lars nyberg : the financial market turmoil speech by mr lars nyberg, deputy governor of the sveriges riksbank, to the riksdag committee on finance, stockholm, 22 november 2007. * * * i would like to begin by thanking you for the invitation to come here to discuss how we at the riksbank view the recent unrest in the financial markets. i shall begin by talking about the background to the market turbulence and about the spark that ignited the actual chain of events. then i shall go on to discuss developments during the autumn and what we can learn from what has happened – as far as is possible at this early stage. in conclusion, i shall talk about the risks we see before us. rapid changes in the credit market in recent years there have been major changes in the international credit markets. new agents have entered the market at the same time as new instruments have been introduced at a rapid pace. at the core of the changes in the credit market is a phenomenon called securitisation. this has to a great extent been practised by us mortgage institutions and banks since the 1970s. so it is not a new phenomenon. in brief, securitisation entails a number of loans, such as mortgages or credit card accounts, being placed in a specially - created company, which is then financed by issuing bonds on the market. these bonds are usually called asset backed securities ( abs ). managed properly, there are considerable advantages to securitisation. illiquid loans are converted into liquid bonds, which can easily be sold. many investors are happy to have credit risk in their portfolios for better diversification. but they do not want to manage individual credits, and they also want liquidity in their investments. they therefore appreciate the securitised products. in recent years, however, it has become increasingly common for securitised loans ( which have been converted into bonds ) to be repackaged into various so - called structured credit instruments. an impressive variety of this type of structured product has arisen in a short period of time. perhaps the most common form are those known as cdos, collateralised debt obligations. with a cdo it is possible to put together bonds from many different securitised loan portfolios and even to add other assets if desired. the idea is that the portfolio that has been put together is structured in different parts ( tranches ) with different credit risks ( this is in practice often done by

. the bottom right panel shows the corresponding forecasts of the output gap, the gap between output and potential output. these three panels are shown in the june 2005 inflation report. we see that there is a tradeoff between stabilizing inflation and resource utilization, measured as the output gap. the lower ( higher ) policy - rate path stabilizes inflation better ( worse ) around the see svensson ( 2010a, c ) for details. the mean squared gap for inflation is calculated as [ ( t, t ) * ] / ( t 1 ), where π ( t + τ, t ) denotes the forecast in quarter t of inflation in quarter t + and t 0 * denotes the inflation target. 0 [ y ( t, t ) y * ( t, t ) ] 2 / ( t 1 ) the mean squared gap for output is calculated as t, where y ( t + τ, t ) denotes the forecast in quarter t of output in quarter t + τ and y * ( t + τ, t ) denotes the forecast in quarter t of potential output in quarter t + τ, and t is the forecast horizon ( normally 12 quarters ). bis central bankers ’ speeches inflation target of 2. 5 percent but resource utilization worse ( better ). the qvigstad necessary ( but not sufficient ) condition for optimal policy is satisfied, namely that the inflation gap and the output gap should be of opposite signs. the bottom left panel, with the mean squared gap for inflation plotted along the horizontal axis and the mean squared gap for output plotted along the vertical axis, has been added by me. the closer the mean squared gap for inflation and output is to zero, the better inflation or the output gap is stabilized. the less sloped straight line is an iso - loss line that corresponds to equal weight on inflation and output - gap stabilization, that is to a “ lambda ” equal to one. 4 with such equal weight, the high policy - rate path is preferred. the steeper straight line corresponds to lambda equal to 0. 3, that is, with a weight on output - gap stabilization equal to 0. 3 relative to the weight on inflation stabilization. with such a weight, the main policy - rate path is about as good as the higher and clearly better than the lower policy - rate path. at the time, norges bank had announced that its decisions were consistent with a relative weight on output - gap stabilization equal to 0. 3 and a relative weight on interest - rate