Wall Street History

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Wall Street History

03/14/2008

Crisis in the Financial System

On March 6, 2008, the president of the Federal Reserve Bank of
New York, Timothy Geithner, gave a speech to the Council on
Foreign Relations concerning the challenges facing the U.S. and
financial system. As Geithner himself notes, “The central
questions are: what caused the crisis and what explains its
severity? What mix of policy measures will best contain the
damage? And what changes to the financial system are likely to
produce greater stability and resilience in the future?”

Following are extensive excerpts from Mr. Geithner’s
presentation. It’s a bit bleak.

[Just a reminder “nominal interest rate” is the stated rate of
interest, “real interest rate” is the nominal rate minus the rate of
inflation.]

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Origins

The origins of this crisis lie in the complex interaction of a
number of forces. Some were the product of market forces.
Some were the product of market failures. Some were the result
of incentives created by policy and regulation. Some of these
were evident at the time, others are apparent only with the
benefit of hindsight. Together they produced a substantial
financial boom on a global scale.

In the five years leading up to the present stress, the world
experienced an unusual mix of financial conditions.

Real short-term interest rates were reduced around the world,
following a nearly decade long secular decline in inflation rates,
a slowdown in growth at the turn of this decade and subsequent
deflation. As central banks raised their policy rates when the
outlook improved and deflation risks had dissipated, both real
and nominal long-term interest rates remained anomalously low.

Global savings appeared to rise faster than did perceived real
investment opportunities, and this development helped to push
down real long-term interest rates around the world. At the same
time, many emerging market economies built up very large
levels of official reserves to reduce external vulnerability and to
hold the value of their currencies stable against the dollar. The
exchange rate policies in these economies – economies that
together accounted for an increasing share of global GDP – made
overall global financial conditions more accommodative, even as
the United States and other countries tightened their monetary
policies.

Expected and realized volatility in both debt and equity markets
were remarkably low for most of the last half a decade. Term
premiums declined and remained low over much of this period.
Credit spreads across a wide range of asset classes fell to levels
that assumed unusually low levels of future losses. In the United
States, credit, and mortgage credit in particular, expanded
relative to GDP. Many households – including those previously
lacking access to credit or with access only to expensive credit –
found they could borrow on a significant scale to finance the
purchase of a home and other expenses. Prices rose across a
range of real and financial assets, most notably the prices of
homes.

This constellation of broad economic and financial conditions
was accompanied by rapid innovation in financial instruments
that made credit risk easier to trade and, in principle at least, to
hedge. These instruments allowed investors to buy insurance or
protection against a broader range of individual credit risks, such
as the default by a home owner or a company. Issuance of asset-
backed securities (ABS), collateralized debt obligations (CDOs)
and collateralized loan obligations (CLOs), as well as credit
default swaps (CDS), expanded on a dramatic scale, particularly
from 2005 through to mid-2007. And over this same period, the
composition of the assets in ABS, as well as in CDOs and CLOs,
shifted to higher credit risk mortgages and loans issued by
noninvestment grade companies.

Even though these instruments allow credit risk to be shared,
their holders remain exposed to the less probable, but potentially
very damaging effects of a significant increase in losses driven
by macroeconomic factors. As underwriting standards
deteriorated over this period, this exposure grew. And yet risk
premia continued to fall, suggesting that investors did not fully
appreciate the dynamic that was at work. As the boom persisted,
investors grew more confident in the relative stability of macro
and financial conditions and in the high levels of liquidity of a
recent past, and projected that stability into the future. That
confidence in a more stable future led to greater leverage and a
larger exposure to the risk of a less benign world.

The interaction of these forces made the financial system as a
whole more vulnerable to a range of different weaknesses. The
models used by issuers to structure these products and by credit
rating agencies to assess risk and assign ratings turned out to be
much more sensitive to macroeconomic assumptions than was
apparent to investors at the time. Assumptions about home price
appreciation and the correlation of defaults within the underlying
collateral pool were particularly critical in this context.

