bonds when the price of bonds is rising. conversely, they must sell bonds when the price of bonds is falling. put another way, they will always be reinforcing the current direction of the market and never “ leaning against the wind. ” clearly, if these hedging - related transactions are large relative to the underlying market, the hedging strategy could make significant demands on market liquidity and lead to higher market volatility. that is the theoretical argument behind the concern that dynamic hedging of mortgages could exacerbate volatility in fixed - income markets. to see whether this concern is just a theoretical curiosity or is more practical, two more questions must be answered. first, are the hedging - related transactions large relative to the underlying market? second, could other mechanisms for hedging prepayment risk have a smaller impact on volatility and therefore hedge the risk more effectively? on the first question, both research and market observation suggest that hedging - related transactions are large enough to have an effect on the underlying fixed - income markets, but the effect is small and dissipates relatively quickly. research at the federal reserve bank of new york covering the years 1996 through 2000 and also the monetary policy tightening in spring 1994 has found hedging - related effects to be present in u. s. dollar interest rate movements. although the effect was large enough to be detectable, it was small relative to overall interest rate volatility and lasted no longer than six weeks. market participants have described the market conditions of november and december 2001 as a unique combination of circumstances that made the hedging - related effects much stronger than usual. these circumstances included a recent history of declining mortgage rates ( which increased prepayment risk ), a sharp unanticipated rise in market rates in november and december, low market liquidity in the months right before year - end, and a general reduction in activity after september 11. even with these factors, market participants estimate that the temporary hedging - related effect on the ten - year treasury yield was no more than 25 basis points - - again, a measurable but small effect. according to market reports, hedging - related effects on the underlying fixed - income markets appear to have been muted so far this year, despite a record volume of mortgage refinancings thus far in the second half of 2002 that has surpassed last year ’ s peak. turning to the second question

prepayable mortgages outstanding has risen from around $ 1 trillion in 1980 to almost $ 5 trillion today. as all of us are probably aware, the old model concentrated interest rate risk in depository institutions, specifically in savings and loans. and when interest rates soared in the early 1980s, the savings and loan industry suffered huge losses with collateral effects on the real economy. in comparison, the market - based model clearly seems to have spread the interest rate risk of mortgages throughout the economy, with depository institutions still bearing some of the risk through investments in mortgagebacked securities or callable debt. what are the lessons for policymakers? i can suggest two. first, policymakers still need to fulfill their traditional supervisory role. they need to ensure that regulated intermediaries manage prepayment risk effectively and have adequate capital to absorb losses. second, i would note that new risk - transfer instruments, such as swaps and swaptions, are playing an important role in transferring the interest rate risk of mortgages to a broader and more diversified group of investors. herding my second topic today is the concern that common approaches to risk management, such as value - atrisk modeling, may be promoting herding behavior that can destabilize markets. the idea is that market participants who use similar risk management techniques may respond to a perceived increase in the riskiness of their positions by paring back the size of those positions and perhaps by paring back positions in other markets as well. such a response, while rational from the perspective of individual market participants, may have the collective and unintended consequence of reducing market liquidity at the time when it is most needed. i recognize the relevance of the questions and realize that herding might theoretically occur in a number of markets. however, based on some observations of how models are actually constructed and used at financial firms, i would like to outline three reasons why this concern might be overstated. first, the sophistication and structure of risk - management models vary widely. this point applies with full force to value - at - risk models in use at commercial banks, an area the federal reserve has some knowledge of through our supervisory oversight. our examiners have observed that banks implement a common objective - - measuring the value - at - risk of the bank ’ s trading account - - in highly diverse ways. given their early stage of development and the diversity with which they are implemented, the use of these models does not seem likely to create