Even an institution that was relatively untouched by recent events should remain vigilant about the next potential source of turbulence, to ensure that it is prepared to analyze information about its risk exposures and distribute that information throughout the firm. Going forward, therefore, senior management at financial institutions should ensure that they have complete and timely information about risk and demonstrate the ability and will to act on it. They should also be aware that the next crisis could come precisely in the area where they are most exposed or have weaknesses. That is, a certain degree of humility is wise, because all firms have a limited understanding of what might happen next.

Because systematic approaches to dealing with troubled loans are often likely to lead to better aggregate investor returns than foreclosures, we are encouraged by industry efforts to pursue these approaches. When servicers modify loans, however, they may face potential litigation risk from investors because of their contractual obligations under the servicing agreements. One particular source of litigation risk, we understand, may be that different asset classes have conflicting interests. Therefore, we encourage ongoing industry efforts to agree to standards for addressing these issues. We are hopeful that the industry can resolve these conflicts on a consensual basis so that they do not preclude servicers from taking actions that are in the overall best interests of consumers and the industry.

The supply of funds for subprime loans is likely to remain low for some time as investors gather information and reevaluate the risks.

I noted a moment ago that periods of financial instability are characterized by valuation risk and macroeconomic risk. Monetary policy cannot have much influence on the former, but it can certainly address the latter--macroeconomic risk. By cutting interest rates to offset the negative effects of financial turmoil on aggregate economic activity, monetary policy can reduce the likelihood that a financial disruption might set off an adverse feedback loop. The resulting reduction in uncertainty can then make it easier for the markets to collect the information that enables price discovery and to hasten the return to normal market functioning. To achieve this result most effectively, monetary policy needs to be timely, decisive, and flexible. Quick action is important for a central bank once it realizes that an episode of financial instability has the potential to set off a perverse sequence of events that pose a threat to its core objectives. Waiting too long to ease policy in such a situation would only risk a further deterioration in macroeconomic conditions and thus would arguably only increase the amount of easing that would eventually be needed.

To me, the uncertainties about how financial conditions might evolve and affect the real economy mean that risk management considerations have an important role in the current policy environment. The cutback in nonconforming mortgage originations and the continued high level of inventories of unsold homes will result in further weakness in housing markets. Under one scenario, the effects on overall growth will be fairly isolated to declines in residential construction similar to our experience in 2006 and early 2007. However, there is a less benign possibility. Housing demand and prices could weaken a good deal more than we expect either because a new shock hits the sector or because we have underestimated the weakness already in train. A more pronounced downturn could weigh more heavily on consumer spending. In addition, further delinquencies and foreclosures could add to the problems with mortgage-backed securities. This, in turn, could generate further adverse effects on financial conditions that support economic activity. Together, such events would pose a more serious downside risk to growth. I want to emphasize that I do not see this extreme outcome as likely. But it is one of those high cost outcomes that we should guard against.

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.

Of course, we all want to consider whether the recent problems related to securitizing assets are going to have a longer lasting impact on the economy or financial markets. Securitizations have made it possible to efficiently finance pools of assets. In particular, investors with low risk tolerance were willing to buy what they thought were investment grade securities without a detailed understanding of the underlying assets as long as they had confidence in the ratings of the securities. To the extent that these investors have less confidence in ratings, they may choose to buy government or agency securities, where they do not need to make an independent analysis of potential credit risk. In part, this accounts for the reduction in rates on government securities relative to other financial instruments over the past two months.

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.

...

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.

Although this episode of financial turmoil is still unfolding, my preliminary judgment is that there are no new lessons. Weak underwriting practices put far too many borrowers into unsuitable mortgages. As borrowers default, they suffer the consequences of foreclosure and loss of whatever equity they had in their homes. It is painful to have to move, especially under such forced circumstances. Investors are suffering heavy losses. There is no new lesson here: Sound mortgage underwriting should always be based on analysis of the borrower’s capacity to repay and not on the assumption that a bad loan can be recovered through foreclosure without loss because of rising property values.

