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Posted by Warren Mosler (208.49.176.241) on 14:18:59 12/02/07
Governor Randall S. Kroszner
At the Philadelphia Fed Policy Forum, Philadelphia, Pennsylvania
November 30, 2007
Innovation, Information, and Regulation in Financial Markets
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
THIS IS HIGHLY QUESTIONABLE BUT ASSUMED BY THE FED TO BE TRUE. THE
ALLOCATION IS NECESSARILY A FUNCTION OF THE MARKET FORCES OPERATING
WITHIN THE LEGISLATED INSTITUTIONAL STRUCTURE.
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. YES, THAT'S BEEN THE FED'S
ISSUE FOR THE LAST THREE MONTHS. WHAT THEY CALL 'MARKET FUNCTIONING'
AS RELATED TO THE REAL ECONOMY.
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 adjusted in response to market acceptance--or lack
thereof. During this period, market participants are seeking and
providing information so that they can properly value the product,
judge its potential for risk and return, assess its market acceptance
and liquidity, and determine the extent to which the risks of the
product can be hedged or mitigated.
When a product's track record is not well established, there should be
a strong market demand for information in order to facilitate price
discovery. Price discovery is the process by which buyers' and
sellers' preferences, as well as any other available market
information, result in the "discovery" of a price that will balance
supply and demand and provide signals to market participants about how
most efficiently to allocate resources. This market-determined price
will, of course, be subject to change as new information becomes
available, as preferences evolve, as expectations are revised, and as
costs of production change.
In order for this process to work most effectively, market
participants must utilize information relevant to value that product.
Of course, searching out and using relevant sources of information--as
well as determining what information is relevant--has its own costs.
To underscore the last point, with new instruments, it may not even be
clear exactly what information is needed for price discovery--that is,
some market participants may not know what they do not know and they
may therefore terminate the information-gathering stage prematurely,
unwittingly bearing the risks and costs of incomplete information.
HE LEAVES OUT THE FACT THAT FED MEMBER BANKS ARE SPECIFICALLY DESIGNED
TO BE OUTSIDE THIS PROCESS. THEY LEND BASED ON INTERNAL CREDIT
ANALYSIS BASED ON STANDARDS SET BY FEDERAL REGULATORS. THE LOANS ARE
REVIEWED CONTINUOUSLY REGARDING THE BORROWER'S ABILITY TO MAKE TIMELY
PAYMENT OF PRINCIPAL AND INTEREST, BOTH SHORT TERM AND LONG TERM. IF
THESE ARE NOT DEEMED ADEQUATE, LOANS MUST BE 'QUALIFIED' AND BANKS
MUST ADD TO THEIR LOSS RESERVE. FOR ALL PRACTICAL PURPOSES, BANKS
HAVE GOVT INSURED LIABILITIES WHICH EXERT NO 'MARKET DISCIPLINE' ON
ASSETS, AND THEREFORE GOVT. REGULATION IS REQUIRED TO FILL THAT
FUNCTION. THIS SYSTEM OPERATES INDEPENDENTLY OF MARKET PRICING OF
THESE BANK ASSETS. MARKET DISCIPLINE COMES VIA SHAREHOLDERS IN FIRST
LOSS POSITION.WITH REGULATORS DETERMINING APPROPRIATE CAPITAL RATIOS.
OVER THE YEARS THIS HAS PROVED A MUCH MORE STABLE PLATFORM FOR CREDIT
EXPANSION.
THE CURRENT PROBLEM AREAS ARE THE 'MARKET PRICE' BASED ACTIVITY THAT
IS OUTSIDE OF THE ABOVE STANDARD BANK MODEL
ONE RESULT HAS BEEN A SHARP DECLINE IN COMMERCIAL PAPER, FOR EXAMPLE,
AND A CORRESPONDING INCREASE IN BANK LENDING,
AS THE UNDERLYING LENDING HAS BEEN REPLACED BY TRADITIONAL, NON
MARKET, BANK LENDING AND CREDIT ANALYSIS.
Price Discovery
Due diligence is an important part of the price discovery process. The
due-diligence process allows market participants to "trust but verify"
market-provided information through a range of activities, from
assessing risks and exposures through stress-testing to assessing the
enforceability of the contracts that define the legal relationship
among originators, sponsors, investors, and guarantors. The due
diligence is complemented by risk-management structures that allow
participants to interpret, understand, and act appropriately in
response to the information in the market.
Recently we have seen how a lack of information and inadequate due
diligence and risk management have created problems in the market for
certain structured finance products. Let me focus a moment on
structured investment vehicles, or SIVs. SIVs have been created with a
variety of terms and characteristics--for example, different
underlying assets, different levels of liquidity support or
guarantees, and various triggers that require the forced sale of
assets or liquidation of the structure. Although SIVs or similar
vehicles have existed for many years, many recent SIV structures
involved a much higher level of complexity of the underlying credit
risks, legal structures, and operations. This complexity--and the lack
of information about where the underlying credit, legal, and
operational risks resided--made these products more difficult and
costly to value than many investors originally thought. Investors
suddenly realized that they were much less informed than they assumed
and, not surprisingly, they pulled back from the market.
