Over the last several decades we've seen an evolution from a bank-centered financial intermediation system to a market-centered system. As a result, lenders have become investors, loan spreads have become investment yields, and individual loans have become the feedstock of pools of like assets brought together through a process known as securitization. These changes have had significant implications both for loan underwriting and where in the system loans are ultimately held. In terms of underwriting, the old "banker-looking-borrower-in-the-eye" business model has been largely replaced by an "originate and distribute" business model.

[W]e would expect that the direct effect of current events on small businesses would be limited.  Indeed, the data we have on business lending at small banks show that such loans have continued to expand at a fairly robust pace through mid-October.  Such data and our conversations with bankers suggest that, at least to date, the supply of credit to small businesses remains healthy.  

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. Comprehensive data about how many loan workouts and modifications have actually occurred are not available, but some reports suggest that the numbers may be limited thus far.

Given the substantial number of resets from now through the end of 2008, however, I believe it would behoove the industry to join together and explore collaborative, creative efforts to develop prudent loan modification programs and other assistance to help large groups of borrowers systematically.

Second, I believe that modernization of programs administered by the Federal Housing Administration, which has considerable experience helping low- and moderate-income households obtain home financing, could also help avoid foreclosures. FHA modernization could give the agency the flexibility to work with private-sector lenders to expedite the refinancing of creditworthy subprime borrowers and to design products that improve affordability through such features as variable maturities or shared appreciation.

Third, we must pursue initiatives to prevent these problems from recurring, and the Federal Reserve is making strides in this direction. ... For example, as I mentioned earlier, failure to escrow for taxes and insurance can lead to a situation akin to payment shock for borrowers. It is a common practice for these payments to be escrowed in the prime markets, and I see no reason that escrows should not be standard practice in the subprime markets too.

In our research, we looked at what happened to homeowners who used subprime loans to buy their homes and found that five years later, 90 percent were either still in their house or had profitably sold it.  While our research also shows that number will likely be lower for the most recent vintages, which already exhibit elevated defaults, most subprime buyers have a positive experience with homeownership. So, perhaps the most critical issue is that financing that supports responsible subprime lending continues, despite recent problems. Since the broker channel has been disrupted, as described earlier, I believe there is an opportunity for commercial and savings banks to help provide liquidity in this market. Most commercial and savings banks were not involved in originating subprime mortgages and are well capitalized, and may have profitable opportunities to explore in this market.

I am hopeful that financial institutions will play an important role in providing financing for many of the borrowers facing higher rates as their mortgages reset. In the past, rate-resets may not have been as problematic as they could be now, because borrowers had an easier time refinancing or selling. As we look at the situation now, we want to see borrowers continue to have the option to refinance, and want to see lenders continue lending so that resets do not become an increasing problem. As I said a moment ago, perhaps the most critical issue is that financing that supports responsible subprime lending continue.

Should we view the current developments and concerns in credit markets as a wholesale reassessment (or repricing) of risk by investors, and are the recent problems related to securitizing assets likely to have a longer lasting impact on the economy or financial markets?

I think the answer is no, investors are not reassessing risk in a wholesale way. Consider that a variety of assets that normally are impacted by investor desire for risk reduction have shown little reaction to current problems. For example, if one looks at emerging market debt, or stock prices in emerging economies, the current problems have left little trace in the data. Prices for stocks in many emerging markets are close to or at their highs for the year.

By contrast after September 11, 2001 and during the problems triggered by Long-Term Capital Management, stocks in many emerging markets fell sharply. Similarly, emerging market debt has shown only a modest widening of spreads. Following the September 11 attacks and during the Long-Term Capital Management problems, emerging market interest rates rose sharply.

Short-term debt markets, where relatively low risk financial assets are traded primarily between large financial institutions, are experiencing significantly reduced volumes and unusually large spreads. This is consistent with liquidity problems rather than a change in the willingness to hold risky assets in general.

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.

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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.

Fortunately, legislative and regulatory changes in the U.S. over the past several decades have allowed banks and other financial firms to diversify their portfolios of assets and their geographic boundaries. Institutions that make mortgage loans no longer are limited to taking deposits within limited geographic areas. They no longer are restricted as to what interest rate they can pay on those deposits. And they no longer are prevented from making other types of loans. In addition, financial innovations, such as asset securitization, have allowed the spreading of risks in the financial system. This means that today banks and many other financial institutions are much better diversified than during previous housing cycles. Thus, both deregulation of the financial system and innovations in financial products have lessened the risk of asset price declines triggering substantial adverse effects in the financial sector. 

