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06/06/2008

How We Got Here

I said I was going to do more on energy this week, but after I saw
and read Federal Reserve Chairman Ben Bernanke’s speech to
the International Monetary Conference on June 3rd, I thought I’d
take advantage of it and note his comments on the genesis of the
problems we face today, this being a column titled “Wall Street
History,” after all.

---

Ben Bernanke

The Sources of the Financial Turmoil: A Longer-Term
Perspective

Although the severity of the financial stresses became apparent
only in August, several longer-term developments served as
prologue for the recent turmoil and helped bring us to the current
situation.

The first of these was the U.S. housing boom, which began in the
mid-1990s and picked up steam around 2000. Between 1996 and
2005, house prices nationwide increased about 90 percent.
During the years from 2000 to 2005 alone, house prices
increased by roughly 60 percent – far outstripping the increases
in incomes and general prices – and single-family home
construction increased by about 40 percent. But, as you know,
starting in 2006, the boom turned to bust. Over the past two
years, building activity has fallen by more than half and now is
well below where it was in 2000. House prices have shown
significant declines in many areas of the country.

A second critical development was an even broader credit boom,
in which lenders and investors aggressively sought out new
opportunities to take credit risk even as market risk premiums
contracted. Aspects of the credit boom included rapid growth in
the volumes of private equity deals and leveraged lending and
the increased use of complex and often opaque investment
vehicles, including structured credit products. The explosive
growth of subprime mortgage lending in recent years was yet
another facet of the broader credit boom. Expanding access to
homeownership is an important social goal, and responsible
subprime lending is beneficial for both borrowers and lenders.
But, clearly, much of the subprime lending that took place during
the latter stages of the credit boom in 2005 and 2006 was done
very poorly.

A third longer-term factor contributing to recent financial and
economic developments is the unprecedented growth in
developing and emerging market economies. From the U.S.
perspective, this growth has been a double-edged sword. On the
one hand, low-cost imports from emerging markets for many
years increased U.S. living standards and made the Fed’s job of
managing inflation easier. Moreover, currently, the demand for
U.S. exports arising from strong global growth has been an
important offset to the factors restraining domestic demand,
including housing and tight credit.

On the one hand, the rapid growth in the emerging markets and
the associated sharp rise in their demand for raw materials have
been – together with a variety of constraints on supply – a major
cause of the escalation in the relative prices of oil and other
commodities, which has placed intense economic pressure on
many U.S. households and businesses.

In the financial sphere, the three longer-term developments I
have identified are linked by the fact that a substantial increase in
the net supply of saving in emerging market economies
contributed to both the U.S. housing boom and the broader credit
boom. The sources of this increase in net saving included rapid
growth in high-saving East Asian countries and, outside of
China, reduced investment rates in that region; large buildups in
foreign exchange reserves in a number of emerging markets; and
the enormous increases in the revenues received by exporters of
oil and other commodities. The pressure of these net savings
flows led to lower long-term real interest rates around the world,
stimulated asset prices (including house prices), and pushed
current accounts toward deficit in the industrial countries –
notably the United States – that received these flows.

To be sure, the large inflows of savings and low global interest
rates presented a valuable opportunity to the recipient countries,
provided they invested the inflows wisely. Unfortunately, this
did not always occur, as an increased appetite for risk-taking – a
“reaching for yield” – stimulated some financial innovations and
lending practices that proved imprudent or otherwise
questionable. Regulators identified some of these issues in real
time; for example, federal banking regulators issued new
guidance on nontraditional mortgage lending and on commercial
real estate lending. The Federal Reserve, in cooperation with the
other supervisors, encouraged improvements in market
infrastructure and conducted a series of targeted reviews
designed to improve risk-management practice with respect to
derivatives, exposures to hedge funds, leveraged lending, and
other areas. And, in preparation for the new Basel II capital
regulations, supervisors required more-demanding standards for
the measurement and management of risk. Despite these efforts,
however, the risk-management systems of many financial
institutions proved inadequate in the face of a major housing
downturn and substantial disruptions in market liquidity.

The current economic and financial situation reflects, in
significant part, the unwinding of two of these longer-term
developments – the housing boom and the credit boom – and the
continuation of the pressure of global demand on commodity
prices.