THE BETTER WAY TO STATE THIS IS THAT RISK WAS REPRICED. THE SPREADS
GOT WIDE ENOUGH FOR BANKS TO UNDERWRITE AND 'ABSORB' THE LOAN DEMAND.
THAT'S HOW THOSE MARKETS FUNCTION UNDER CURRENT INSTITUTIONAL
STRUCTURE.
We have seen similar problems in the subprime residential
mortgage-backed securities market and the related derivatives markets.
The lack of long historical data on the performance of these
instruments, and their correlations with other assets and instruments,
made it difficult to assess their overall risk-return profile,
especially in times of stress. Moreover, in the subprime residential
mortgage-backed securities market, many market participants were
willing to proceed without conducting robust due diligence and without
establishing appropriate risk-management structures and processes.
THIS MEANS THEY PRICED THE RISK LOW ENOUGH TO 'WIN' THE RIGHT TO
INVEST. THEY CHANGED THEIR MINDS, AND AT THAT POINT OWNED OVER PRICED
SECURITIES, TO BE SOLD ONLY AT LOWER PRICES/HIGHER YIELDS. SAME
BELOW-
They did not follow "trust but verify," that is, they instead accepted
the investment-grade ratings of these securities as substitutes for
their own risk analysis. Ratings keyed to expected default or credit
loss do not adequately capture the full range or magnitude of risks to
which a product may be subject, including--as we have seen most
dramatically--market liquidity risks. In addition, some originators
may not have demanded sufficient information about the purchased
assets underlying these structures and therefore may not have fully
appreciated the credit risk of the assets and the consequential risk
that the structures would come back on balance sheet when the assets
defaulted.
When the problems in the subprime mortgage market began to emerge and
delinquencies exceeded rating agency estimates and the defaults
predicted by limited historical data, we had moved beyond our past
experience with these instruments. Information was not readily
available about the extent to which the economic context had changed,
or even whether underlying loans would or could be modified to prevent
default. When ratings were downgraded, investors lost confidence in
the quality of the ratings and hence the quality of the information
they had about subprime investments. Lack of information, a disrupted
price-discovery process, and a stressed environment led to a
reassessment of risk, not only in the subprime market but also in the
residential mortgage market across the board.
Of course, this is not the first time that participants in a market
for an innovative product have suffered losses. In the early 1990s,
participants in the collateralized mortgage obligation (CMO) market
and the markets for structured notes and certain types of interest
rate derivatives did not have adequate information about the potential
volatility and prepayment risk involved. Consequently, market
participants did not appropriately model these risks and suffered
significant losses when market interest rates rose sharply in the
mid-1990s. As in the case of the residential mortgage-backed
securities market today, the general market reaction was a flight away
from these instruments. However, over time, the market was restored as
market participants came to better understand the risks and as
standardized methods were developed to measure the risks and model the
value of these instruments under alternative scenarios. Increased
information and standardized pricing conventions, such as the use of
option-adjusted spreads, moved these instruments from the
experimentation and learning phase to the phase of broad market
acceptance.
When market participants realize that they do not have the information
necessary for proper valuation of risks, the price-discovery process
can be disrupted, and market liquidity can become impaired. A
significant investment in information gathering, processing, and
evaluation may be necessary to revive the price discovery process.
This revival is likely to take time and the market may not look the
same when it re-emerges.
WE'VE HAD THREE MONTHS SINCE THE 'CRISIS' BEGAN. WE MADE IT THROUGH
SO FAR. RISK HAS BEEN REPRICED. SPREADS ARE WIDER. LESS IS TRADING
WHICH IS NOT NECESSARILY A 'BAD THING' AT THE MACRO LEVEL. BANKS ARE
LENDING AGGRESSIVELY DIRECTLY TO BORROWERS IN GOOD STANDING.
Let me describe in a bit more detail the ways in which these
investments will take place and hence why recovery of price discovery
may be a gradual process. First, market participants will likely need
to collect more-detailed data in a more systematic manner in order to
better understand the nature and risks of the instruments and their
underlying assets. Second, investments in enhanced systems to
warehouse and model data related to these instruments will facilitate
a better understanding of their risks, particularly under stress
conditions. Third, investors need to ensure that they have the
so-called human capital expertise--that is, the people--to understand,
interpret, and act appropriately on the results of the modeling and
analysis of the information gathered. The pay-off from these
investments will be a greater understanding of risks and greater
ability to value the instruments.
