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).

Most notably, investors' concerns about exposures to subprime mortgage credit risk caused them to shun commercial paper that might be backed by such assets, in both Europe and the United States.  This aversion, in turn, meant that commercial banks that had written backup liquidity lines for commercial paper programs or had other connections with these programs might have to make good on their actual or implied support by extending credit.  With leveraged buyout credit and some mortgage originations also possibly staying on the balance sheet unexpectedly, the banks faced substantial, but uncertain, calls on their liquidity and capital.  All this uncertainty led the banks and other short-term lenders to turn very cautious; interest rates on bank deposits and other sources of credit beyond just a few days rose steeply, funding in money markets became concentrated in the very short term, and concerned and uncertain lenders generally became much less willing to extend the credit needed for liquid and efficient financial markets. 

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.

And in private equity in particular, [private pools of capital and hedge funds] play an important role in the market for corporate control. We need to have a mechanism whereby poorly run companies, weak managements are subject to being taken over, replaced and their companies improved. And when it's working right, at least, private equity -- as LBOs in the past -- helps to serve that function. So they do serve some positive functions.  

They raise many issues of financial stability and the like, you know, making sure that their counterparties are taking appropriate attention to their risks and the like. And we've discussed those some in the president's working groups' principles. But they certainly are a benefit to the economy.  

In the Q&A session

The Federal Reserve is focusing on the risks to U.S. bank holding companies from leveraged lending activities--that is, from lending to relatively higher risk corporate borrowers, often to finance acquisitions or leveraged buyouts. The largest U.S. banks typically distribute a large share of the loans that they originate to other banks and institutional investors. Nonetheless, the banks can be exposed to significant risks, and the review is intended to assess the scale of these risks and the effectiveness of the banks' associated risk-management practices. The Federal Reserve's efforts in this area are being coordinated with the OCC and the SEC.

For example, in response to the problems in the subprime variable rate mortgage market, spreads on certain debt and credit default swaps linked to those instruments have recently moved up substantially. In addition, there has recently been some tightening of lending standards and higher pricing of debt being issued in connection with private-equity financed leveraged buyouts. These recent reassessments of risk premiums suggest to me that they are focused on certain targeted instruments and therefore essentially represent the market's appropriate response to the discovery of a higher probability of specific adverse events. Nonetheless, I also believe such developments are worth watching with some care, since there is always the possibility that they do presage a more general and pronounced shift in risk perceptions.

My concern, however, is that investors may be underestimating the risks in both in domestic and foreign markets as indicated by a number of investment strategies. For example, here in the U.S., the rapid rise of lending at variable rates in the subprime mortgage market may have reflected an unduly benign view of the underlying risks, and some lenders have paid a high price for this view. Inflows into hedge funds have soared and private equity firms are borrowing at low interest rates with favorable terms, resulting in a wave of leveraged buyouts in both the U.S. and abroad. Some observers question whether the supposedly sophisticated investors in these funds fully understand the complexities of the investment strategies pursued by fund managers and the risks to which they are exposed.

In foreign markets, investor demand for emerging market assets has continued to expand, with inflows into dedicated bond and equity funds in those countries, including instruments denominated in local currencies, without much increase in risk spreads. Low costs of borrowing have also attracted money into “carry trades,” where investors borrow short-term at lower rates in one currency and invest, unhedged, in riskier, higher-yielding bonds in another currency. This strategy exposes investors to substantial exchange rate risk.

Another area of possible financial risk that we are watching is leveraged lending.  Business borrowing for mergers and acquisitions and for corporate refinancing has been quite robust over the past few years as firms have taken advantage of relatively low interest rates to reduce their cost of capital.  As underwriters have brought these deals to the market, the good earnings of corporate borrowers and several years of very low defaults have encouraged lenders and investors to fund hundreds of billions of dollars in leveraged loans.  However, with this growth we are seeing some trends in the leveraged loan market that warrant closer monitoring:  Deals continue to be structured with thin pricing, more leverage, and looser covenants than is typical for non-investment-grade borrowers.  Further, originating banks are capitalizing on the strong investor demand for these loans by underwriting to distribute them, including through securitization, while holding only nominal exposures themselves. 

Some market participants tell me that the very low bond default rates seen recently, realized and expected, are themselves a reflection of liquidity. That is, excess market liquidity may have allowed less than creditworthy firms to refinance their obligations, thereby only deferring their financial difficulties. Other observers note the rise in the second half of last year in the share of new bond issuance that is rated highly speculative, and an increase in purchase and debt-multiples for leveraged buyouts, suggesting some pickup in risk-taking that may be indicative of overconfidence.

Many signs point to a continuation of this high pace of equity retirements. Valuations for many firms appear attractive to private equity sponsors. (Although, as I noted earlier, stock prices have risen quite a bit since 2002, their gains have been far outstripped by the boom in earnings.) Lower valuations for firms in industries that are in the throes of downsizing also provide opportunities for LBOs.