The proliferation of credit risk transfer instruments was driven in
part by an assumption of frictionless, uninterrupted liquidity.
This left credit and funding markets more vulnerable when
liquidity receded. Banks and other financial institutions lent
substantial amounts of money on the assumption that they would
be able to distribute that risk easily into liquid markets. A
sizable fraction of long-term assets – assets with exposure to
different forms of credit risk – ended up in vehicles financed
with very short-term liabilities and was placed with investors and
funds that were also exposed to liquidity risk.

As is often the case during periods of rapid change, more
significant concentrations of risk were present than was apparent
at the time. Banks and investment banks sold insurance against
what seemed like low probability events, but did so at what even
at the time seemed like low prices. And on the assets they
retained, these same institutions purchased insurance from
financial guarantors and other firms that were exposed to the
same risks.

The crisis exposed a range of weaknesses in risk management
practices within financial institutions in the United States and
throughout the world. Today, a group of the primary supervisors
of the largest banks and investment banks in the world released a
comprehensive assessment of risk management practices in these
institutions. This assessment will help lay the foundation for
consensus on changes to supervision going forward in the major
financial centers .Banks and investment banks with stronger
risk management practices and cultures did substantially better.
The most common failures were in how firms dealt with
uncertainty about the scale of losses they would face in a less
benign economic and financial environment; the scale of the
cushion they built up against that uncertainty; how well they
managed the internal tension between risk and reward; and how
quickly they moved to mitigate risk as conditions deteriorated.

The typical arsenal of risk management tools relies, by necessity,
on history and experience, and as a result has only limited value
in assessing the scale of potential future losses. These limitations
were particularly damaging in a period in which significant
innovation in financial instruments and market structure was
coupled with relatively stable macroeconomic and financial
conditions. Uncertainty about the future, and the greater
complexity of leveraged structured products, created a dense fog
around estimates of potential loss, making institutions and
markets more vulnerable to an adverse surprise when conditions
changed, and making it harder to manage the many principal
agent problems inherent in the financial business.

In effect, some major banks and investment banks made the
choice to follow the market down as underwriting practices
eroded. They took on more exposure to low probability but
extremely adverse events, despite the potential consequences of
getting caught when the music stopped. And even though the
largest firms were able to move quickly to protect themselves as
conditions worsened, those actions had significant negative
effects on market functioning and liquidity.

The current episode has a basic dynamic in common with all past
crises. As market participants have moved to reduce exposure to
further losses, to step on the brake, the brake became the
accelerator, amplifying the shock. Measured risk has increased
more quickly than many institutions have been able to reduce it,
and attempts to reduce it have added to volatility and downward
pressure on prices, further increasing measured exposure to risk.
Uncertainty about the market value of securities and about
counterparty credit risk has increased, and many hedges have not
performed as intended. The rational actions taken by even the
strongest financial institutions to reduce exposure to future losses
have caused significant collateral damage to market functioning.
This, in turn, has intensified the liquidity problems for a wide
range of bank and nonbank financial institutions.

In this environment, banks have faced several different types of
liquidity and funding challenges. They have been called on to
fund a range of different contingent liquidity and credit
commitments, as is typically the case in crises. The substantial
impairment of securitization and syndication markets has been an
additional challenge because it has reduced banks’ access to
liquidity and their capacity to move assets off balance sheets. As
the market value of many securities has declined, and investors
have reduced their willingness to finance more risky assets,
liquidity conditions have eroded further. In response, even the
strongest institutions have become much more cautious, building
up large cushions of liquidity, bringing down leverage and
reducing financing for their leveraged counterparties .

The intensity of the crisis is in part a function of the size of the
preceding financial boom, but also of the speed of the
deterioration in confidence about the prospects for growth and in
some of the basic features of our financial markets. The damage
to confidence – confidence in ratings, in valuation tools, in the
capacity of investors to evaluate risk – will prolong the process
of adjustment in markets. This process carries with it risks to the
broader economy. Macroeconomic and supervisory policies
have an important role to play in containing those risks.

