SF Fed Reserve President Yellen on Credit, Housing, Commodities, and the Economy
SF Federal Reserve President & CEO Janet Yellen addressed the CFA Annual Conference in Vancouver today. Her remarks addressed credit, housing, commodities, and her economic outlook.
Excerpt (emphasis mine):
Financial Markets and the Credit Crunch
[...]
This benign view [of underlying risks] may well have been linked, in part, to rapid transformations taking place in our financial system. Securitization and financial engineering fundamentally changed financial markets in a relatively short period of time, appearing to make it possible to slice and dice and spread risk more effectively—indeed, it appeared that these innovations had made the usual terms of the risk-return tradeoff more favorable.[2] The surge in lending occurred as securitization promulgated the originate-to-distribute business model—that is, underlying loans were securitized and sold to investors. Notably, the main compensation of many participants in the securitization chain came in the form of upfront origination fees. Without the strong incentives to maintain underwriting standards that exist when originating institutions keep loans on their own books, the credit quality of many of the securitized loans deteriorated significantly. Subprime mortgages are a good example, as combined loan-to-value ratios and the percentage of low- or “no-doc” loans rose steadily through 2006. And, in any case, even subprime mortgages looked like a good bet, with house prices seeming to be on an ever-upward march.
Furthermore, with the economy booming, investors, including highly leveraged investment banks, hedge funds, and SIVs (structured investment vehicles)—the so-called “shadow banking sector”—were actively seeking projects to finance and willing to increase their leverage. With interest rates so low, they were motivated to reach for higher yields on these projects.[3] Many investors found reassurance in getting involved in many of these complex securities by relying on the evaluations given by rating agencies. Unfortunately, these ratings turned out not to be very reliable.
So long as house prices kept soaring, as they did until a couple of years ago, these credit problems did not show up. But once house prices flattened out and then began to fall, it became clear that delinquencies and foreclosures on subprime and other mortgages would be far higher than had been anticipated. This arguably was the trigger of a far broader reappraisal of credit market risks and attitudes.
Clearly, the market discipline that “sophisticated investors” are supposed to provide was lacking. As we saw, even some of the largest, most sophisticated financial institutions inadequately incorporated into their risk-management models the full range of hazards entailed in the originate-to-distribute business and the liquidity risks that would result from a drying up of short-term funding. Also lacking were reliable ratings from the agencies. But financial supervisors and regulators, including the Federal Reserve, were behind the curve, as well. We missed some of the risky developments that were unfolding. Our consumer regulations were unfortunately insufficient to protect households from some egregious and unfair lending practices. And we took too long to ramp up some supervisory policies in the face of mounting risks. On a broader level, the situation exposed holes in the existing regulatory framework for financial services, which allowed some risky activities to flourish, hurting both consumers and financial stability. Significantly, the Fed was compelled to open the discount window to investment banks because of the outsized risks some took and their significant interconnectedness with the financial market infrastructure. Investment banks thus were able to operate with less capital and supervision than such access otherwise entails.
... there is much more.
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