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Posted by Paul Palmer (72.93.220.55) on 12:00:22 12/06/07
In Reply to: comments on Kroszner speech posted by Warren Mosler
: 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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