Let me mention several critical areas of policy.

Monetary policy: The Federal Open Market Committee (FOMC)
has reduced the nominal federal funds rate target substantially in
a relatively short period of time, with much of this reduction
occurring ahead of the deterioration in confidence and the
broader slowdown in spending that is now apparent. But even
with those reductions in short-term interest rates in place,
financial conditions have tightened as risk spreads on a wide
range of asset classes and institutions have increased
considerably. The critical risk to the economic outlook remains
the potential for the strains in financial markets to have an
outsized adverse effect on real economic activity, particularly by
exacerbating the already significant weakness in the housing
sector. It is important for monetary policy and liquidity
instruments to be used proactively in addressing this risk.

But this is not the only challenge we face. Headline and core
inflation have come in higher than anticipated, and inflation
expectations have also moved up. If the risk of significant
damage to growth from these financial market pressures is
attenuated and if global growth remains strong and drives a
continuing rise in energy and commodity prices, then inflation
may not moderate as much as we anticipate. If the medium term
outlook for inflation deteriorates significantly, the FOMC will
move with appropriate speed and force to address this risk.

This requires a fine balance. The principal challenge for policy
is to provide an adequate degree of insurance against the
downside risks that still confront the economy as a whole,
without adding to concerns about inflation over the medium
term. We cannot know with confidence today what level of the
short-term real funds rate will be consistent with our objectives
of sustainable growth and low inflation, but if turbulent financial
conditions and the associated downside risks to growth persist,
monetary policy may have to remain accommodative for some
time .

Encouraging financial repair: The Federal Reserve is working
closely with other financial supervisors and regulators to
facilitate the adjustment underway in markets. This approach
has two important elements. The first is to encourage
improvements in the quality of valuation methods and disclosure
by the major regulated financial institutions and the necessary
adjustment in valuations and reserves to reflect the deterioration
in expected losses. Better disclosure can reduce some
uncertainty about the incidence and magnitude of potential losses
across the financial system, although it is important to note that
these estimates of losses are a function of the outlook for the
economy and will necessarily change as expectations of the
future change.

The second element is to encourage new equity capital raising, so
that the burden for preserving capital ratios does not fall
principally on actions, such as asset sales or reduced lending, that
might exacerbate the credit crunch. We have seen a very
substantial flow of new capital into the financial system much
more quickly than has been the case in past crises. More will
come. Those institutions that move more quickly will obviously
be in a stronger position to deal with the challenges, and take
advantage of the opportunities, ahead .

Targeted support for housing. Policy can also play an important
role in helping cushion the effects of the fall in housing prices
and the rise in foreclosures in the United States. The decline in
house prices and the surge in foreclosures now underway will
have significant spillovers to other homes in the same
neighborhoods, effects that are not fully incorporated into
decisions by private creditors and investors to workout
mortgages on mutually beneficial terms. The degree to which
mortgages are now held in securitized and complex leverage
structures exacerbates the incentive and coordination problems
inherent in this situation. Carefully designed, targeted programs
in cooperation with the private sector can play an important role
in resolving the various constraints that are now impeding
economically viable mortgage restructurings. Given the
breakdowns in the securitization process and its potential impact
on the supply of new mortgage credit, it also makes sense to
explore ways to expand the scope for existing government
programs to support financing of new homes .

Longer Term Reforms of the Financial System

The unwinding of this global financial boom has caused a
substantial degree of stress to the financial system.

Was this preventable? I don’t believe that asset price and credit
booms are preventable. They cannot be effectively diffused
preemptively. There is no reliable early warning system for
financial shocks. And yet policy plays an important role in
determining the dimensions of financial booms, and policy helps
determine the ability of the financial system and the economy to
adjust to its aftermath. We need to undertake a broad set of
changes to address the vulnerabilities in our financial system
revealed by this crisis. Just as a long list of factors contributed to
the trauma, there is no single reform that offers the promise of
sufficient change .

