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.