The other aspect of the current financial turmoil that reaffirms an old lesson is that it is risky to finance long-term assets with short-term liabilities.

The Federal Reserve has neither the power nor the desire to bail out bad investments. We do have the responsibility to do what we can to maintain normal financial market processes. What that means, in my view, is that we want to see restoration of active trading in assets of all sorts and in all risk classes. It is for the market to judge whether securities backed by subprime mortgages are worth 20 cents on the dollar, or 50 cents, or 100 cents. Obviously, the market will judge different subprime assets differently, based on careful analysis of the underlying mortgages. That process will take time, as it is expensive to conduct the analysis that good mortgage underwriting would have conducted in the first place. Although there is a substantial distance to go, restoration of normal spreads and trading activity appears to be under way, and we can be confident that in time the market will straighten out the problems. We do not know, however, how much time will be required for us to be able to say that the current episode is over.

The simple risk-bucketing approach in the existing Basel I rule, for example, creates perverse incentives for risk-taking. This approach--in which (1) the same amount of regulatory capital is assessed against all unsecured corporate loans and bonds regardless of actual risk, (2) all unsecured consumer credit card exposures are treated equivalently, and (3) almost all first-lien residential mortgage exposures are deemed equally risky--provides incentives for banking organizations to shed relatively low-risk exposures and acquire relatively high-risk exposures within each of these asset classes. The existing Basel I rule also ignores important elements of credit-risk mitigation--such as most forms of collateral, many guarantees and credit derivatives, and the maturity and seniority of an exposure--and thus blunts bank incentives to reduce or otherwise manage risk.

Of course, in some respects financial innovation makes risk management easier. Risk can now be sliced and diced, moved off the balance sheet, and hedged by derivative instruments. Indeed, the need for better risk sharing and risk management has been a primary driving force behind the recent wave of innovation. But in some respects, new instruments and trading strategies make risk measurement and management more difficult. Notably, risk-management challenges are associated with the complexity of contemporary instruments and trading strategies; the potential for market illiquidity to magnify the riskiness of those instruments and strategies; and the greater leverage that their use can entail.

The conditions we see prevailing in global financial markets today reflect a range of different factors, some fundamental and others that are less likely to be enduring. The most effective thing that policymakers and market participants can do in what is a necessarily uncertain world is to work to ensure that the shock absorbers are strong relative to the range of potential economic and financial outcomes.

The dramatic changes we’ve seen in the structure of financial markets over the past decade and more seem likely to have reduced this vulnerability {to financial crashes}. The larger global financial institutions are generally stronger in terms of capital relative to risk. Technology and innovation in financial instruments have made it easier for institutions to manage risk. Risk is less concentrated in the banking system, where moral hazard concerns and other classic market failures are more likely to be an issue, and spread more broadly across a greater diversity of institutions.

And yet this overall judgment, that both financial efficiency and stability have improved, requires some qualification. Writing a decade ago about the history of the financial shocks of the 1980s and early 1990s, Jerry Corrigan argued that these same changes in financial markets we see today, though less pronounced then than now, created the possibility that financial shocks would be less frequent, but in some contexts they could be more damaging. This judgment, that systemic financial crises are less probable, but in the event they occur could be harder to manage, should be the principal preoccupation of market participants and policymakers today.

What factors might contribute to this risk, a risk that could be described as the possibility of longer, fatter tails? One reason is a consequence of consolidation...  Another reason is the consequence of leverage...  A third reason is the consequence of long periods of low losses and low volatility.

`What's happening is the front end of this wave of teaser-rate loans that are coming into full pricing,'' Bies said at a risk-management forum in Charlotte, North Carolina. ``So what we're seeing in this narrow segment is the beginning of the wave -- this is not the end, this is the beginning.''   ... Bies said the problems in the mortgage market are well-contained.  ``We're seeing this in a very narrow segment,'' Bies said.  ``We're watching for contagion, we haven't seen it.''  Outside of the housing and auto industries, ``the economy is strong,'' Bies said.   (As reported by Bloomberg News)