Regulatory reform and simplification. The regulations that affect
incentives in the U.S. financial system have evolved into a very
complex and uneven framework, with substantial opportunities
for arbitrage, large gaps in coverage, significant inefficiencies,
and large differences in the degree of oversight and restraint
upon institutions that engage in very similar economic activities.
Some illustrations of this include the large shift in subprime
mortgage originations to less regulated institutions; the
incentives to shift risk to where accounting and capital treatment
is more favorable; and the amount of risk built up in entities that
operate in the grey areas of implied support from much larger
affiliated institutions .

Capital. The U.S. banking system entered this financial shock
with capital cushions significantly above the regulatory
thresholds, and in a stronger position to withstand a downturn
than was the case in the past. This has made it possible for bank
balance sheets to expand rapidly, which in turn has helped offset
the effects of the withdrawal of many nonbank financial
institutions from credit markets.

Yet the shock absorbers in the financial system as a whole – the
financial cushions that are critical to financial stability – have
proved to be thinner, and behavior has been more pro-cyclical
than desirable.

This is in part the consequence of changes in the structure of the
financial system. Because banks are now a smaller share of the
system, a given level of stress on nonbanks creates greater strain
on the system as a whole. It is in part the consequence of the fact
that the present system focuses on mitigating the risks of firm
specific shocks, rather than a systematic market shock. And it is
in part the consequence of the fact that the present system is not
designed to induce institutions, particularly the largest ones, to
internalize the negative consequences, the negative externalities,
of their actions on markets as a whole in conditions of stress.

There is no simple solution to this problem. It requires a broad
look at the design of the present capital regime, the incentives it
creates for holding different forms of risk, and the scope of the
application of these requirements. As we move to a more
modern and risk-sensitive capital framework and reduce the
perverse incentives in the current capital requirements, we need
to make sure that reserves, capital, and liquidity provisions are
more forward looking, and adjust appropriately through the
peaks and valleys of the cycle. This will increase the scope for
banks and other institutions that are subject to risk-based capital
requirements to act more as a stabilizing force in response to
future financial market shocks.

Market infrastructure. We are in the midst of a dramatic period
of financial innovation and growth in derivative instruments, but
the pace of change with the growth in volume has brought a lot
of challenges. Substantial progress has been made to strengthen
this infrastructure over the past two and a half years, and the
resilience of the broader financial infrastructure has been a
source of strength for the financial system during this crisis.
However, the systems and practices that support the over-the-
counter (OTC) derivatives market significantly lags that of
securities markets and other mature markets. We need to move
quickly to put in place a more integrated operational
infrastructure that supports all major OTC derivatives products,
is highly automated, has robust operational resilience and risk
management, and is capable of handling very substantial growth
in volumes.

Conclusion

The U.S. economic and financial system is undergoing a very
challenging period of adjustment, and we are likely to be living
with a high degree of uncertainty for some period of time about
the ultimate magnitude and duration of the slowdown underway.
But it is important to recognize that we have already seen a lot of
adjustment. Prices and risk premia in many markets already
reflect a much more sober and cautious view of the world than
they did a year ago. And the degree of stress on markets that we
have seen over the past six months is due in part to the sheer
magnitude and speed of that adjustment to a more cautious view
of the future.

The United States, the world economy, and the financial system
as a whole, are more resilient than they were on the eve of
previous downturns. The improvements in productivity growth
in the United States of the past decade have been followed by
significant improvements in potential growth and wealth
accumulation in many other countries. The scale of investable
assets around the globe is very substantial, and this will be an
important source of demand for risk assets. The improvements
in monetary policy credibility and in financial strength developed
over the past few decades mean that policy around the world has
more room to adjust to deal with the challenge in the present
environment.

Nevertheless, the challenges that remain are substantial. The
speed and agility with which public policy makers and private
financial institutions respond to the continuing pressures in a
rapidly evolving environment will determine how quickly and
how smoothly market conditions return to normal – and how
rapidly the risks to the economic outlook are mitigated.

[Source: ny.frb.org]

Wall Street History returns next week.

Brian Trumbore

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