Ben S Bernanke: Addressing weaknesses in the global financial markets
- the Report of the President's Working Group on Financial Markets
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal
Reserve System, at the World Affairs Council of Greater Richmond's Virginia Global
Ambassador Award Luncheon, Richmond, Virginia, 10 April 2008.
* * *
In recent months, the Federal Reserve has been intensely focused on the continuing strains
in financial markets. Healthy, well-functioning financial markets are essential to sustainable
growth. In particular, much experience shows that economies cannot perform at their full
potential when financial conditions are such as to restrict the supply of credit to sound
borrowers. We are addressing these financial strains and their potential economic
consequences with a number of tools, including the provision of extra liquidity to the system
and reductions in our target for the federal funds rate.
Even as we have worked to resolve the current crisis, however, the Federal Reserve has
also been part of a national and international effort to draw at least some preliminary
conclusions about the sources of the current turmoil as well as the implications for public
policy. In my remarks today I will discuss some of these conclusions and, in the process,
identify some measures that should be taken to strengthen the global financial system in light
of the recent experience.
In the United States, policymakers' efforts to identify the sources of the financial turmoil and
the appropriate public- and private-sector responses have been coordinated through the
President's Working Group on Financial Markets (PWG), chaired by the Secretary of the
Treasury. The group's other principals include the heads of the Securities and Exchange
Commission (SEC), the Commodity Futures Trading Commission, and the Board of
Governors of the Federal Reserve System. With the support of the staff of the respective
agencies, the PWG began to address these issues last fall, as the severity of the financial
turmoil became increasingly apparent; in mid-March, we issued a brief statement outlining
our tentative conclusions and policy recommendations.1 At the international level, the
Financial Stability Forum (FSF), whose membership consists of central bankers, regulators,
and finance ministers from many countries, including the United States, will also soon
release a report on the causes of and potential responses to the turmoil. I describe these
policy development processes to underscore the cooperative nature of the enterprise, both
among the U.S. authorities and between the United States and other countries. Given the
global nature of our financial markets and institutions, international cooperation is essential to
making the regulatory and supervisory structure more effective. As I will discuss, many of our
recommendations involve actions to be taken by market participants, and so their buy-in and
cooperation is essential as well. We have consulted extensively with market participants on
these issues and will continue to do so.
As you may know, the Department of the Treasury recently issued a blueprint for regulatory
reform in the United States. The focus of the Treasury's work is on the appropriate design
principles for our regulatory system - including the system's structure and governance, the
appropriate scope of regulators' responsibilities, and how those responsibilities should be
allocated across agencies - rather than on the specific issues raised by the current crisis.
Given its focus on fundamental reform, the recommendations of the Treasury blueprint are
mostly intended to be undertaken in the longer term. In that respect, it is an important first
step, and we look forward to working with the Congress and others in developing a
framework that modernizes our financial and regulatory architecture. The analysis of the
PWG that I will be discussing today is more sharply focused on recent events, and its
recommendations are intended to be part of the near-term and medium-term effort to restore
more normal functioning of financial markets and to improve the operation of the current
system.
Diagnosis
Let me begin with the diagnosis of the causes of the crisis, focusing primarily on the U.S.
case and the conclusions drawn by the PWG.
Although many factors played a role, to a considerable extent the current problems arose in
the implementation of the so-called originate-to-distribute approach to credit extension. The
originate-to-distribute model breaks down the process of credit extension, from origination to
the ultimate financing, into component parts, or stages, in a manner reminiscent of how
contemporary manufacturers distribute the stages of production across firms and locations.
This approach has had considerable benefits, including increased access of small and
medium-sized borrowers to the broader capital markets, but pitfalls in its implementation are
now evident.
To describe how the originate-to-distribute model works, let's consider a simplified
description of how a mortgage loan is made and financed within this framework. In the first
stage of the process, the originator - a lender or a broker serving as a lender's agent -
extends the mortgage loan to a potential homebuyer. The originator is responsible for the
underwriting - that is, for ensuring that the borrower is creditworthy and that the terms of the
mortgage appropriately reflect the risks of the transaction. In the next stage, the originator
sells the mortgage to another financial institution, let's call it the packager, which combines
the mortgage with many other loans to create a marketable security. (This process usually
involves the creation of a separate legal vehicle, which holds the underlying mortgages or
other assets and issues claims against itself. I will skip the technical details here. Sometimes
the originator and what I have called the packager are the same institution.) The most
straightforward case involves combining the mortgage with other mortgages to create a
mortgage-backed security (MBS); the owner (or owners) of an MBS has claims on the cash
flows arising from the underlying mortgages. MBS are familiar financial instruments; indeed,
the government-sponsored enterprises Fannie Mae and Freddie Mac have been creating
and selling MBS for a long time, as have a number of other financial institutions.
