Below is the text to a speech given by Federal Reserve Chairman Ben Bernanke on "The Recent Financial Turmoil and its Economic and Policy Consequences" on October 15, 2007 in New York City.
The Recent Financial Turmoil and its Economic and Policy Consequences
The past several months have been an eventful period for the U.S. economy. In financial markets, sharpened concerns about credit quality induced a retrenchment by investors, leading in some cases to significant deterioration in market functioning. For some households and firms, credit became harder to obtain and, for those who could obtain it, more costly. Tightening credit conditions in turn threatened to intensify the ongoing correction in the housing market and to restrain economic growth. In response to these developments, the Federal Reserve has taken a number of measures to help ensure the normal functioning of financial markets and to promote sustainable economic growth and price stability. In my remarks this evening I will review recent events, discuss the Federal Reserve's responses to those events, and conclude with some comments on the economic outlook in light of recent developments. Although financial markets around the world have come under pressure in the past few months, I will focus my comments primarily on the United States. I will also have little to say this evening about the serious implications of rising rates of mortgage delinquency and foreclosure for troubled borrowers and their communities or about the Federal Reserve's responses to these important problems; I have discussed these issues several times in the past and will return to them in the future.
The Origins and Evolution of the Financial Turmoil
Overall, U.S. economic performance so far this year has been reasonably good. The rate of economic expansion slowed somewhat in late 2006 and early 2007, but growth in the second quarter was solid and some of that momentum appears to have carried over into the third quarter. The pace of private-sector job creation has slowed this year, but the unemployment rate has moved up only a little from its recent lows. And, although energy prices have been volatile, indicators of the underlying inflation trend, such as core inflation, have moderated since the middle of last year.
Moderate growth in overall economic activity has continued despite a notable contraction in the housing sector that began in the second half of 2005. The housing correction has intensified this year as demand has declined further, inventories of unsold new homes have climbed relative to sales, and house prices have decelerated, with some areas of the country experiencing outright declines in home values. In response to weak demand and bloated inventories, homebuilders have sharply curtailed new construction. The decline in residential investment directly subtracted about 3/4 percentage point from the average pace of U.S. economic growth over the past year and a half. In its regular reports to Congress, most recently in July, the Federal Reserve Board has highlighted as a downside risk the possibility that housing weakness might spill over to other parts of the economy--for example, by acting as a restraint on consumer spending. Thus far, however, direct evidence of such spillovers onto the broader economy has been limited.
The housing correction has taken a more visible toll on the financial markets. In particular, since early this year, investors have become increasingly concerned about the credit quality of mortgages, especially subprime mortgages. The rate of serious delinquencies has risen notably for subprime mortgages with adjustable rates, reaching nearly 16 percent in August, roughly triple the recent low in mid-2005.1 Subprime mortgages originated in late 2005 and 2006 have performed especially poorly, in part because of a deterioration in underwriting standards. Moreover, many recent-vintage subprime loans will experience their first interest-rate resets in coming quarters. With the softness in house prices likely to make refinancing more difficult, delinquencies on these mortgages are expected to rise further.
At one time, most mortgages were originated by depository institutions and held on their balance sheets. Today, however, mortgages are often bundled together into mortgage-backed securities or structured credit products, rated by credit rating agencies, and then sold to investors. As mortgage losses have mounted, investors have questioned the reliability of the credit ratings, especially those of structured products. Since many investors had not performed independent evaluations of these often-complex instruments, the loss of confidence in the credit ratings led to a sharp decline in the willingness of investors to purchase these products. Liquidity dried up, prices fell, and spreads widened. Since July, few securities backed by subprime mortgages have been issued.
Investors' reluctance to buy has not been confined to securities related to subprime mortgages. Notably, the secondary market for private-label securities backed by prime jumbo mortgages has also contracted, and issuance of such securities has dwindled.2 Even though default rates on such mortgages have remained very low, the experience with subprime mortgages has evidently made investors more sensitive to the risks associated with other housing-related assets as well.
The problems in the mortgage-related sector reverberated throughout the financial system and particularly in the market for asset-backed commercial paper (ABCP). In this market, various institutions have established special-purpose vehicles to issue commercial paper to help fund a variety of assets, including some private-label mortgage-backed securities, mortgages warehoused for securitization, and other long-maturity assets. Investors had typically viewed the commercial paper backed by these assets as quite safe and liquid, because of the quality of the collateral and because the paper is often supported by banks' commitments to provide lines of credit or to assume some credit risk. But the concerns about mortgage-backed securities and structured credit products (even those unrelated to mortgages) greatly reduced the willingness of investors to roll over ABCP, particularly at maturities of more than a few days. The problems intensified in the second week of August after the announcement by a large overseas bank that it could not value the ABCP held by some of its money funds and was, as a result, suspending redemptions from those funds. Some commercial paper issuers invoked their right to extend the maturity of their paper, and a few issuers defaulted. In response to the heightening of perceived risks, investors fled to the safety and liquidity of Treasury bills, sparking a plunge in bill rates and a sharp widening in spreads on ABCP.
The retreat by investors from structured investment products also affected business finance. In particular, issuance of collateralized loan obligations (CLOs) and collateralized debt obligations (CDOs), which in turn had been major buyers of leveraged syndicated loans, fell off significantly during the summer. Demand for leveraged loans slowed sharply, reducing credit access for private equity firms and other borrowers seeking to finance leveraged buyouts (LBOs).
Concerns about liquidity and credit risk surfaced even in markets in which securitization plays a much smaller role. For example, spreads on lower-tier unsecured commercial paper jumped and issuance was limited to very short maturities. In corporate bond markets, issuance of speculative-grade bonds dropped off sharply as risk spreads widened. And although equity prices have moved up on balance since late spring, swings in prices have been large; indeed, the expected stock-price volatilities implicit in options prices roughly doubled during the summer before falling back more recently.
As the strains in financial markets intensified, many of the largest banks became concerned about the possibility that they might face large draws on their liquidity and difficult-to-forecast expansions of their balance sheets. They recognized that they might have to provide backup funding to programs that were no longer able to issue ABCP. Moreover, in the absence of an active syndication market for the leveraged loans they had committed to underwrite and without a well-functioning securitization market for the nonconforming mortgages they had issued, many large banks might be forced to hold those assets on their books rather than sell them to investors as planned. In these circumstances of heightened volatility and diminished market functioning, banks also became more concerned about the possible risk exposures of their counterparties and other potential contingent liabilities.