YES, AND THAT'S WHY IT TOOK SEVERAL WEEKS FOR THE BANKING SYSTEM TO
'ABSORB' MARKET BASED LENDING. THAT PROCESS IS NOW WELL UNDERWAY.
The Development of Greater Standardization in a Market
Another consequence of information investments is a tendency towards
greater standardization of many of the aspects of an instrument, which
can help to increase transparency and reduce complexity. As was
demonstrated in the CMO market, as the market gains information about
a product and develops a level of confidence in that information, the
product tends to become increasingly standardized. Standardization in
the terms and in the contractual rights and obligations of purchasers
and sellers of the product reduces the need for market participants to
engage in extensive efforts to obtain information and reduces the need
to verify the information that is provided in the market through due
diligence. Reduced information costs in turn lower transaction costs,
thereby facilitating price discovery and enhancing market liquidity.
Also, standardization can reduce legal risks because litigation over
contract terms can result in case law that applies to similar
situations, thus reducing uncertainty.
The benefits of the development of standardization for enhancing the
liquidity of financial markets have a long history. One particularly
clear example dates back to the development of exchange-traded
commodities futures contracts in the mid-1800s. The standardization of
the futures markets improved the flow of information to market
participants, reducing transaction costs and fostering the emergence
of liquid markets. FOSTERED AN ARMY OF TRADERS WHO COULD HAVE BEEN
OUT CURING CANCER OR SOMETHING ELSE MORE USEFUL. LITTLE OR NONE OF
THE 'FINANCIAL INNOVATION' HAS LED TO MORE EFFICIENT ALLOCATIONS OF
REAL RESOURCES, BUT INSTEAD HAS ABSORBED THE BRIGHTEST AND BEST INTO
THE WORLD OF 'REARRANGING OF FINANCIAL ASSETS' ENCOURAGED UNDER
CURRENT INSTITUTIONAL STRUCTURE, INCLUDING TAX LAW AND TAX ADVANTAGE
SAVINGS PROGRAMS UNDER THE MISGUIDED NOTION THAT 'SAVINGS IS NEEDED TO
PROVIDE FUNDS FOR INVESTMENT' AS EVERY ECONOMIST IS (OR WAS AT ONE
TIME) WELL AWARE.
In the early days of the Chicago Board of Trade, in the mid-1850s,
standardization took the form of creating "grades" or quality
categories for commodities such as wheat, allowing for the fungibility
of grains stored in elevators and warehouses, and breaking the link
between ownership rights and specific lots of a physical commodity.
Traders no longer needed to verify that a certain quantity of grain
was of a sufficiently high grade because the exchange established a
system of internal controls in the form of grain inspectors and a
self-regulatory system to arbitrate disputes. The grain inspectors
charged a set fee to certify the quality of the grain for any receipt
traded at the board, a system with parallels to the mechanisms
employed today by the rating agencies.1
In effect, standardization and related controls reduced traders'
information requirements and, thus, their transaction costs. In 1865,
the Chicago Board of Trade standardized the delivery dates for the
contracts, thus fostering the emergence of liquid markets in which
traders could readily hedge the risk of price changes in the
commodities and contracts. A final step toward standardization came
years later with the adoption of the clearinghouse for the exchange as
the common counterparty to all of the contracts traded on the
exchange. With a central counterparty, the costs and uncertainties of
failures and restructurings were significantly reduced, thereby
reducing work-out costs and enhancing liquidity of the contracts
traded on the exchange.2 AS ABOVE, FOR WHAT FURTHER PURPOSE??? HE
IS TREATING 'MARKET FUNCTIONING' AS AN END RATHER THAN A MEANS WITH A
PROPER COST/BENEFIT ANALYSIS.
The benefits of standardization can be realized not only on organized
exchanges but also in over-the-counter markets. In more recent times,
for example, the creation of the International Swaps and Derivatives
Association (ISDA) master agreement for over-the-counter swaps and
derivatives contracts has brought about the benefits of
standardization while also allowing for product flexibility and
customization. The ISDA 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. YET THE MOST EFFICIENT
STRUCTURE WOULD BE A FUTURES CONTRACT WHICH THE DEALERS HAVE
SUCCESSFULLY BLOCKED OVER THE YEARS.
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.
HOW ABOUT JUST LET THE BANKS UNDERWRITE THE MTGS TO REGULATORY STANDARDS???
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 be able to work with their lender or
servicer to adjust their payments or otherwise change their loans to
make them more manageable.
THE GOVT HAS TO EITHER BAN THE ORIGINATION OF ADJUSTABLE RATE MTGS BUT
NOT LEGALLY ENFORCING ANY SUCH CONTRACTS OR FACE THE CONSEQUENCES OF
ALLOWING THEM, WHICH WE ARE SEEING. EITHER YOU BELIEVE IN THAT MUCH
PERSONAL FREEDOM AND RISK TAKING OR YOU DON'T.
