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Kevin M Warsh: Financial market developments - page 4 / 5





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and if so, they may help to ease the effects of fluctuations in liquidity should they occur. The prices and conditions may also reflect increased appetite for risk; or, far less auspiciously, they may be indicative of investor overconfidence. 7

Confidence can be fleeting. Confidence can beget complacency. If, in liquid times, investors in structured products become complacent, they may not understand fully the value of the underlying assets. High levels of confidence, perhaps even complacency, were also observable in the behavior of many financial intermediaries. Many hedge funds, growing in size and scope, invested in less-liquid assets in search of higher expected returns. Many commercial banks increased sponsorship of structured investment vehicles to invest in long- term securities, often financing them off-balance-sheet with short-term commercial paper. Those financial intermediaries that recognized the risks of extrapolating high levels of liquidity indefinitely were threatened with eroding market share and less-impressive profit profiles. They may have hoped that robust trading markets would allow them to exit positions ahead of a crowded trade. But, to paraphrase an old Wall Street saw, they don't ring a bell when the markets are at the top or at the bottom.

As you know, liquidity conditions started to deteriorate by mid-July. Subprime-mortgage markets suffered significantly from a rapid withdrawal of liquidity. They were a particularly tempting target: Many subprime mortgage products were newer, performance histories were shorter, prices were rising faster, securitization structures were more complex, disclosure was more opaque, and credit standards were weaker than most other asset classes.

But, were subprime credit problems the source of contagion causing broader reductions in liquidity and market functioning, as has become a common refrain? Or did reductions in liquidity – and concomitant changes in investor sentiment – simply manifest themselves first in the subprime-mortgage markets? If the latter is the case, then the true causes of recent financial tumult may well have preceded the turmoil in the subprime-mortgage markets altogether. And policy prescriptions should be judged accordingly.

Subprime lending: the spark, not the cause

Throughout the summer, delinquency rates for subprime adjustable-rate mortgages jumped as house prices decelerated and effective interest rates rose. The rate of serious delinquencies for subprime mortgages with adjustable interest rates reached close to 15 percent in July. Investors incurred large losses from forced sales of securities backed by subprime mortgages. Credit-rating agencies downgraded numerous securities backed by subprime and alt-A mortgages.

The resulting investor skepticism about the accuracy of ratings, combined with mounting losses at mortgage lenders, caused investors to pull back from a broad range of structured products, even though unrelated to mortgages. Financing for leveraged buyouts halted; demand for securities backed by syndicated loans evaporated. Investors began to shun non- mortgage related asset-backed commercial paper.

These subsequent financial problems may not be a reflection of subprime contagion after all. Instead, it may be that investors fundamentally lost confidence in their ability to value a broad range of assets, particularly those that rely on robust securitization and secondary markets. Moreover, uncertainty about the ability of large financial institutions to fund their commitments eroded confidence in counterparties more generally. Risk premiums and term premiums rose rapidly, and investors sought refuge. The principles, products, and practices


Warsh, "Financial Intermediation and Complete Markets."


BIS Review 104/2007

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