The past two months have been quite unusual for financial markets. Short-term liquidity has been disrupted for almost two months, as investors have reevaluated the securitization process. I am hopeful that with appropriate underwriting, the securitization process and the ABCP [asset-backed commercial paper] will continue to be a source of financing for a wide range of assets.

Of course, we all want to consider whether the recent problems related to securitizing assets are going to have a longer lasting impact on the economy or financial markets. Securitizations have made it possible to efficiently finance pools of assets. In particular, investors with low risk tolerance were willing to buy what they thought were investment grade securities without a detailed understanding of the underlying assets as long as they had confidence in the ratings of the securities. To the extent that these investors have less confidence in ratings, they may choose to buy government or agency securities, where they do not need to make an independent analysis of potential credit risk. In part, this accounts for the reduction in rates on government securities relative to other financial instruments over the past two months.

As questions have been asked on ratings of securities, many investors have chosen not to roll over commercial paper that was not backed by solid assets and did not have liquidity provisions provided by banks. This freeze-up, of course, means problems for financing a variety of assets, including mortgages, student loans, and home-equity loans.

...

The alternative to securitizations and financing assets with commercial paper is financing by commercial banks. Fortunately, most banks are very well capitalized and have the ability to finance these assets. In fact, bank balance sheets did expand in both August and September, reflecting in part banks holding assets on their balance sheet that have been difficult to securitize. However, while banks have the capacity to finance many of these assets, it is likely that the cost of financing for these assets will increase if they are done by banks rather than through financial markets.

My expectation is that over time, investors will gain more confidence in their ability to evaluate the quality of ratings, and that conservatively underwritten securitizations and asset-backed commercial paper will find acceptance by investors. A reevaluation of ratings and the models used to determine ratings, and a greater onus on investors to understand the underlying assets and securities they are purchasing is likely to make these markets more resilient. However, this process of evaluation may take some time. While we have seen improvement in financial markets over the past month, we continue to observe wider spreads and reduced volumes on securitized products, which may remain until investor confidence has been restored.

The Federal Reserve has neither the power nor the desire to bail out bad investments. We do have the responsibility to do what we can to maintain normal financial market processes. What that means, in my view, is that we want to see restoration of active trading in assets of all sorts and in all risk classes. It is for the market to judge whether securities backed by subprime mortgages are worth 20 cents on the dollar, or 50 cents, or 100 cents. Obviously, the market will judge different subprime assets differently, based on careful analysis of the underlying mortgages. That process will take time, as it is expensive to conduct the analysis that good mortgage underwriting would have conducted in the first place. Although there is a substantial distance to go, restoration of normal spreads and trading activity appears to be under way, and we can be confident that in time the market will straighten out the problems. We do not know, however, how much time will be required for us to be able to say that the current episode is over.

The scientific principle that financial frictions matter to economic fluctuations has led to increased attention at central banks to concerns about financial stability. Many central banks now publish so-called Financial Stability reports, which examine vulnerabilities to the financial system that could have negative consequences for economic activity in the future.

A change in monetary policy would be required if the outlook for the economy changes in a way that is inconsistent with the Fed’s goals of price stability and maximum sustainable economic growth. Certainly, standing here today, it is obvious that tighter credit conditions and disruptions in financial markets have increased the uncertainty surrounding our forecasts of the economy. The FOMC continues to monitor incoming data and other economic information for signs that these disruptions are having a broader impact on the economy. In my view, it will be very important to assess such information in light of the Fed’s commitment to achieving its long-run goals of price stability and sustainable economic growth.

Second, in my view, we're witnessing more than just a repricing of risk. The credit markets of recent years feasted on a low cost of capital through leveraged investing and aggressive financing structures at both the retail and wholesale levels. I believe we're also seeing a broad retreat from higher-risk practices, such as

• no document/no equity mortgages,
• covenant-light leveraged buyouts, and
• the carry trade—in other words, borrowing in one currency to invest unhedged in debt instruments in another.

I believe we've been experiencing the unpleasant process of the financial world changing its ways after a prolonged period of relatively cheap credit, and in consequence, high leverage. What we've been going through is an intense adjustment in both price and practice, and this process may be continuing. 

It is not the responsibility of the Federal Reserve--nor would it be appropriate--to protect lenders and investors from the consequences of their financial decisions.  But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy.

...

Well-functioning financial markets are essential for a prosperous economy… The Federal Reserve stands ready to take additional actions as needed to provide liquidity and promote the orderly functioning of markets...

...

The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets.

