2007 Annual Report

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By Charles L. Evans, President and CEO

Financial markets have been characterized by significant turmoil since the summer of 2007. Even as this annual report went to press in April of 2008, credit conditions remained tight, and market volatility continued to be high. These market disruptions raise many issues, but one of particular importance to the Federal Reserve System is the appropriate role of public policy in response. As the premier public policy institution for addressing financial stability issues in the U.S., the Fed must understand the underlying causes of financial disruption in order to design an appropriate policy response.

Senior Vice President David Marshall, head of the Chicago Fed's Financial Markets Group, contributed to the development of this essay. It is derived from a speech given by Charles Evans in Chicago in late November of 2007. The opinions expressed herein represent the opinions of the author, and do not necessarily reflect the views of the Federal Open Market Committee or the Federal Reserve System. The essay was strongly influenced by the ideas of Riccardo Caballero and Arvind Krishnamurthy. (See R. Caballero and A. Krishnamurthy, 2008, "Collective Risk Management in a Flight to Quality Episode," forthcoming, Journal of Finance.)

This article focuses on one such underlying cause of financial disruptions: innovation. This is a source of great benefit for our economy and our standard of living. But, like any sort of innovation, financial innovation can be disruptive. To quote Joseph Schumpeter, economies progress via a process of "creative destruction." Financial turmoil can be a way in which this sort of creative destruction works in the financial sector.

This article discusses recent market turmoil, looks at the role that financial innovation plays in such disruptions, and then explores why even highly beneficial innovations may be disruptive when first introduced. It concludes with some thoughts about the role of the Fed in responding to disruptions.

RECENT TURMOIL IN FINANCIAL MARKETS

Over the last fifteen years, financial markets have been characterized by a remarkable variety of innovative instruments and practices, including securitized cash flows, structured investment vehicles, and a veritable explosion of derivative contracts. These innovations not only enabled the creation of new financial products and opened up new sources of funding for businesses and consumers, but also directed these funds to a broader range of borrowers. Businesses and consumers who were previously unable to tap a wide range of funding sources gained access to credit at a lower cost. Financial institutions also benefited from these developments, increasing their fee-based income and overall profitability while economizing on expensive capital.

As we entered 2007, benign conditions generally prevailed. There was substantial liquidity in financial markets, and investors continued to place an unusually low price on risk. This state of affairs came to an end suddenly in the summer of 2007. In response to increased default rates on subprime mortgages, risk avoidance rose sharply, and market participants reduced their perceived value of all financial instruments with subprime exposure.

In addition, market participants started to question the value of other securities. This could be seen in the market for asset-backed commercial paper-known as ABCP-where rates soared even for paper supported by assets unrelated to subprime mortgages. Many ABCP issuers and other borrowers had to turn to very short-term financing, as lenders were unwilling to commit funds at normal terms because of uncertainty over collateral valuation and other counterparty risks. Moreover, there were periods in August when markets in certain debt instruments virtually disappeared. Without actual market transactions, it became difficult to assess the fair value of the more complex securities.

THE LINK BETWEEN FINANCIAL INNOVATION AND FINANCIAL TURMOIL

Economic history has much to teach us about financial crises. Banking panics were common in the nineteenth and early twentieth centuries. The Panic of 1907 was particularly severe and ultimately led to the establishment of the Federal Reserve System six years later. More recent episodes include the Penn Central commercial paper default in 1970, the stock market crash of 1987, and the disruption associated with the Russian default in 1998.

Each of these episodes, as well as the recent turmoil, had unique features. But there is an important common element to them: In each case, the event was associated with a drying up of liquidity. The most liquid assets are those that can be immediately used to discharge indebtedness: cash, bank reserves, and the like. When liquidity is said to "dry up," market participants find it increasingly difficult to convert otherwise sound assets into these more liquid media of exchange. This would be the case if lenders are unwilling to accept the illiquid assets as collateral, if dealers in these assets substantially widen bid-ask spreads, or if transactions in these securities simply cease to occur.

Why do periods of financial stress occur periodically, and why is liquidity an integral part of these events? Surprisingly, innovation in financial markets can play an important role. Continuous innovation is one of the key strengths of our economy. Financial innovation enhances markets' ability to allocate capital and risk. But during periods of rapid financial innovation, it can take time for market participants to learn how these innovative instruments and practices operate, especially in the event of falling asset prices.

To elaborate on this theme a bit, think about a financial innovation, say, the development of some new type of derivative contract introduced at a time when markets are expanding. The innovation performs well and becomes widely used, and market participants look at this record of success when designing risk-management systems. Now suppose that something happens to stress the market. The new contract may interact with market forces in ways that are largely unexpected. The strategies that market participants had used to quantify and manage risk may not adequately encompass the events and interactions now taking place, making these risk-management strategies inadequate to address the unexpected developments. A natural response may be to pull back, conserve liquidity, and curtail trading in risky markets until a clearer picture of the level of risk emerges. If market participants were to withdraw from risk-taking in this way en masse, the result would be a liquidity crisis. Interestingly, a body of academic research exists that explores precisely this process: That when investors can't quantify a particular type of risk, they may respond by avoiding that risk entirely.¹

Recent financial events seem to fit this narrative in many ways. The innovation behind the recent difficulties relates to the widespread use of the originate-to-distribute business model, in which mortgages are funded by selling them bundled together in highly structured securities. Of course, mortgages have been securitized for many years, but there are two features of this business model that are relatively new and that are particularly important for the current situation. The first is the extension of the originate-to-distribute model to subprime mortgages. Subprime mortgages represented only 8.5 percent of the mortgage-backed securities (MBSs) issued in 2000. By the end of 2006, this fraction had increased to 20 percent.