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. 

As a final thought, I counsel policymakers and market participants alike to remember that no two crises are the same.  Recall that the Asian crisis of 1997-98 actually manifested itself differently across Asian countries, with each country having its own set of problems and needing to find its own solutions.  In other words, there is never a single remedy to each crisis and each brings its own surprises and risks.  Clearly, we can all learn a lot from past crises--which is the value in holding conferences like this one.  But we should not assume that past remedies will fully solve the next set of problems or address all future risks.  The key is to take lessons from the past and tailor them appropriately to future situations of potential distress.

The markets for asset-backed commercial paper and for lower-rated unsecured commercial paper market also have suffered from pronounced declines in investor demand, and the associated flight to quality has contributed to surges in the demand for short-dated Treasury bills, pushing T-bill rates down sharply on some days. Swings in stock prices have been sharp, with implied price volatilities rising to about twice the levels seen in the spring. Credit spreads for a range of financial instruments have widened, notably for lower-rated corporate credits. Diminished demand for loans and bonds to finance highly leveraged transactions has increased some banks' concerns that they may have to bring significant quantities of these instruments onto their balance sheets. These banks, as well as those that have committed to serve as back-up facilities to commercial paper programs, have become more protective of their liquidity and balance-sheet capacity.

The Federal Reserve will do all that it can to prevent fraud and abusive mortgage lending practices.  However, any new rules should be drawn clearly to avoid creating legal or regulatory uncertainty that could have the unintended consequence of restricting consumers' access to responsible subprime credit.  

There are good reasons to think that these developments have made the financial system more resilient to shocks originating in the real economy and have made the economy less vulnerable to shocks that start in the financial system. Borrowers have a greater variety of credit sources and are less vulnerable to the disruption of any one credit channel; risk is dispersed more broadly to people who are most willing to hold and manage it. One can see the effects of these changes in the reduced incidence of financial crises in recent years. From the 1970s through the early 1990s, we seemed to be in almost continuous crisis mode. These crises were centered on depository institutions, and because borrowers were so dependent on depository institutions for credit availability, problems at depository institutions meant problems for the financial system and for the economy more generally.

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But we certainly should not read this experience as meaning that we are free of systemic risk--the risk of financial-sector problems spilling into the real sector or aggravating already difficult economic circumstances. Indeed, I see several reasons for carefully considering the potential for such problems to emerge.

New players and new instruments have become important since 2002, when the last adverse credit cycle peaked. New and already existing market participants are maneuvering for greater shares in a rapidly evolving market structure. Although leverage has declined in the nonfinancial businesses whose credit is being priced and traded, it may well have increased in the structure of intermediary finance. In any event, the growth of tranched CDOs and other structured credit products with substantial embedded leverage has made it more difficult to assess the degree of leverage of individual institutions or of the financial system as a whole.

In addition, the extraordinarily rapid growth of credit derivatives markets in the past few years has occurred against the backdrop of relatively benign macroeconomic performance--good global growth, low inflation, historically high corporate profits and low business failures, and reasonably predictable monetary policies. Partly as a consequence, the prices of financial assets seem to embody relatively low expected volatilities and relatively little reward for taking credit risk or for extending the duration of investor portfolios.

Financial shocks take many forms. Some, such as in 1987 and 1998, involve a sharp increase in risk premia that precipitate a fall in asset prices and that in turn leads to what economists and engineers call "positive feedback" dynamics. As firms and investors move to hedge against future losses and to raise money to meet margin calls, the brake becomes the accelerator: markets come under additional pressure, pushing asset prices lower. Volatility increases. Liquidity in markets for more risky assets falls.

In systems where credit is more market-based and more credit risk is in leveraged financial institutions outside the banking system, a sharp rise in asset-price volatility and the concomitant reduction in market liquidity, can potentially have greater negative effects on credit markets. If losses in these institutions force them to withdraw from credit markets, credit availability will decline, unless or until other institutions in a stronger financial position are willing to step in. The greater connection between asset-price volatility, market liquidity and the credit mechanism is the necessary consequence of a system in which credit risk is dispersed outside the banking system, including among leveraged funds. This does not make the system less stable, though, only different. For if risk is spread more broadly, shocks should be absorbed with less trauma. Moreover, the system as a whole may be less vulnerable to distortions introduced by the moral hazard associated with the access that banks have to the safety net.