The housing boom came to an end because rising prices made
housing increasingly unaffordable. The end of rapid house price
increases in turn undermined a basic premise of many adjustable-
rate subprime loans – that home price appreciation alone would
always generate enough equity to permit the borrower to
refinance and thereby avoid ever having to pay the fully-indexed
interest rate. When that premise was shown to be false and
defaults on subprime mortgages rose sharply, investors quickly
backpedaled from mortgage-related securities. The reduced
availability of mortgage credit caused housing to weaken further.

The losses from subprime mortgages have been significant in
themselves, but their greater impact was to trigger the end of the
broader credit boom. Notably, as subprime losses forced the
credit rating agencies to downgrade what had been highly rated
mortgage-backed securities, investors also came to doubt the
reliability of ratings that had been awarded to other highly
complex securities. As a result, investors became much more
cautious and reversed their aggressive risk-taking of the credit
boom period. The resulting pullback affected a much broader
range of securities, including leveraged and syndicated loans,
asset-backed commercial paper, commercial mortgage-backed
securities, and a variety of structured credit products. Large
financial institutions, especially in the United States and Europe,
were particularly affected by these events, having reported a total
of roughly $300 billion in writedowns and credit losses. These
institutions have also been forced to bring onto their balance
sheets the assets of sponsored investment vehicles that can no
longer be financed on a standalone basis. Fortunately, most
financial institutions entered this episode with strong capital
positions, and many have raised substantial amounts of new
capital. Still, balance sheet pressures and the relatively high cost
of new bank capital have reduced the willingness and ability of
these institutions to make markets and extend new credit.
Prospectively, financial conditions seem likely to be closely tied
to both domestic and global economic developments, including
the course of the prices of oil and other commodities.

This brief overview makes clear that both global and domestic
factors have played important roles in recent developments in the
United States. The housing and credit booms were driven to
some extent by global savings flows, but they also reflected
domestic factors, such as weaknesses in risk measurement and
management and lax standards in subprime lending. Higher
commodity prices are for the most part a global phenomenon, but
U.S. dependence on oil imports makes this country quite
vulnerable on that score.

[Source: Federalreserve.gov]

---

I’ll offer more comments on the here and now in my “Week in
Review” column.

Wall Street History returns next week. Back to energy.

Brian Trumbore



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-06/06/2008-      
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Wall Street History

06/06/2008

How We Got Here

I said I was going to do more on energy this week, but after I saw
and read Federal Reserve Chairman Ben Bernanke’s speech to
the International Monetary Conference on June 3rd, I thought I’d
take advantage of it and note his comments on the genesis of the
problems we face today, this being a column titled “Wall Street
History,” after all.

---

Ben Bernanke

The Sources of the Financial Turmoil: A Longer-Term
Perspective

Although the severity of the financial stresses became apparent
only in August, several longer-term developments served as
prologue for the recent turmoil and helped bring us to the current
situation.

The first of these was the U.S. housing boom, which began in the
mid-1990s and picked up steam around 2000. Between 1996 and
2005, house prices nationwide increased about 90 percent.
During the years from 2000 to 2005 alone, house prices
increased by roughly 60 percent – far outstripping the increases
in incomes and general prices – and single-family home
construction increased by about 40 percent. But, as you know,
starting in 2006, the boom turned to bust. Over the past two
years, building activity has fallen by more than half and now is
well below where it was in 2000. House prices have shown
significant declines in many areas of the country.

A second critical development was an even broader credit boom,
in which lenders and investors aggressively sought out new
opportunities to take credit risk even as market risk premiums
contracted. Aspects of the credit boom included rapid growth in
the volumes of private equity deals and leveraged lending and
the increased use of complex and often opaque investment
vehicles, including structured credit products. The explosive
growth of subprime mortgage lending in recent years was yet
another facet of the broader credit boom. Expanding access to
homeownership is an important social goal, and responsible
subprime lending is beneficial for both borrowers and lenders.
But, clearly, much of the subprime lending that took place during
the latter stages of the credit boom in 2005 and 2006 was done
very poorly.

A third longer-term factor contributing to recent financial and
economic developments is the unprecedented growth in
developing and emerging market economies. From the U.S.
perspective, this growth has been a double-edged sword. On the
one hand, low-cost imports from emerging markets for many
years increased U.S. living standards and made the Fed’s job of
managing inflation easier. Moreover, currently, the demand for
U.S. exports arising from strong global growth has been an
important offset to the factors restraining domestic demand,
including housing and tight credit.