    William Poole, president of the Federal Reserve Bank of St. Louis, said there's no sign that the subprime-mortgage rout is harming the broader U.S. economy, and an interest-rate cut isn't yet needed.   ``I don't see any impact as yet on the real economy or on the inflation rate,'' he said in an interview in the bank's boardroom. ``Obviously, there could be an impact, but we have to rely on some real evidence.''
     Barring a ``calamity,'' there is no need to consider an emergency rate cut, Poole said. His comments were the first by a Fed official since the U.S. central bank joined counterparts in
Europe and Asia to inject emergency funds after a surge in money-market rates. The Fed has added $71 billion of reserves in the past five trading days.
     Poole, 70, said businesses have maintained their hiring and investment plans and banks have sufficient capital to weather the credit-market turmoil. The St. Louis Fed chief stressed that the best course is for policy makers to assess the latest economic data when they next meet Sept. 18. The comments contrast with the certainty that traders put on a rate cut next month.   ``If the data confirm the market's view that the economy is sagging, we'll have to decide whether to share that view,'' said Poole, who votes on the rate-setting Federal Open MarketCommittee this year. He cited the monthly jobs, retail sales and industrial production reports as key gauges he'll be watching.

As reported by Bloomberg News

Central bankers have one instrument (the policy rate) and changes in that instrument are likely to affect other assets, not just the one whose price is rising rapidly. In the U.S., house prices and stock prices do not necessarily move in tandem. Yet, preemptively raising the fed funds rate to slow a rise in house prices may affect the stock market and other assets, not just the housing market. By focusing excessive attention on one sector or asset, the law of unintended consequences may raise its ugly head, resulting in more economic harm than good.

We need to accept that accidents will happen--that asset prices will fluctuate, often over wide ranges, and those fluctuations will be driven in part by trading strategies, by the cycles of greed and fear that have always been with us, and by the ebb and flow of competition for market share. The fluctuations will result in redistributions of wealth and, on occasion, will confront us with financial crises. But we cannot and should not try to prevent this process through a monetary policy that puts special emphasis on stabilizing asset prices or through regulatory policies that limit access to markets by qualified participants or that attempt to restrain competition materially. Monetary policy that proactively leans against asset price movements runs a considerable risk of yielding macroeconomic results that fall short of maximum sustainable growth and price stability. Regulatory policies that try to prevent failures of core participants or others under all conceivable circumstances will tend to stifle innovation and reduce our economy's potential for long-run growth.

Financial markets over the past several years have been characterized by an unusual constellation of low forward interest rates, ample liquidity, low risk premia and low expectations of future volatility. In some markets, asset prices have risen substantially, and credit growth has expanded rapidly. In credit markets more generally, spreads have declined to levels that reflect very low expectations of near term losses and credit standards have weakened.

It would not be accurate to say this is a world without volatility, for we have had a series of episodes of sharp declines in asset prices and increases in volatility. But these episodes have been contained and short lived, with markets recovering relatively quickly and with little appreciable effect on global economic activity.

The dramatic changes we’ve seen in the structure of financial markets over the past decade and more seem likely to have reduced this vulnerability {to financial crashes}. The larger global financial institutions are generally stronger in terms of capital relative to risk. Technology and innovation in financial instruments have made it easier for institutions to manage risk. Risk is less concentrated in the banking system, where moral hazard concerns and other classic market failures are more likely to be an issue, and spread more broadly across a greater diversity of institutions.

And yet this overall judgment, that both financial efficiency and stability have improved, requires some qualification. Writing a decade ago about the history of the financial shocks of the 1980s and early 1990s, Jerry Corrigan argued that these same changes in financial markets we see today, though less pronounced then than now, created the possibility that financial shocks would be less frequent, but in some contexts they could be more damaging. This judgment, that systemic financial crises are less probable, but in the event they occur could be harder to manage, should be the principal preoccupation of market participants and policymakers today.

What factors might contribute to this risk, a risk that could be described as the possibility of longer, fatter tails? One reason is a consequence of consolidation...  Another reason is the consequence of leverage...  A third reason is the consequence of long periods of low losses and low volatility.

But at this point, it seems to me there is no, my judgment, no pressing need for any immediate action {in response to the drop in the stock market}. There is a lot of stability in the market responses themselves. Just for example, should it turn out, this is not a forecast by any means, but should it turn out that the economy is weaker than the prevailing baseline forecasts that I talked about, then you'll see interest rates in general declining in anticipation of future Federal Reserve action, and that will help to stabilize the economy and prevent the weakness from developing into a serious matter.

In comments to reporters after his speech, as reported by Bloomberg News

Many signs point to a continuation of this high pace of equity retirements. Valuations for many firms appear attractive to private equity sponsors. (Although, as I noted earlier, stock prices have risen quite a bit since 2002, their gains have been far outstripped by the boom in earnings.) Lower valuations for firms in industries that are in the throes of downsizing also provide opportunities for LBOs.