However, much more complex securities can also be created, backed for example by a mix
of different types of loans or other assets combined with various guarantees or hedges; in
recent years the issuance of these so-called structured credit products increased sharply.
Importantly, the newly created securities may be broken into pieces, or tranches, of varying
seniority and credit quality. In the third stage of the originate-to-distribute process, these
tranches are rated separately by one or more credit rating agencies, then sold to investors
with differing preferences for risk or retained by the lender. In principle, the
originate-todistribute model spreads risk and reduces financing costs while affording borrowers greater
access to capital.
In practice, however, problems arose in recent years throughout the originate-to-distribute
chain, resulting ultimately in a broad retreat from this model late last summer. First, at the
point of origination, underwriting standards became increasingly compromised. The
bestknown and most serious case is that of subprime mortgages, mortgages extended to
borrowers with weaker credit histories. To a degree that increased over time, these
mortgages were often poorly documented and extended with insufficient attention to the
borrower's ability to repay. In retrospect, the breakdown in underwriting can be linked to the
incentives that the originate-to-distribute model, as implemented in this case, created for the
originators. Notably, the incentive structures sometimes often tied originator revenue to loan
volume, rather than to the quality of the loans being passed up the chain. Investors normally
have the right to put loans that default quickly back to the originator, which should tend to
apply some discipline to the underwriting process. However, in the recent episode, some
originators had little capital at stake, reducing their exposure to the risk that the loans would
perform poorly.
So long as house prices were rising, subprime borrowers saw their home equity increase and
were often able to refinance into more-sustainable mortgages. However, when house prices
began to fall, borrowers' refinancing options disappeared and the problems with subprime
mortgage underwriting were exposed. Delinquency rates soared, particularly on subprime
mortgages with adjustable rates. Because subprime mortgages were frequently securitized,
often as part of complex structured credit products, the losses associated with these
delinquencies spread throughout the system.
Although subprime mortgages were the most obvious example, the loosening of credit
standards and terms occurred more broadly, reflecting a general boom in credit markets that
peaked and then reversed last summer. This boom was characterized by a general erosion
of market discipline, underpricing of risk, and insufficient attention by investors to the quality
or riskiness of the instruments they purchased. For example, in the market for so-called
leveraged loans, used to finance mergers or buyouts, investors showed themselves willing to
purchase debt with few covenants or other protections.
The PWG also concluded that investors often took insufficient care in evaluating the risks of
structured credit products, in part because they over-relied on the evaluations provided by
the credit rating agencies. Unfortunately, the methodologies and assumptions the agencies
used to rate many credit products proved faulty, and their data were inadequate (in part
because of the lack of extensive experience with these products). When rising delinquencies
and losses on mortgages forced the agencies to sharply downgrade many structured credit
products, investors lost confidence in those ratings and became unwilling to provide new
funds. As financing disappeared, the markets for these products and for related investments,
such as asset-backed commercial paper, seized up.
Another factor that the PWG identified as contributing to the financial turmoil was weakness
in the risk-management practices of large global financial institutions that created and held
complex credit products. As demonstrated by comparative studies of institutions'
performance, which we at the Federal Reserve conducted in concert with regulators both in
the United States and abroad, some firms fell short in identifying and managing the risks they
were taking. For example, some firms had not developed adequate capacity to measure their
aggregate exposures to subprime credit risk across business lines, leaving them vulnerable
to significant losses at the level of the entire firm. Thus, the spreading of risk that was one of
the supposed benefits of the originate-to-distribute model proved to be much less extensive
than many believed. The pullback of investors from structured credit products also imposed
significant liquidity pressures on many of the largest financial institutions, which were left
scrambling to fund instruments they could not sell or to meet contingent funding obligations
for which they had not adequately planned. These weaknesses were particularly evident with
respect to managing risks from exposures related to collateralized debt obligations,
offbalance-sheet conduits that issued asset-backed commercial paper, and leveraged loan
syndications. The combination of unanticipated losses, which reduced capital, and severe
liquidity pressures has significantly reduced the ability and willingness of some large financial
institutions to extend fresh credit or to make markets, with adverse effects for the broader
markets and for the economy.