On the one hand, the rapid growth in the emerging markets and
the associated sharp rise in their demand for raw materials have
been – together with a variety of constraints on supply – a major
cause of the escalation in the relative prices of oil and other
commodities, which has placed intense economic pressure on
many U.S. households and businesses.

In the financial sphere, the three longer-term developments I
have identified are linked by the fact that a substantial increase in
the net supply of saving in emerging market economies
contributed to both the U.S. housing boom and the broader credit
boom. The sources of this increase in net saving included rapid
growth in high-saving East Asian countries and, outside of
China, reduced investment rates in that region; large buildups in
foreign exchange reserves in a number of emerging markets; and
the enormous increases in the revenues received by exporters of
oil and other commodities. The pressure of these net savings
flows led to lower long-term real interest rates around the world,
stimulated asset prices (including house prices), and pushed
current accounts toward deficit in the industrial countries –
notably the United States – that received these flows.

To be sure, the large inflows of savings and low global interest
rates presented a valuable opportunity to the recipient countries,
provided they invested the inflows wisely. Unfortunately, this
did not always occur, as an increased appetite for risk-taking – a
“reaching for yield” – stimulated some financial innovations and
lending practices that proved imprudent or otherwise
questionable. Regulators identified some of these issues in real
time; for example, federal banking regulators issued new
guidance on nontraditional mortgage lending and on commercial
real estate lending. The Federal Reserve, in cooperation with the
other supervisors, encouraged improvements in market
infrastructure and conducted a series of targeted reviews
designed to improve risk-management practice with respect to
derivatives, exposures to hedge funds, leveraged lending, and
other areas. And, in preparation for the new Basel II capital
regulations, supervisors required more-demanding standards for
the measurement and management of risk. Despite these efforts,
however, the risk-management systems of many financial
institutions proved inadequate in the face of a major housing
downturn and substantial disruptions in market liquidity.

The current economic and financial situation reflects, in
significant part, the unwinding of two of these longer-term
developments – the housing boom and the credit boom – and the
continuation of the pressure of global demand on commodity
prices.

The housing boom came to an end because rising prices made
housing increasingly unaffordable. The end of rapid house price
increases in turn undermined a basic premise of many adjustable-
rate subprime loans – that home price appreciation alone would
always generate enough equity to permit the borrower to
refinance and thereby avoid ever having to pay the fully-indexed
interest rate. When that premise was shown to be false and
defaults on subprime mortgages rose sharply, investors quickly
backpedaled from mortgage-related securities. The reduced
availability of mortgage credit caused housing to weaken further.

The losses from subprime mortgages have been significant in
themselves, but their greater impact was to trigger the end of the
broader credit boom. Notably, as subprime losses forced the
credit rating agencies to downgrade what had been highly rated
mortgage-backed securities, investors also came to doubt the
reliability of ratings that had been awarded to other highly
complex securities. As a result, investors became much more
cautious and reversed their aggressive risk-taking of the credit
boom period. The resulting pullback affected a much broader
range of securities, including leveraged and syndicated loans,
asset-backed commercial paper, commercial mortgage-backed
securities, and a variety of structured credit products. Large
financial institutions, especially in the United States and Europe,
were particularly affected by these events, having reported a total
of roughly $300 billion in writedowns and credit losses. These
institutions have also been forced to bring onto their balance
sheets the assets of sponsored investment vehicles that can no
longer be financed on a standalone basis. Fortunately, most
financial institutions entered this episode with strong capital
positions, and many have raised substantial amounts of new
capital. Still, balance sheet pressures and the relatively high cost
of new bank capital have reduced the willingness and ability of
these institutions to make markets and extend new credit.
Prospectively, financial conditions seem likely to be closely tied
to both domestic and global economic developments, including
the course of the prices of oil and other commodities.

This brief overview makes clear that both global and domestic
factors have played important roles in recent developments in the
United States. The housing and credit booms were driven to
some extent by global savings flows, but they also reflected
domestic factors, such as weaknesses in risk measurement and
management and lax standards in subprime lending. Higher
commodity prices are for the most part a global phenomenon, but
U.S. dependence on oil imports makes this country quite
vulnerable on that score.

[Source: Federalreserve.gov]

---

I’ll offer more comments on the here and now in my “Week in
Review” column.

Wall Street History returns next week. Back to energy.

Brian Trumbore