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.

Rating agencies are already undertaking their own reforms, but ratings are unlikely to be as singularly dominant as they have been in some markets in recent years. Moreover, investors and rating agencies will not soon forget the lessons of recent months in evaluating pool probabilities. Tail events can materialize and, given recent experience, seem to do so with higher frequency than was contemplated by the models employed—models that were built for other purposes and products.

In the early days of the Chicago Board of Trade, in the mid-1850s, standardization took the form of creating “grades” or quality categories for commodities such as wheat, allowing for the fungibility of grains stored in elevators and warehouses, and breaking the link between ownership rights and specific lots of a physical commodity. Traders no longer needed to verify that a certain quantity of grain was of a sufficiently high grade because the exchange established a system of internal controls in the form of grain inspectors and a self-regulatory system to arbitrate disputes. The grain inspectors charged a set fee to certify the quality of the grain for any receipt traded at the board, a system with parallels to the mechanisms employed today by the rating agencies.¹

As I mentioned earlier, one of the reasons that the price discovery mechanism has broken down in some U.S. markets in recent months is that a number of investors failed to exercise due diligence and relied on rating agency assessments.  That is, there was a lot of trust but not much verification.  I would suggest that the value of independent due diligence on the part of investors is especially high for newer and more-complex products compared with more traditional, familiar, and less-complex products.  

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.

Some estimates are in the order of between $50 billion and $100 billion of losses associated with subprime credit products. The credit rating agencies have begun to try to make sure they account for those losses, and they have downgraded some of these products.  I should say that the investors, many of them recognize that even before the downgrades occurred that there were risks associated with these products, including not only credit risks, but also liquidity and interest rate, other types of risks.