Kevin M Warsh: Financial market turmoil and the Federal Reserve - the
plot thickens
Speech by Mr Kevin M Warsh, Member of the Board of Governors of the US Federal
Reserve System, at the New York University School of Law Global Economic Policy Forum,
New York, 14 April 2008.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
What's past is prologue; what to come, in yours and my discharge.
Shakespeare, The Tempest, Act 2, Scene 1
Thank you to the New York University School of Law for inviting me to participate in today's
Global Economic Policy Forum.1
Prologue
A little more than a year ago, I began to recount a story - already long-in-the-making - of the
transformation of financial institutions driven by abundant liquidity in global financial
markets.2 In those early chapters, one could not help but worry about the inherent risks to
financial markets and the economy when the gloss of confidence wears thin, causing me to
wonder aloud: "What happens when liquidity falters?"3 Let me briefly try to recount this tale
over the last few quarters before offering some rough plot lines from which the balance of the
story can be divined.
The sleepy complacency of a bygone era seemed rudely interrupted by a liquidity shock last
August.4 A global margin call on virtually all leveraged positions began. As you know, the
Federal Reserve found it necessary to begin to exercise its monetary muscles in
unprecedented ways. The seasons darkened, and the plot thickened. New structured
products and old financial institutions evidenced increasing signs of weakness. Some central
banks, including the Federal Reserve, helped supply liquidity to where it was most in need.
Financial market turmoil, partly as a result, was periodically placed in abeyance. Casualties
of the liquidity contraction nonetheless appeared; some remained in the narrative for awhile,
others were removed with great dispatch.
The narrative continued to morph through the first quarter of 2008. Central banks, while
generally more comfortable remaining behind the scenes, took center stage with new tools
and policy prescriptions. The script was rewritten so that product innovation flowed, but this
time from the public authorities. Many private market participants receded to the shadows of
the stage, some anxiously anticipating intermission.
What some originally read as a short story punctuated by a liquidity shock evolved into a
longer narrative. Credit is threatening to displace liquidity as the primary antagonist. A credit
crunch, particularly for small businesses and consumers, poses meaningful downside risks to
the real economy. And market participants are struggling to assess the possibility that the
narrative turns into a multi-act, macroeconomic drama.
In the remainder of my remarks, let me explore three of the most trenchant and overlapping
plot lines, none of which seem to avail themselves readily to a speedy resolution. First, a
striking loss of confidence is affecting financial market functioning. Second, the business
models of many large financial institutions are in the process of significant re-examination
and repair. Third, the Federal Reserve is exercising its powers to mitigate the effects of
financial turmoil on the real economy. This third plot line, however necessary, will not, in and
of itself, ensure a more durable return of trust to our financial architecture. In my view, public
liquidity is an imperfect substitute for private liquidity. That is, only when the other plot lines
advance apace - meaning that significant, private financial actors return to their proper role
at center stage - will credit market functioning and support for economic growth be fully
restored. And for that to happen, as I am confident it will, we will find that the financial
markets and financial firms are outfitted quite differently.
Plot line 1: liquidity in financial markets
As I advanced in prior remarks, liquidity is confidence. Liquidity expands with confidence in
the efficacy of our financial architecture. When information, securities, markets, and
institutions work in a seamless fashion to intermediate the flow of funds between investors
and borrowers, liquidity flourishes. When the confidence in the financial architecture is
meaningfully impaired, liquidity flounders. A couple of examples highlight the dramatic
change in liquidity that is gripping financial markets.
First, consider structured product markets. Recall the explosive growth in securitization
markets in recent years.5 The loss in confidence in structured products was first evidenced
last year in securities backed by subprime mortgages. Actual and projected credit losses
began to mount across many housing-related assets.6 Participants also lost confidence in
the value provided through the securitization process itself. Some highly structured products,
such as collateralized debt obligations squared, vanished. Yields on non-agency
mortgagebacked securities and commercial mortgage-backed securities skyrocketed; and, in some
cases, securitization markets simply shut down.
All in all, this decline in confidence, while painful, is understandable. Investors and financial
institutions became complacent in their abilities - and the ability of credit rating agencies - to
evaluate credit risks of complex structured products. And while the originate-to-distribute
model entails legitimate principal-agent problems, investors did not demand or enforce
safeguards. Even many large, sophisticated financial institutions chose to retain super senior
and AAA-rated tranches for their own accounts. In so doing, they systematically erred in
assessing the assets' risk profile. Moreover, these products - born in times of massive
liquidity - were often not well designed to ensure efficient workout arrangements should the
abundant pools of liquidity retreat or should unexpected defaults emerge.