The second feature is the increasing use of multiple layers of structure. For example, a mortgage originator may sell a portfolio of mortgages to an intermediary, who in turn divides up the cash flow into collateralized debt obligations (CDOs) of different risk tranches. These CDOs can be sold directly or can be combined with other securities to back instruments such as ABCP, and so on. In all, there may be numerous layers of structure between the original mortgage loans and the ultimate providers of funds.

The benefit of this complex structuring is that it accommodates different levels of risk tolerance on the part of different investors, thus tapping a wider range of funding sources. However, these multiple layers of structure can be extremely opaque, making it more difficult for the ultimate providers of funds to assess the true level of risk they are taking on.

These innovations in structured housing finance had never been tested in a period of widespread weakness in housing markets. But with the recent declines in housing prices, these structured securities have behaved quite differently than they did during better times. For example, many investors appeared to have assumed that the triple-A tranche of a sub-prime MBS would act like a triple-A corporate bond, which carries little default risk and low downgrade risk. We now know that these highly rated MBSs have a risk profile rather different from a comparably rated corporate obligation. The rating of an MBS is less certain than that of a corporate bond, so MBSs have much greater downgrade risk. In addition, most of the default risk of a corporate bond is idiosyncratic to the firm, so it can be readily diversified away by investors. In contrast, a security backed by a diverse pool of mortgages has little idiosyncratic risk. Most of the risk in these securities is due to common systematic factors, such as the general movements in home prices. This sort of risk is considerably more problematic for investors than idiosyncratic risk, because it can't be diversified away.

These characteristics of MBSs were unanticipated during the quiescent period before the summer of 2007, but they became apparent during the ensuing turmoil. We saw abrupt and unexpectedly large ratings downgrades of triple-A-rated MBSs and other collateralized mortgage debt obligations, with ratings declines of ten notches or more not uncommon. The perceived downside risk of these securities increased in a highly correlated fashion, as would be expected for securities sharing the same systematic risk factors. Many market participants started calling into question the safety of securities that had received high scores from the ratings agencies. For example, even the so-called super-senior tranches of CDOs, thought to be extremely well insulated from losses, were shunned by investors. These investors also began to shun other types of structured securities, even those completely free of mortgage-related collateral.

“The Fed and other public policy institutions play an important role in monitoring and facilitating efficient market functioning.”

An important factor influencing these developments was the complexity of the structured credit products used to finance mortgages. This complexity made it difficult and costly for the ultimate investors to learn about the underwriting standards being applied to the original mortgages. There were few defaults during the long period of rising home prices, and investors paid little attention to the growing evidence of lax underwriting, such as high loan-to-value ratios, negative amortization, and deficient documentation. But when housing markets weakened, the consequences became apparent. Default rates on subprime loans rose far beyond those anticipated by the risk-management models commonly in use.

History provides us with other examples of linkages between financial innovations and liquidity crises, and there are some interesting common elements between them and the current situation.² Consider the unexpected bankruptcy in 1970 of Penn Central, a major railroad that was an important issuer of commercial paper. The Friday before its collapse, Penn Central was seen to be in financial trouble, but the company was expected to receive a government loan guarantee that would keep it afloat. Over the weekend, it became evident that no government support was forthcoming, and Penn Central declared bankruptcy. Investors woke up Monday morning with commercial paper that was essentially worthless. Penn Central's failure raised doubts about the integrity of the commercial paper market in general. A predictable flight to quality ensued: Treasury yields declined, and corporate debt yields rose.

The financial innovation in the Penn Central example was the use of commercial paper to substitute for bank loans. Commercial paper had become an important source of funds for large firms in the 1960s, but risk-management systems for commercial paper remained untested until the recession of 1969-70. The Penn Central bankruptcy was a rude awakening that these systems were inadequate.

The stock market crash of October 19, 1987, may also be associated with financial innovation. While there is no universally accepted explanation for the sharp drop, a widely held theory focuses on the innovation of portfolio insurance.3 Portfolio insurance is a form of computerized dynamic hedging that can involve automatic selling after certain market declines. Portfolio insurance implicitly relies on the availability of market liquidity-that is, the ability to sell shares at the prevailing price-when the automatic selling kicks in. Prior to October 1987, this innovation seemed to work well. But on October 19, liquidity was grossly inadequate. It appears that computerized selling into the declining market turned the morning's losses into a wholesale rout that was completely unforeseen by existing risk-management models. As with the Penn Central episode, a flight to quality followed, with Treasury yields falling dramatically.

A third example is the market crisis in the fall of 1998 that was triggered by the Russian bond default. This shock caused bond spreads to widen in both emerging and developed countries, and induced a major liquidity crisis. The financial innovation that magnified this shock was the growth of highly leveraged and opaque hedge funds, notably Long Term Capital Management (LTCM). The possibility that failing hedge funds would respond to falling market prices with a fire sale of available assets led intermediaries to withdraw liquidity from the market and reinforced the initial shock.

In each of these cases, markets eventually learned from the crises. This resulted in improved approaches to risk management that could address the new types of market risks. The commercial paper default of Mercury Financing in 1997 was much larger than Penn Central, yet caused virtually no disruption to the markets. Similarly, the 6 percent fall in stock prices that occurred on October 13, 1989, had nowhere near the impact of the market break two years earlier. Finally, the failure of the Amaranth hedge fund in 2006 was twice the size of LTCM's failure, yet this default was absorbed by the markets without turmoil. And market participants undoubtedly will learn important lessons from the turmoil of 2007 and 2008 that will improve their structure and functioning in the future.

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