##da master agreement provides standard definitions and a general outline for the contract but allows latitude in customizing terms. the master agreement also sets forth a template for workout procedures if a counterparty defaults, allowing parties to the agreement to adjust their risk - management strategies in light of the agreed - upon work - out process. this standardization reduces uncertainty about the instruments, which lowers transaction costs and facilitates price discovery and market liquidity. the examples from the long - and more recent - past may hold some valuable lessons for how improvements in standardization could help to address some of the challenges in the subprime market. uncertainty about the work - out process and the options that are available, for example, could be contributing to the difficulties in reviving price discovery and liquidity in the market for subprime residential mortgage - backed securities. part of the valuation challenge is gauging the extent of the difficulties that borrowers will have in making payments and being able to stay in their homes given the reduction in house price appreciation – or actual declines in some areas – and the large number of interest rate resets coming on many adjustable - rate mortgages. from now until the end of next year, monthly payments for an average of roughly 450, 000 subprime mortgages per quarter are scheduled to undergo their first interest rate reset. in addition, tightening credit conditions as reported in the federal reserve ’ s senior loan officer opinion surveys on bank lending practices suggest that refinancing may become more difficult. lenders and servicers generally would want to work with borrowers to avoid foreclosure, which, according to industry estimates, can lead to a loss of as much as 40 percent to 50 percent of the unpaid mortgage balance. loss mitigation techniques that preserve homeownership are typically less costly than foreclosure, particularly when applied before default. borrowers who have been current in their payments but could default after reset may see randall s. kroszner ( 1999 ), “ can the financial markets privately regulate risk? the development of derivatives clearing houses and recent over - the - counter innovations, ” journal of money, credit, and banking, vol. 31 ( august ), p. 600. see kroszner, “ can the financial markets privately regulate risk? ”, p. 601. be able to work with their lender or servicer to adjust their payments or otherwise change their loans to make them more manageable. it is imperative that we work together as

randall s kroszner : innovation, information, and regulation in financial markets speech by mr randall s kroszner, member of the board of governors of the us federal reserve system, at the philadelphia fed policy forum, philadelphia, pennsylvania, 30 november 2007. * * * good afternoon. i am pleased to participate in the excellent annual philadelphia federal reserve policy forum to discuss this year ’ s timely topic of innovations in financial markets. innovations in financial markets have created a wide range of investment opportunities that allow capital to be allocated to its most productive uses and risks to be dispersed across a wide range of market participants. yet, as we are now seeing, innovation can also create challenges if market participants face difficulties in valuing a new instrument because they realize that they do not have the information they need or if they are uncertain about the information they do have. in such situations, price discovery and liquidity in the market for those innovative products can become impaired. in my remarks today, i would like to explore the role of information in the development of new financial products and then draw some lessons about risk management and regulation. in particular, i will examine the role that investment in information gathering, processing, and evaluating plays in supporting the price discovery process and how such investment can lead toward a tendency to greater standardization as markets for innovative financial products mature. examples from both history and current experience will help to illustrate this tendency with respect to loan work - outs and restructurings. i will then conclude by considering how a regulatory approach that encourages transparency and sound risk management, such as basel ii, can be valuable in fostering a robust environment for the introduction of innovative financial products. experimentation and learning in new instrument development typically, when a new product is being developed, there is an initial experimentation phase in which market participants learn a great deal about the product ’ s performance and risk characteristics. this phase involves gathering and processing information and modeling the performance of the product in various scenarios and under different market conditions. it may then take time for market participants to understand what, exactly, they need to know to value a product. during the early phases, a fair amount of due diligence is appropriate, given the greater uncertainty associated with innovative products. the investment in gathering, processing, and evaluating information then, as i will discuss, often leads to greater standardization of products and contract terms, which can enhance liquidity of products as their markets mature. in the initial experimentation phase, the terms and characteristics of a new product are