Next, consider short-term credit markets. Many financial products, such as asset-backed
commercial paper (ABCP), auction rate securities (ARS), interbank funding products, and
repurchase agreements (RPs), were intended to be steady, supportive credit facilitators in a
liquidity-rich environment. In reality, these products involved a good deal of maturity
mismatching and rollover risk. So, when liquidity retrenched, these markets experienced
substantial disruptions. ABCP outstanding fell by a staggering $300 billion this past summer.
Issuance of ARS - long-term bonds that reissue and reprice at very short intervals - came to
an abrupt halt. And, the interbank funding and RP markets showed significant signs of strain.
Credit quality concerns alone do not appear, even now, sufficiently widespread to induce the
depth of problems witnessed in financial markets during the past several months. Some ARS
that failed, for example, funded pools of federally guaranteed student loans. I do not mean to
suggest that counterparties themselves are blameless - many had been less than fully
transparent. Unclear disclosure by some financial institutions with respect to their
offbalance-sheet commitments and liquidity support accentuated the uncertainty that is
responsible for some of the poor market functioning.
More fundamentally, in my view, funding market disruptions reflect a striking decline in
confidence in the financial architecture itself. Perhaps an analogue to banking systems
without deposit insurance is appropriate: Depositors withdraw funds if they believe others will
act similarly. In short-term credit markets with minimal liquidity support, investors balk if they
lose confidence in other investors' willingness to roll maturing paper. Even when liquidity
support exists, it may well prove insufficient to address market-wide concerns. Many dealers
of ARS, for example, withdrew their implicit liquidity support when failures became more
frequent. Even those ABCP programs purportedly with full explicit liquidity support were
implicated in the turmoil. I hesitate to ascribe this loss in confidence simply to a change in
animal spirits or to dismiss this occurrence as some kind of contagion. After all, a loss in
confidence can be completely rational: Illiquidity forces issuers to sell assets into distressed
markets.
So, I argue, the functioning of short-term credit markets is invariably tied to changes in
confidence of our financial architecture - on the way up and on the way down. The arc of this
narrative, thus, necessarily began some years ago. Increasingly abundant confidence when
things were advancing apace - unsustainably so, it turns out - gave rise to levels of liquidity
that engendered complacency among investors and counterparties. The financial
architecture grew increasingly impervious to skeptics and dissenters, perpetuating
insufficient transparency and under-informed risk-taking. It was commonly believed that
short-term, secured credit markets would perpetually remain open to finance high-quality
assets. And the notion of liquidity risk management was anachronistic, or so it seemed.
Market participants now seem to be questioning the financial architecture itself. The fragility
of short-term credit markets is a powerful manifestation of that loss of confidence. There are
some encouraging, early signs of repair, but regaining the confidence that markets require
will take time, and perhaps uncomfortably to some, patience. It may also require new forms
of credit intermediation.
Plot line 2: transformation of financial institutions
The rise and fall of liquidity is not only changing fund flows in financial markets. It may also
be transforming the business models of financial institutions themselves - no matter their
size, regulatory structure, peer group, funding status, or geography.
The period that preceded the recent turmoil was marked by abundant liquidity, high
transaction volumes, and remarkably low volatility. That environment proved exceptionally
hospitable to significant profits across classes of financial institutions. It also was supportive
of high leverage, and correspondingly high returns on equity for financial intermediaries. Of
no less consequence, it drove a conflation of roles among commercial banks, investment
banks, and asset managers. The core functions of credit intermediation - creating,
distributing, and owning risk - remained constant, but more institutions came to believe that
there were inescapable synergies by operating across all three primary functions. From 2002
to mid-2007, many large financial institutions did just that, and to great effect - creating
products by aggregating and reconstituting assets, distributing bespoke risks across
institutional and retail channels, and retaining certain preferred positions for proprietary
accounts.
A changing paradigm of financial intermediation may well be on the horizon. From the
market's perspective, financial institutions overproduced goods and services that now have
to be warehoused or liquidated. From the perspective of financial institutions themselves, the
old business models may be in the process of being upended. And from the perspective of a
dispassionate central banker, the contemporaneous changes in balance sheets and income
statements by incumbent financial institutions - most notably, deleveraging and paring of
business lines - are likely to prove highly consequential to the near-term outlook for the real
economy.
Changing forms of financial intermediation are expected, given higher volatility and less
leverage, in some cases building on old-fashioned banking products. Commercial and thrift
deposits, for example, backed by a loyal customer base, may offer greater franchise value.