WARREN
It is imperative that we work together as a financial services
community to look for ways to help borrowers address their mortgage
challenges, particularly for those who may have fewer alternatives,
such as lower-income families. The Federal Reserve and other
regulators have been active in encouraging lenders and servicers to
take a proactive approach to work with borrowers who may be at risk of
losing their homes. For example, the agencies have issued statements
underscoring that prudent workout arrangements that are consistent
with safe and sound lending practices are generally in the long-term
best interest of both the investor and the borrower and have had
numerous meetings with interested parties to foster the development
and implementation of work-out arrangements.
Given the substantial number of resets from now through the end of
2008, I believe it would behoove the industry to go further than it
has to join together and explore collaborative, creative efforts to
develop prudent loan modification programs and other assistance to
help large groups of borrowers systematically. I am not suggesting a
one-size-fits-all approach, but a bottom-up approach designed to
appropriately balance the needs of all parties. Getting to borrowers
who have been making payments but are at risk of falling behind before
they actually do become delinquent, for example, can help to preserve
work-out and refinancing options.
Some industry participants and consumer groups have begun to work
collaboratively to develop loan-modification templates, standards, and
principles that can help to streamline the work-out and modification
process. This can reduce transaction costs and potentially provide
timely relief to a wider range of borrowers. A systematic approach to
loan modifications would likely reduce some of the uncertainties in
the market for such subprime mortgage-backed securities, helping to
restore price-discovery and liquidity. This would help to ease the
tightening of credit conditions in the market.
I am privileged to serve as a board member of NeighborWorks America, a
national nonprofit that partners with the HOPE NOW Alliance. This
alliance is developing ways to facilitate the flow of information
between servicers and distressed borrowers and to work toward
clarification of loan-modification procedures. Increased
standardization and certainty could also benefit investors in the
mortgage market by improving information flows and the price-discovery
process, thereby improving market liquidity while at the same time
helping to avoid foreclosures and promoting sustainable homeownership.
A Regulatory Environment That Encourages Sound Risk Management and Transparency
Recent market events have underscored the need for better market
information about new products, robust due diligence to verify that
information, and risk-management strategies to utilize the information
in management decisionmaking. The supervisory agencies and the
industry both are addressing the need for improved risk management in
light of the market disruptions
The newly adopted Basel II capital framework for large
internationally-active banking organizations, for example, is an
important advance that encourages the types of investment in
information I discussed earlier. The Basel II framework is comprised
of three pillars. Pillar 1 requires information gathering and robust
modeling techniques to better take into account the risks of different
types of instruments and securities than under the traditional Basel I
framework. It also provides incentives for more robust risk management
in connection with certain higher-risk activities, such as
securitization and other off-balance-sheet activities. Pillar 2
emphasizes the further stress testing and analysis of the data in
conjunction with an ongoing evaluation of the institution's capital
adequacy in light of its risks through the internal capital adequacy
assessment process. Pillar 3 reflects the need for better information
through investments in data gathering and analysis that are reflected
in enhanced public disclosures and regulatory reporting.
More-comprehensive and more-transparent information allows investors
to better understand the banking organization's risk profile and thus
reduces transaction costs and facilitates price discovery and market
liquidity. The three pillars of Basel II promote precisely the three
types of investment in information discussed earlier that facilitate
the price discovery process.
In addition to supervisory initiatives, industry leaders' efforts to
influence the adoption of sound practices and codes of conduct can
efficiently and effectively facilitate market-correcting behaviors. To
this end, the industry is actively engaged in efforts to improve sound
practices for risk management through improved stress-testing
practices to cover contingent exposures, marketwide events, and
potential contagion and enhanced due diligence and modeling for new
products. As they look into the causes of the recent market
disruptions and determine the appropriate response, both supervisory
and industry groups are carefully analyzing the weaknesses in risk
management and the lack of transparency in complex structures--and the
implications of that lack of transparency for proper valuations.
Conclusion
The recent market disruptions have dramatically underscored the
importance of gathering and analyzing information about innovative
products. When the price-discovery process for a product is disrupted,
both investors and sellers need to engage in a period of information
gathering, processing, and analysis in order to re-establish a market
price. This can be a gradual process and one that results in
fundamental changes to the market for the product. Efforts underway by
both supervisors and the industry should encourage improvements in
risk analysis and management and, thus, price discovery. We are
hopeful that our efforts to increase the standardization of
loan-modification options and processes for subprime loans will help
to provide more information to lenders, investors, homeowners, and
communities faced with potential mortgage loan defaults while at the
same time helping to provide more timely relief for borrowers in
distress.
--------------------------------------------------------------------------------
Footnotes
1. 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. Return to text
2. See Kroszner, "Can the Financial Markets Privately Regulate Risk?",
p. 601. Return to text
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