Donald L Kohn: Comments on "Financial Regulation in a System
Context", "Beyond Leveraged Losses: The Balance Sheet Effects of the
Home Price Downturn", and "The Central Role of House Prices in the
Financial Crisis: How Will the Market Clear?"
Speech by Mr Donald L Kohn, Vice Chairman of the Board of Governors of the US Federal
Reserve System, at the Brookings Panel on Economic Activity, Washington DC,
11 September 2008.
* * *
I appreciate the opportunity to comment on these three papers.1 They illuminate the sources
and effects of the current financial market turmoil, and I learned a considerable amount from
reading them and thinking about their implications. Instead of providing detailed comments
on each paper, I'd like to draw out the relationships among them and, in the process,
comment a little on the papers and their implications. To foreshadow: I will be highlighting the
role of leverage - in the household sector and in financial intermediaries - as a critical factor
in understanding the buildup of excesses and their unwinding.
At the beginning of the chain of causation is the housing cycle in the United States. Chip
Case points out the difference between this housing cycle and others over past decades and
asks why the difference developed. One culprit he identifies is changes in the financial
system that affected the way that mortgage credit is made available to borrowers. A key
element of these changes, and one that accounts for a good part of the subsequent effects of
the financial system and the economy, is the rise in leverage in housing finance. As Case
notes, for several years, mortgage indebtedness rose substantially relative to the value of
owner-occupied housing. The willingness of lenders to tolerate - or, in some cases,
encourage - huge increases in loan-to-value ratios added to the demand for housing,
especially by people who normally might not have had the savings to enter the market, and
contributed to the rise in home prices.
One reason for the loosening of standards was the expectation that house prices would
continue to rise - and even more certainly that they could not fall in all regions at the same
time, supporting diversification through securitization. Rising prices would enable lenders to
recoup their funds even if the borrower was unable to service the loan, mostly because the
borrower would be able to obtain extra cash through refinancing. Expectations of house price
appreciation facilitated and interacted with the increasing complexity of mortgage securities,
including multiple securitizations of the same loan, which made it virtually impossible for
ultimate lenders to monitor the creditworthiness of borrowers - a task they, in effect, had
outsourced to credit rating agencies. The absence of investor caution and due diligence was
especially noticeable for the highest-rated tranches of securitized debt.
Elevated leverage in housing markets has meant that as prices have fallen, lenders have had
to absorb an unusually high proportion of the losses. As Case points out, foreclosures by
lenders have added to the downward pressure on those prices. Conceptually, such price
declines moving down the demand curve for housing services could accelerate and cushion
the adjustment in activity necessitated by previous overbuilding. I am encouraged that Case
finds the pace of declines abating in a number of markets. However, partly owing to the
feedback of price declines on lenders, mortgage conditions have tightened some since the
late spring readings he is using for his conclusion, and in my view, the jury is still out on
whether housing prices are close to finding a bottom.
The heavy involvement of financial intermediaries in amplifying the housing boom and the
subsequent economic effects of the bust brings me to the Morris and Shin paper, which
raises a host of important issues related to the systemic aspects of financial intermediation
and the lessons from the recent turmoil. As they emphasize, one of the important lessons
has been the greater-than-expected vulnerability of secured financing when intermediaries
are engaged in maturity, credit, and liquidity transformation. Recall that the turmoil first came
onto the balance sheets of the banks through the collapse of the asset-backed commercial
paper market last fall before it affected the funding of investment banks through the triparty
repurchase agreement market. The new vulnerability results importantly from the extension
of secured short-term financing to increasingly illiquid and riskier long-term assets. As
uncertainty about the liquidity and creditworthiness of those assets - especially related to
mortgage-backed securities - was called into question, lenders became more concerned
about the possibility that they might end up owning the underlying assets, and they raised
haircuts or simply refused to roll over loans.
Clearly, as Morris and Shin point out, what we have learned about various risks implies the
need for intermediaries to build greater liquidity and capital buffers in good times, as well as
to improve their abilities to manage their risks. And those larger buffers would help to offset
the moral hazard that may have been created through the expansion of our liquidity facilities.
Getting the micro-prudential piece right - having each institution adequately protected -
would go a long way toward making the whole system more robust and resilient.
But Morris and Shin would go further; they would impose additional requirements on
institutions to take account of the externalities for the system created when common shocks
impair markets and credit availability by provoking widespread actions to preserve
shareholder value. They would do this through a higher liquidity requirement and through the
imposition of a leverage ratio on investment banks, which is already in place for commercial
banks.
