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Bernanke: Breakdown in Credit Model Caused Crisis

Reuters
Thursday, 10 Apr 2008 | 1:54 PM ET

Breakdowns in the U.S. financial industry's model of extending credit are at the root of the current crisis, but the approach remains effective and should endure with reforms, Federal Reserve Chairman Ben Bernanke said.

Ben Bernanke
CNBC.com
Ben Bernanke

The model, known as originate-to-distribute, "broke down at a number of key points, including at the stages of underwriting, credit rating, and investor due diligence," Bernanke told the World Affairs Council.

At the same time, financial institutions were tripped up by inadequate risk management and liquidity planning, Bernanke said.

"These problems notwithstanding, the originate-to-distribute model has proven effective in the past and with adequate repairs could be so again in the future," he said.

In that credit model, one entity makes a loan to a borrower, assessing that individual's credit-worthiness and ability to repay. The loan is then sold to an institution, which bundles it with other loans to create a security, which is in turn sold to investors.

"The spreading of risk that was supposed to be one of the benefits of the originate-to-distribute model proved to be much less extensive than many believed," Bernanke said.

The Fed chairman did not comment on the outlook for the U.S. economy or interest rates in the text of his speech.

Bernanke told Congress last week that a recession is possible as the United States weathers a deep housing correction and a credit crunch paralyzing credit markets.

In his speech, Bernanke said policy-makers will not have the luxury of waiting for financial markets to stabilize before taking steps to rebuild links in the credit chain, adding that some proposed reforms may be necessary for markets to recover, Bernanke said.

"Many of the changes that have been identified, including increasing transparency, improving risk management, and attaining better coordination among regulators, could provide important support to the process of normalizing our financial markets," he said.

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