The originate-to-distribute model thus broke down at a number of key points, including at the
stages of underwriting, credit rating, and investor due diligence. Financial institutions were
caught, in some cases, by inadequate risk management and liquidity planning. These
problems notwithstanding, the originate-to-distribute model has proven effective in the past
and with adequate repairs could be so again in the future.
Recommendations
The PWG's recommendations flow logically from the problems that we identified. First, the
weaknesses in the origination stage of the originate-to-distribute model must be corrected;
no matter how elaborate and sophisticated, credit instruments can be no stronger than the
underwriting that supports them. Market participants will not easily forget the lessons of the
recent period, and so market discipline will help in this respect. I expect that, in the future,
investors will be eager to ensure that their own interests and those of the originators are
better aligned, which should lead to more conservative and careful underwriting.
But better consumer protections and disclosures, as well as greater supervisory scrutiny of
the processes that originators follow and the incentives they face, are also needed. In the
mortgage area, the PWG recommended action at both the federal and state levels, including,
for example, stronger nationwide licensing standards for mortgage brokers and more
consistent government oversight for all originators. In particular, the PWG recommended that
the Federal Reserve use its authority to strengthen consumer protection rules and enhance
required disclosures for mortgage originations.
I strongly support this recommendation, and its implementation is well under way.
Specifically, the Federal Reserve has used its authority under the Home Ownership and
Equity Protection Act to propose and seek comment on new rules that, for higher-cost loans,
would strengthen consumer protections. The rules would restrict the use of prepayment
penalties and low-documentation lending, require the use of escrow accounts for property
taxes and homeowner's insurance, and ensure that lenders give sufficient consideration to
borrowers' ability to repay. In addition, for all mortgage loans, we have proposed rules
regarding broker compensation methods and the ability of appraisers to provide judgments
free of undue influence, as well as rules regarding the accuracy of advertisements and
solicitations for mortgage loans and the timeliness of required disclosures. We also plan to
propose a revised set of required mortgage disclosures based on the results of a program of
consumer testing already under way. We will monitor the effectiveness of the new rules and
take additional steps as necessary. To strengthen enforcement, we have initiated a pilot
program to improve the coordination among federal and state authorities in the examination
of nonbank mortgage lenders.
Another problem identified by the PWG was the inadequate care by investors in their
evaluations of securitized credits, particularly the more complex structured securitizations.
More transparency about the risks and other characteristics of securitized credits on the part
of their sponsors would obviously help. But more generally, investors must take responsibility
for developing independent views of the risks of these instruments and not rely solely on
credit ratings. Some investors, such as public pension funds, are subject to government
oversight, and in these instances, the PWG will look to their government overseers to
reinforce implementation of stronger due diligence practices. When investors employ
advisers, the mandates and incentives given to these advisers should be structured so as to
induce a more careful and nuanced evaluation of the risks and returns of alternative
products.
Improving the performance of the credit rating agencies is another key priority. As I
mentioned, analytical weaknesses and inadequate data underlay many of the problems in
the ratings of structured finance products. Beyond improving their methods, however, the
credit rating agencies would serve investors better by providing greater transparency. Credit
rating agencies should, for example, publish sufficient information about the assumptions
underlying their rating methodologies and models so that users can understand how a
particular rating was determined. It is also important for the credit rating agencies to clarify
that a given rating applied to a structured credit product may have a different meaning than
the same rating applied to a corporate bond or a municipal security. Indeed, some have
suggested that the agencies use different rating nomenclatures for different types of
products. Transparency about methods should also help to reduce concerns about conflicts
of interest that might arise from the fact that issuers of securities pay the rating agencies for
their work in rating those securities.
The credit rating agencies themselves clearly appreciate that concerns about the quality of
ratings and potential conflicts of interest represent a fundamental challenge to their business
model, and they have begun to address these issues. The SEC, which has regulatory
responsibility for the credit rating agencies, is conducting a broad review of issues regarding
potential conflicts of interest at the rating agencies and is likely to identify further measures
that should be implemented.