I agree with the authors, and with Chairman Bernanke, that we need to consider the level of
buffers that is appropriate to ameliorate systemic risk. That said, a host of difficult judgments
are inherent in how we establish such a system, and I'll raise just a few on a very general
level. One set concerns the size of the buffers. How far into the tail should intermediaries be
required to insure themselves? Shouldn't the Federal Reserve take some of the liquidity tail
risk to facilitate intermediation of illiquid credits, as was intended at our founding? Moreover,
the larger the regulatory tax, the more likely it is that activity will migrate to unregulated
sectors in an environment of fluid and free capital movements. How can we gain better
assurance of systemic stability when we are unlikely to be able to continuously extend the
reach of regulation, and will it be sufficient to deepen the moats around the core institutions?
In this regard, the leverage ratio gives incentives to move some activities away from
regulated institutions.
A second question is, How we can structure these requirements and other aspects of
regulation to damp, rather than reinforce, the natural procyclical tendencies of the financial
system? Among the challenges will be encouraging firms and supervisors to comfortably
allow buffers to be eroded in bad times. Interestingly, prompt corrective action under the
Federal Deposit Insurance Corporation Improvement Act of 1991 was intended, in part, to
induce an element of countercyclical behavior by banks. It gives banks an incentive to build
excess capital - on both a risk-based and leverage ratio basis - in good times to avoid
prompt corrective action when circumstances are less favorable. Now that we are in the latter
state of the world, a study of how commercial banks are viewing capital ratios, including the
leverage ratio, could inform consideration of the Morris and Shin proposal.
The Morris and Shin paper also provides a framework for thinking about the Federal
Reserve's credit facilities. On page 9, they note that liquidity makes borrowers feel more
robust and lenders less likely to withdraw, raising the odds for a more stable equilibrium for
the entire system. That is exactly what we have been trying to do with our various discount
lending facilities. The assurance of the availability of liquidity to sound institutions against
good collateral should counter the greater uncertainty and risk aversion that have impaired
normal arbitrage and intermediary functions by making those institutions more willing to
extend credit and take positions in the process of making markets. It should also assure
other creditors of those institutions that illiquid markets will not impede the repayment of their
loans, and therefore make them more willing to keep lending. A number of markets remain
disrupted and illiquid. But I believe that they would have been even more illiquid and the risk
of disruptive runs even greater without our various facilities; that's certainly what market
participants are telling us.
Jan Hatzius is trying to gauge the combined effects on spending of the losses generated by
the effects of the decline in housing prices outlined in the Case paper and the impulse for
deleveraging in the financial sector inherent in the processes discussed by Morris and Shin.
To restore capital ratios depleted by mortgage losses and to raise those ratios even further in
order to reduce leverage to safer levels demanded by counterparties, banks and other
lenders need to reduce assets. They do so by tightening terms and standards across a broad
array of credit - and we have seen this behavior reflected in our surveys of bank lending
officers and in various spreads and other measures of risk perceptions, risk aversion, and
reduced supply of credit at benchmark interest rates. In the current circumstances, some of
the tightening we have seen has been in anticipation of possible adverse events in the
economy and in confidence toward the financial sector. These types of actions not only move
up the demand-for-credit curve, but they also bolster profits going forward to cover potential
write-offs and to attract new equity capital. Pressures on profits arise not only from write-offs,
but also because some sources of earnings, like securitization of mortgages or leveraged
loans, are no longer available.
In the steady state, lenders will get greater returns for taking risk than they did two years ago,
intermediaries will be less leveraged and better capitalized, and the financial system will be
more robust and resilient to shocks. The transition to the new steady state, however, as
lenders deleverage and protect themselves against various downside risks, involves some
overshooting - making terms and standards tighter than will be necessary over the long run.
This story is completely consistent with the one told in the Hatzius paper, which relies mostly
on quantity relationships to gauge the possible effects on gross domestic product (GDP). My
instinct has been to go from the actual and expected indicators of tightening supply, such as
the instrumental variables used in the paper, directly to estimates of the effects of that supply
shift on GDP. Measures of flows would fall out of that exercise, but not be its focus. And I
have questions about the stability and reliability of the debt-GDP relationship used in the
forecasts at the end of the paper. But I will admit that we are in uncharted waters here, and
the navigators shouldn't discard any potential information about the location of the shoals.
The message of the paper is that restraint on credit supplies is likely to persist because
intermediaries have some way to go to rebuild their balance sheets. The process of
adjustment to a safer, more resilient financial system is going to take a while. I agree with
this observation.