rational self - interest given the borrower ’ s situation, since a distress sale or foreclosure at current market prices would generally yield larger losses. earned principal reduction investment firms that purchase delinquent mortgages routinely reduce principal in order to maximize value on these loans. it would make sense for fannie and freddie to do this as well in order to minimize loss of value on the delinquent loans they guarantee. however, i am uncomfortable with the notion that “ underwater ” borrowers who owe more on their mortgages than their homes are worth should have to go delinquent before they have a chance of securing a reduction in their mortgage debt. i believe we should also develop a program for earned principal reduction for borrowers who are underwater but keep on making their mortgage payments. such a program would strengthen the incentives for mortgage holders who are underwater to continue to stay current on their loans, and reduce the likely number of defaults and reo sales. negative equity is one of the most significant predictors of mortgage default across all types of mortgage products, including when you control for credit scores and level of income documentation. while recent underwater borrowers have not been defaulting at a rapid pace, they are also not prepaying, implying that underwater mortgages remain “ at risk ” for a prolonged period of time to any adverse shock to the borrower. it is admittedly challenging to predict how underwater borrowers will ultimately perform and this performance will be sensitive to the path of home prices. nonetheless, analysis by my staff that looks at likely borrower behavior over an extended time horizon suggests that without a significant turnaround in home prices and employment, a substantial proportion of those loans that are deeply underwater will ultimately default – absent an earned principal reduction program. one option developed by my staff is for fannie mae and freddie mac to give underwater borrowers on loans that they have guaranteed the right to pay off the loan at below par in the future under certain circumstances, including that the borrowers have continued to make timely payments. for instance, the borrower could be given an open - ended option to pay off the loan at an ltv of 125 percent, and the right to pay off the loan at an ltv of 95 percent after three years of timely payments. the borrower would be protected from further declines in home prices, but in return would give up a portion of any upside from future capital gains on the home via a shared appreciation agreement. note that under this arrangement some of

timothy f geithner : us monetary policy in the global financial environment remarks by mr timothy f geithner, president and chief executive officer of the federal reserve bank of new york, at the japan society corporate luncheon, new york city, 9 march 2006. i would like to thank margaret mcconnell of the bank ’ s research and statistics group for valuable contributions to this speech. * * * we are in the midst of another wave of global economic and financial integration. this movement toward greater openness and the associated rise in capital mobility offers the prospect of substantial economic gains for the u. s. and the global economy. stronger real and financial linkages across nations have the potential to significantly raise the prospects for long - run world growth. the ensuing development of the market sector in emerging market and developing economies offers probably the most powerful means available for raising income growth and living standards in a very large share of the world ’ s population. these changes, and the complementary advances in technology, offer the prospect of more productive and stable real economies. the increase in the ties between national financial systems, the greater sophistication of financial markets and financial market instruments and the increase in capital flows across borders, allow risks to be shared more broadly and capital to flow to where the returns are highest, also contributing to stronger and more stable future economic growth. this process of integration has, of course, a range of implications for policymakers. many of these implications are positive, for the benefits of integration over time are powerful and compelling for all economies. in important ways, economic integration may have made the principal job of central banks easier, by contributing to productivity growth and reducing some sources of inflation pressure, at least during the transition when a large share of the working age population of the world is being brought into the market. but the process of change in how economies and financial markets interact also complicates the task of central banks. our understanding of the how these changes affect our capacity to forecast economic activity and inflation and our ability to assess how monetary policy affects the economy almost certainly lags the changes underway. in my remarks today, i will talk about some of the implications of these challenges for the conduct of monetary policy. i will focus on two features of what is happening in the world economy and financial markets today that are among the most interesting and consequential of the many questions we face today in thinking about the changes in the world economy and the task of central banking. these are, first,