Investment banks may reconfigure capital structures and core trading businesses to
maximize benefits in a higher volatility environment. Asset-gatherers, whether in the form of
traditional money-management firms or hedge funds, that survive this time of testing may
rely more on term funding and seek equity returns across beaten-down classes of structured
and debt products. And dependable, recurring revenues, even at lower levels, may warrant a
premium valuation in the public markets.
The case for opportunistic capital is improving. Some curative steps by incumbent financial
institutions are in the offing. Financial institutions should continue to reassess their sources
and uses of funding, their risk-management systems, risk tolerance, and human capital.
Generally, they should not hesitate to pare their dividend and share repurchase programs.
And, they should raise new capital to strengthen their balance sheets. These actions, in my
view, are important signs of strength, and will ensure that financial institutions thrive in the
emerging financial architecture replete with new opportunities. These actions will have
concomitant benefits on real economic activity.
Plot line 3: Federal Reserve's policy formulation
The central bank's responsibility is not to individual firms but to financial markets, and only
then, to the extent that financial market stresses affect the real economy. Given the fragility
evidenced in financial markets, and the toll it is taking on real activity, the Federal Reserve
agreed to take center stage. This is a role for which we did not volunteer, but one in which
we are prepared to serve. The role has been thrust upon us by a loss of confidence in our
existing financial architecture. Hence, we should remain at center stage as long as is
necessary, but no longer.
The Fed responded aggressively to mitigate spillovers to the real economy, exercising some
authorities for the first time in decades. To prevent more serious financial fallout, the Fed
established and expanded various lending facilities to depository institutions and primary
dealers.7 Some facilities allow daily access to variable amounts of funding, and others
provide access to a fixed amount of longer-term funding at pre-announced auction dates. Still
other facilities target action involving repurchase transactions with primary dealers.
These recently implemented measures appear to have reduced, to some extent, strains in
the financial situation. In particular, conditions in the RP market have improved. And, while
Libor and commercial-paper spreads have remained elevated, they are below their year-end
highs. In the corporate bond market, risk spreads have narrowed a bit in recent weeks and
measures of secondary-market functioning are improved.
While the adjustment process by financial intermediaries is showing signs of promise, the
healing process is not likely to be linear. More consequentially, we should recognize that
Fed-supplied liquidity is a poor substitute for private-sector-supplied liquidity. When liquidity
flows among private-sector participants, the players can more judiciously assess risk and
reward, more adroitly learn from the recent turmoil to strengthen the resiliency of credit
intermediation, and more ably allocate capital to its most productive uses in the real
economy. Moreover, Fed-provided liquidity should not be mistaken for capital.
Volatility is generally a friend, not a foe, of market functioning. It should not be treated as an
externality from which we suffer. Volatility, absent destabilizing moves, should be allowed to
effectuate change in the financial architecture of private markets. Only then, I suspect, will a
more robust recovery in market liquidity, investor confidence, and real economic activity be
achieved.
Of course, monetary policy continues to play an important role in the Federal Reserve's
policy formulation. We have reduced the policy target rate by a cumulative 3 percentage
points since August. These actions, together with significant actions to support liquidity, are
intended to promote growth and mitigate downside risks to economic activity. Consistent with
our dual mandate of promoting maximum employment and stable prices, we also need to be
alert to risks to price stability. Increases in food and energy prices have pushed up overall
consumer prices and are putting upward pressure on core inflation and inflation expectations.
We will continue to monitor the inflation situation closely. And, more broadly, in my view, as
financial intermediation channels reset, monetary policy will become still more efficacious.
Fed policy - both with respect to liquidity tools and monetary policy - is partially offsetting the
consequences of the liquidity and credit pullback on real activity. But we must be careful to
not ask policy to do more than it is rightly capable of accomplishing. The problems afflicting
our financial markets are indeed long-in-the-making. Correspondingly, the curative process is
unlikely to be swift or smooth. Time is an oft-forgotten, yet equally essential, tool of our policy
response.
Epilogue
Some believe the story of the current market turmoil began in August, and will end when the
housing market stabilizes. But, in my view, the narrative actually began in a seemingly more
benign time with underpinnings more fundamental than the value of the housing stock.
Financial institutions and other market participants grew increasingly dependent on the
extraordinary liquidity around them. When liquidity faltered, the weaknesses of the existing
architecture abruptly revealed itself. A metaphor, perhaps, is instructive: Fish don't know they
are wet. And they don't learn unless their memories are long or the water is gone. A new
financial architecture, born of the forces of creative destruction, is early in the process of
construction with the aid of the Federal Reserve and other public authorities. But for the new
paradigmatic architecture to be enduring, market-supplied liquidity must come to
predominate. To that end, I remain confident that financial institutions and financial markets
will evolve to meet these challenges.