Randall S Kroszner: Recent events in financial markets
Speech by Mr Randall S Kroszner, Member of the Board of Governors of the US Federal
Reserve System, at the Institute of International Bankers Annual Breakfast Dialogue,
Washington DC, 22 October 2007.
* * *
Good morning. In my remarks this morning, I will share my views on events in U.S. financial
markets over the past several months. Specifically, I will describe what I believe were
contributing factors in the breakdown of the price discovery mechanism in certain markets,
and I will assess the future prospects for these markets. While I will draw some preliminary
conclusions about recent market events, my views and those of other policymakers will likely
continue to evolve as we develop a more informed perspective and benefit from further
analysis.1
Price discovery
When markets are functioning properly, one of the key roles that they perform is what
economists refer to as "price discovery."2 Essentially, price discovery is the process by which
buyers and sellers' preferences, as well as any other available market information, results in
the "discovery" of a price that will balance supply and demand and provide signals to market
participants about how most efficiently to allocate resources. This market-determined price
will, of course, be subject to change as new information becomes available, as preferences
evolve, as expectations are revised, and as costs of production change.
In well-functioning markets, the price discovery process represents the efforts of market
participants to use all available information to decide whether to buy or to sell or to abstain
from buying and selling. In efficient and competitive markets, participants will tend to
undertake a certain amount of due diligence before making their decisions. This means that
prices do not just appear by themselves; a substantial amount of work is required by buyers
and sellers for markets to produce prices that clear markets and provide useful signals to
consumers and producers. Indeed, this is one of the brilliant aspects of the market
mechanism in that a number of participants, each pursuing their own interests and trying to
maximize their own welfare and profits, determine a market-clearing price. A core principle of
economics is that markets are more competitive, and therefore more efficient, when accurate
information is available to both buyers and sellers. But for markets to work best, market
participants must utilize available information, including analysis of costs and benefits of
obtaining such information. In the case of new and innovative products, there might be a
particularly strong demand for information. Then this information must be processed
appropriately before decisions are made about whether to buy or sell.
In some instances, the price discovery process can break down and buyers and sellers are
unable to discover any price at all - perhaps because of a lack of information or because of
general uncertainty among market participants. I would suggest that this is fundamentally
what has occurred in some financial markets over the past several months. This has certainly
not been the case in all markets. For example, while equity markets in the United States
have experienced greater price volatility in recent months, and credit spreads have widened
in markets for highly-rated, traditional debt instruments, I believe this has been a function of
reassessing risk rather than a broader failure of the price discovery process itself. Moreover,
investment-grade corporations faced little trouble in issuing traditional debt instruments
during the market turbulence in August and did so in significant volumes.
In some financial markets, however, the price discovery process appears to have actually
broken down. In particular, I am referring to markets for structured credit products (for
example, collateralized loan obligations and collateralized debt obligations) that are often
complex and opaque, as well as instruments that are linked to these structured products,
such as asset-backed commercial paper. Why did the price discovery process fail in these
markets but not in others? I would suggest that there are two principal related causes.
First, some investors may not have done sufficient due diligence with regard to complex
structured products. Prior to the recent market disruptions, many buyers and sellers of
complex structured products appear not to have demanded sufficient information from
sellers, and simply accepted investment-grade ratings of these securities as a substitute for
their own risk analysis. When the problems in the subprime mortgage market began to
emerge and delinquencies on subprime mortgages in pools backing these securities
exceeded rating agency estimates, subsequently resulting in a number of downgrades,
investors lost confidence in the quality of these ratings, and hence the quality of the
information they had about these instruments, and pulled back from markets for structured
products across the board.
A second, related factor contributing to the breakdown in price discovery is the recognition by
investors of complexity and lack of transparency, both in the instruments themselves and in
the markets more broadly. The complex structures of the innovative instruments, and the
lack of transparency with regard to the underlying assets backing these instruments, made
them more difficult and costly to value than many investors originally thought. At the same
time, many investors realized that it was difficult to identify where the risks were lodged. This
uncertainty, of course, is one of the trade-offs of a more market-intermediated finance
system in which risks are more widely dispersed rather than concentrated in the banking
system. As problems in the subprime mortgage market became more apparent, investors
became unwilling to purchase products that could have any exposure not only to subprime
mortgages, but to housing-related assets and other structured products more generally.
Put simply, investors suddenly realized that they were much less informed than they
originally thought. In these circumstances, it is not necessarily surprising that investors pulled
back from purchasing certain instruments at any price.
