So the boy continued on his way home. Before he arrived, the dike burst and everyone for miles around drowned - including the little Dutch boy.

Perhaps you've heard the Fed's alternative version of the story.  In this kindler, gentler version, the little Dutch boy, somewhat desperate and worried about the horrors of a flood, stuck his finger in the dike and held it there until help arrived. It was painful and not guaranteed to work - and the little boy would rather have been doing other things. But he did it anyway. And all the foolish people who lived behind the dike were saved from the error of their ways.