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.

For example, in foreign markets, low borrowing costs have attracted money into such investment strategies as "carry trades," where investors borrow at lower rates in one currency and invest, unhedged, in higher-yielding bonds in another currency. This strategy obviously exposes investors to substantial exchange rate risk, which they may be underestimating.

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. 

Financial markets over the past several years have been characterized by an unusual constellation of low forward interest rates, ample liquidity, low risk premia and low expectations of future volatility. In some markets, asset prices have risen substantially, and credit growth has expanded rapidly. In credit markets more generally, spreads have declined to levels that reflect very low expectations of near term losses and credit standards have weakened.

It would not be accurate to say this is a world without volatility, for we have had a series of episodes of sharp declines in asset prices and increases in volatility. But these episodes have been contained and short lived, with markets recovering relatively quickly and with little appreciable effect on global economic activity.

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.

Financial shocks take many forms. Some, such as in 1987 and 1998, involve a sharp increase in risk premia that precipitate a fall in asset prices and that in turn leads to what economists and engineers call "positive feedback" dynamics. As firms and investors move to hedge against future losses and to raise money to meet margin calls, the brake becomes the accelerator: markets come under additional pressure, pushing asset prices lower. Volatility increases. Liquidity in markets for more risky assets falls.

In systems where credit is more market-based and more credit risk is in leveraged financial institutions outside the banking system, a sharp rise in asset-price volatility and the concomitant reduction in market liquidity, can potentially have greater negative effects on credit markets. If losses in these institutions force them to withdraw from credit markets, credit availability will decline, unless or until other institutions in a stronger financial position are willing to step in. The greater connection between asset-price volatility, market liquidity and the credit mechanism is the necessary consequence of a system in which credit risk is dispersed outside the banking system, including among leveraged funds. This does not make the system less stable, though, only different. For if risk is spread more broadly, shocks should be absorbed with less trauma. Moreover, the system as a whole may be less vulnerable to distortions introduced by the moral hazard associated with the access that banks have to the safety net.

In recent quarters, we witnessed very strong credit markets, bulging pipelines for leveraged loan and high-yield bond issuance, and near-record low credit spreads...

Fund managers of private pools of capital seized upon this opportunity to acquire more-permanent sources of capital: extending lock-up periods; using retail platforms and co-investment funds to increase ‘stickiness’ of contributed capital; securing greater financing flexibility from prime brokers; accessing the private placement markets; and selling public shares of limited and general partnership interests to new investors; to name just a few.

Liquidity exists when investors are confident in their ability to transact and where risks are quantifiable. Moreover, liquidity exists when investors are creditworthy. When considered in terms of confidence, liquidity conditions can be assessed through the risk premiums on financial assets and the magnitude of capital flows. In general, high liquidity is generally accompanied by low risk premiums. Investors’ confidence in risk measures is greater when the perceived quantity and variance of risks are low.

The fact that official purchases of financial assets are determined by different factors than those influencing private investors suggests that we would probably see a somewhat different combination of capital flows, exchange rates and interest rates in the absence of official intervention...

If the prevailing patterns of capital flows were to exert downward pressure on interest rates and upward pressure on other asset prices, they would contribute to more expansionary financial conditions than would otherwise be the case. Among other things, this outcome complicates our ability to assess the present stance of monetary policy. It can change how monetary policy affects overall financial conditions and the economy as a whole.

Such complications can mask the effect of other forces that might otherwise find expression in risk premiums or interest rates: forces, for example, associated with the concern about fiscal sustainability in the United States or the sustainability of our external imbalances...

Looking ahead, policy adjustments will depend on the implications of incoming data for the projected paths of economic activity and inflation. I must admit I am surprised at how little market participants seem to share my sense that the uncertainties around these paths and their implications for the stance of policy are fairly sizable at this point, judging by the very low level of implied volatilities in the interest rate markets.

I'm a little bit more worried about inflation than Mr. Corrigan, I mean, although he's best to worry. Not that it's high, not that it's going to go running away, but it's kind of creeping up.

And I am impressed by the degree of pressure, if that's the right word, psychological pressure, political pressure there is not to do anything about it. A lot of people out there on Wall Street and on Main Street are operating on the assumption that nothing very startling will happen in terms of the strength. And that's reflected in attitudes pretty globally. But once people are convinced that that's the case, it can creep up on you. And the more it creeps up on you, the more difficult it becomes to do something about it.

If the deficit continues to run at a level close to 7 percent of GDP—and most forecasts assume it will for some time—the net international investment position of the United States will deteriorate sharply, U.S. net obligations to the rest of the world will rise to a very substantial share of GDP, and a growing share of U.S. income will have to go to service those obligations. This fact alone suggests that something will have to give eventually, and this raises the interesting question of how these imbalances have persisted on a path that seems unsustainable with so little evidence of rising risk premia.

Macroeconomic volatility has declined over the past two decades. Some of this decline appears to have fed through to financial markets in the form of lower risk premiums and higher asset valuations. To some extent, the lack of a clear link between macroeconomic volatility and the level of asset prices in existing research and models should not be a surprise. Explaining asset prices is difficult because they are determined by many complex factors, such as risk aversion, expected future earnings, and expected earnings volatility, which are inherently difficult to measure. A more concrete finding is that the decline in macroeconomic volatility has not led to a decline in asset price volatility. News about corporate earnings appears to have become less volatile, but this factor explains only a small part of the reduction in the volatility of asset prices. Rather, existing research suggests that asset price volatility remains largely a reflection of variation in investors' discount rates rather than of changes in forecasts of fundamentals. On a micro level, financial innovations and new types of market participants appear to have led to greater market efficiency and liquidity.

Interest rates also could potentially have been affected by the Great Moderation. Investors in Treasury bonds require a risk (or term) premium to compensate them for the risk of loss on longer-maturity bonds resulting from movements in interest rates. Term premiums could be lower when inflation expectations are well anchored or the macroeconomy is less volatile.