Prospects for market recovery
In light of these factors, what is the prognosis for recovery in markets for complex structured
credit instruments? I would suggest that, while we have seen more normal price discovery
activity slowly returning to some markets, the recovery may be a relatively gradual process,
and these markets may not look the same when they re-emerge. Both investors and sellers
will need to take steps for the price discovery process to be re-established in these markets.
In observing the challenges to price discovery and the repricing of risk in many markets
recently, I have been reminded of a Russian proverb that was made famous in the context of
international relations but applies equally to investment decisions: "Trust, but verify." Let me
explain.
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.
Reducing the chance of unanticipated losses may require significant effort on the part of
investors looking to purchase complex structured products and the creators or sellers of
those products. To be able to better understand the risk profile of such instruments, some
market participants will have to invest in three ways to revive the price discovery mechanism.
First, they will likely need to collect more detailed data. In particular, investors will need to
gather data more systematically to help them understand the nature and risks of the
underlying assets and the structures of the instruments. Second, investors will likely require
enhanced systems to warehouse and model data related to these instruments to better
understand their risk profile, especially under stress conditions. Third, investors will likely
need to ensure that they have the appropriate human capital expertise - that is, people - to
interpret, understand, and act appropriately on the results of their modeling and analysis. The
investment in data, modeling, and assessment will take time so there may be an extended
period before normal price discovery will return in markets for some existing products.
In turn, given the likely increase in the costs of producing and evaluating certain complex
instruments, these actions and efforts may affect investors' risk-reward calculus by
increasing required returns - or the "hurdle rates" - on these investments. Creators and
sellers may respond by reducing complexity, improving quality of underlying assets or
increasing transparency and disclosure. In light of recent events, market innovation may
result in new instruments that satisfy the needs of both buyers and sellers - instruments that,
of course, should not just be accepted on their face but should be subject to proper due
diligence. In the end, investors will decide for themselves whether acquiring the data and
expertise necessary to participate in certain markets is worth the cost. As a result, it is likely
that these markets and instruments will look different than they did prior to the recent market
turmoil.
Let me close by highlighting the role of the Federal Reserve over the past several months as
a backstop source of liquidity in interbank funding markets. As price discovery broke down in
a variety of markets, financial institutions, as intermediaries and liquidity providers
themselves in the affected markets, became protective of their liquid reserves and balance
sheet capacity. As a result, overnight and term interbank funding markets have come under
pressure. The Federal Reserve accordingly took a number of steps to try to alleviate these
pressures.
The Fed's initial action in early August was to increase liquidity in short-term money markets
through larger open-market operations - the standard means by which it seeks to ensure
that the federal funds rate is maintained at or close to the target rate set by the Federal Open
Market Committee. This extra provision of liquidity helped bring the funds rate down to its
target early in the day; it also eased banks' concerns about the availability of funding and
thus assisted the functioning of the interbank market. The vigorous provision of funds
through open market operations succeeded in damping pressures in overnight funding
markets. Yet, markets for term interbank funding remained strained.
On August 17, the Federal Reserve Board took further action by cutting the discount rate -
the rate at which it lends directly to banks - by 50 basis points, or half a percentage point.
The Fed also adjusted its usual practices to facilitate the provision of financing for as long as
thirty days, renewable at the request of the borrower. These actions also appear to have
improved market functioning, though strains, particularly in term funding markets, persist
even now. Moreover, judging from forward curves in interbank and overnight indexed swaps
markets, market participants expect pressures in term funding markets to persist for several
quarters.
I should emphasize that the purpose of these actions was not to insulate financial institutions
from the consequences of their business decisions, but rather to facilitate the orderly function
of markets more broadly in the face of risks to the overall economy. I believe that this
provision of liquidity has contributed, at least in part, to the recent improvements we have
seen in the functioning of financial markets.
Importantly, the Federal Open Market Committee's most recent action, the 50 basis point cut
in the target federal funds rate in September, was an attempt to help offset the potential
effects of financial market turmoil on real economic activity. The breakdown in the price
discovery process can, after all, have real economic consequences that the Federal Reserve
should, in my opinion, consider when fulfilling its statutorily mandated goals of maximum
employment and price stability.
Conclusion
In the months ahead, the Federal Reserve will continue to monitor developments in the
financial markets and act as needed to support the effective functioning of these markets and
to foster sustainable economic growth and price stability. In addition, we will be reviewing the
events of the past several months to understand the likely causes and effects.
Thank you very much, and I look forward to a lively dialogue following my esteemed
colleagues' remarks.