frederic s mishkin : leveraged losses – lessons from the mortgage meltdown speech by mr frederic s mishkin, member of the board of governors of the us federal reserve system, at the us monetary policy forum, new york, 29 february 2008. the original speech, which contains various links to the documents mentioned, can be found on the us federal reserve system ’ s website. * * * the paper being discussed today, " leveraged losses : lessons from the mortgage meltdown, " by david greenlaw, jan hatzius, anil kashyap, and hyun song shin, examines the following puzzle : how could the recent residential mortgage - market meltdown, which the authors estimate will lead to credit losses of around $ 400 billion – less than 2 percent of the outstanding $ 22 trillion in u. s. equities – possibly have such large negative effects on economic activity in the united states? after all, a 2 percent decline in stock market prices sometimes happens on a daily basis and yet leads to hardly a ripple in the u. s. economy. the authors conclude that these losses have such a large potential impact because they are borne by highly leveraged financial institutions, primarily banks. their theory is basically as follows : because banks have so much leverage, they contract their lending by a multiple of their credit losses in order to restore their balance sheets. the resulting contraction in bank lending then leads to a substantial decline in aggregate spending, because bank loans cannot be replaced by credit from other sources. banks are " special " – that is, they have intermediation capabilities not fully shared by other financial market participants, and those capabilities allow banks to overcome informational barriers between borrowers and lenders and thus make loans that otherwise could not be made. i find the basic story the paper tells to be reasonably plausible and, therefore, find the paper to be valuable. i do, however, want to put the analysis of the paper in a broader perspective and provide some different views on their results. 1 the residential mortgage meltdown : a financial development perspective the first part of the paper provides a nice summary of how recent events in the credit markets led to the subprime meltdown. let me offer my own view on how the recent disruptions to financial markets have many features in common with typical cycles in financial development. financial markets perform the essential economic function of channeling funds to those who have productive investment opportunities ( which can include consumer purchases of goods and houses ).

paper, it does emphasize that there are two parts of the recent disruption in the credit market : credit losses at banks and the near - collapse of broad classes of securities markets. this perspective raises the issue, which i will return to later, of whether the negative consequences of the decline in intermediation required both of these elements to be present. estimating mortgage - credit losses the paper performs a very useful function by providing estimates of the credit losses likely to be realized on the current stock of outstanding loans. not only is this calculation crucial for their analysis, it is a useful survey of three different methodologies for arriving at loss estimates. the authors first use a standard vintage curve analysis on outstanding mortgagebacked securities. although this method makes the strong assumption that future loss curves will follow the same shape as previous loss curves, albeit at much higher levels, it provides a reasonable rough guess of the magnitudes of the losses. the second method the authors use is abx pricing of subprime mortgages plus standard loss estimates on prime and near - prime mortgages to come up with loss estimates. abx prices, in principle, ought to reflect the up - to - the - minute credit losses expected by market participants as well as changes in the price of liquidity and market risk. indeed, i was worried that abx pricing might overestimate credit losses because it carries premiums for these other risks, and trading may be light. for example, the aaa - rated tranches of recent vintages are trading for around sixty - six cents on the dollar, which seems to build in either extreme credit - loss estimates or compensation for other risks. however, the authors weight the various vintages and tranches of the abx by outstanding dollar amounts and get reasonable estimates, which suggests that this approach to estimating mortgage - credit losses may have some value. the authors'third method is quite clever and uses state - level foreclosure models to estimate how declines in house prices would increase foreclosure starts and thus lead to losses. figure 1 displays a reasonably tight relationship between the rate of foreclosures started in the third quarter of 2007 and the previous four - quarter change in house prices in the fifty states and the district of columbia. this figure provides some backing for their approach, which, in effect, uses the historical relationship between house price declines and foreclosure starts in states that have had significant house price declines to estimate the likely effect of current projected house price declines