As I noted earlier, the turmoil in financial markets has also revealed significant weaknesses
in the risk-management practices of some large, globally active financial institutions; these
weaknesses have exacerbated the problems in the markets by compromising the abilities of
these key firms to absorb risk and serve as intermediaries. Prudential supervisors in the
affected financial markets began joint work late last summer to identify common deficiencies
on which they and the firms should focus. The supervisors concluded that the firms that
suffered the most significant losses tended to exhibit common problems, including
insufficiently close monitoring of off-balance-sheet exposures, inadequate attention to the
implications for the firm as a whole of risks taken in individual business lines, dependence on
a narrow range of risk measures, deficiencies in liquidity planning, and inadequate attention
to valuation issues. To be sure, firms varied in the degree to which they were subject to
these weaknesses, with better performance on these dimensions generally being reflected in
better financial performance.
Correcting these weaknesses is, first and foremost, the responsibility of the firms'
managements and they have powerful incentives to do so. But prudential supervisors,
including the Federal Reserve, must also review their existing policies and guidance to
identify areas where changes could help firms strengthen their risk management - a process
that is already under way. Two areas of focus in this review will be capital and liquidity, the
principal buffers that firms have against unexpected shocks. Regulators should adopt
policies that lead financial institutions to hold capital and liquidity cushions commensurate
with their firm-wide exposures to adverse market events. The PWG also will be asking U.S.
regulators, working together and through international groups such as the Basel Committee
on Banking Supervision, to enhance their guidance in a variety of areas in which
weaknesses were identified. I expect, for example, to see work forthcoming on liquidity risk
management, concentration risk management, stress testing, governance of the risk-control
framework, and management information systems.
Off-balance-sheet vehicles have been singled out for attention because of the pressures they
have put on financial firms' capital and liquidity during the current episode. The PWG made a
number of recommendations on this topic, including urging regulators to require financial
institutions to provide more detailed and comprehensive disclosures about off-balance-sheet
commitments. The PWG also recommended that the Financial Accounting Standards Board
(FASB) evaluate the need for further modifications to accounting standards related to
consolidation and securitization, and that FASB and the International Accounting Standards
Board achieve more rapid international convergence of accounting standards in this area.
Implications and conclusions
This quick review of the recommendations of the President's Working Group on Financial
Markets does not do justice to the many issues we considered in our discussions and in the
work of the staff. But I think it does give you a flavor of the diagnosis and recommendations.
Implementing these recommendations here in the United States, as well as working with our
international partners to implement compatible and complementary measures abroad, will
have many benefits.
Narrowly, these recommendations should help to improve and strengthen the
originate-todistribute model, which, despite recent problems, seems likely to remain an important
component of our system of credit provision. In the vision set forth by the PWG, however,
this model will be rebuilt on a foundation that includes higher standards of underwriting and
due diligence, a closer alignment of the incentives of originators and investors, greater
transparency and simplicity in the design of credit instruments and in the determination of
credit ratings, and better risk and liquidity management by financial institutions that develop
and hold these instruments. More broadly, these recommendations should moderate the
likelihood and severity of future financial shocks and enable market participants to better
withstand shocks when they occur.
Importantly, the PWG's approach relies on both market and regulatory discipline, not just one
or the other. With respect to market discipline, in light of recent experience, investors are
unlikely to rely solely on credit ratings in the future but will instead require more and better
information from originators and sponsors of credit products. Credit rating agencies will also
be tougher about the information they demand from securitizers, and I expect they will be
more skeptical about especially complex and opaque instruments. To support these efforts to
strengthen market discipline, the PWG called for the private sector to establish several
working groups to make recommendations concerning best practices in key areas.
Regulation complements market discipline - for example, by requiring disclosures that
improve the ability of consumers to shop and of investors to evaluate risks, by providing
protections to less-sophisticated market participants (such as subprime mortgage
borrowers), and by requiring that financial institutions meet high standards in their
management of risk. We regulators must act to ensure that our policies and supervisory
procedures are consistent with the objectives of improving the originate-to-distribute system
and strengthening risk management more broadly. We will review some aspects of our
regulations and strengthen our supervisory guidance and disclosure requirements in key
areas, such as those relating to securitizations and off-balance-sheet vehicles. We will
review our own use of credit ratings as a risk metric. And we must be sure that we are
working effectively with both the private sector and other domestic and international
regulators to help the system function better.
The process of implementing the PWG's implementations will be challenging, in no small
measure because of the continuing pressures of short-term crisis management. However, we
do not have the luxury of waiting for markets to stabilize before we think about the future.
Indeed, many of the necessary changes that have been identified, including increasing
transparency, improving risk management, and attaining better coordination among
regulators, could provide important support to the process of normalizing our financial
markets.