Release Date: May 28, 2008

For immediate release

Frederic S. Mishkin submitted his resignation on Wednesday as a member of the Board of Governors of the Federal Reserve System, effective August 31, 2008.

Mishkin, who has been a member of the Board since September 5, 2006, submitted his letter of resignation to President Bush.  He will return to the Graduate School of Business at Columbia University as a professor of economics and resume teaching in the fall.  The Federal Open Market Committee meeting on August 5 will be his last.

"Rick's contributions to the intellectual underpinnings of monetary policy at the Federal Reserve have been invaluable," said Federal Reserve Board Chairman Ben S. Bernanke.  "His keen insights, deep analysis and humor have enriched our deliberations.  I greatly value his friendship and counsel and wish him all the best as he returns to teaching."

Mishkin, 57, was appointed to the Board by President Bush to fill an unexpired term ending January 31, 2014.  During his time on the Board, he served as Chairman of the Committee on Economic Affairs and as a member of the Committee on Supervisory and Regulatory Affairs and the Committee on Consumer and Community Affairs.

Before joining the Board, Mishkin was the Alfred Lerner Professor of Banking and Financial Institutions at the Graduate School of Business, Columbia University, from 1999 to 2006.  In addition, he has taught at the University of Chicago, Northwestern University, and Princeton University.

A copy of his resignation letter is attached.

Attachment (41 KB PDF)

Vice Chairman Donald L. Kohn

At the National Conference on Public Employee Retirement Systems Annual Conference, New Orleans, Louisiana

May 20, 2008

The Economic Outlook

These have been challenging times for the U.S. economy. Homebuilding and house prices have gone through prolonged and deep declines; the resulting broad pullback in financial markets from risk-taking and credit extension has transmitted some of the weakness in the housing sector to other types of spending. At the same time, a substantial run-up in the prices of petroleum and other commodities has simultaneously increased inflation and damped spending on other goods and services. I don't need to tell you that challenging times for the economy are also challenging times for those entrusted with managing pension funds. So I thought you might find it useful this morning for me to review where I think the economy is and where it might be going. That, in turn, depends critically on developments in financial markets, and I'll have something to say about those developments as well. Finally, I'll end with a few thoughts about what the recent turbulence in financial markets may imply for the administration of public pension funds.¹

Recent Economic Developments
Economic activity this year has been quite sluggish. The weakness in activity continues to be shaped by the fallout from the contraction in housing markets that began two years ago. The demand for housing continued to decline early this year, and sales could fall even further in coming months, given the tightness in mortgage lending. Nonprime mortgages have all but disappeared from the mortgage market. Moreover, with only limited securitizations of prime jumbo loans, rates on those loans are relatively high, and their share of total originations has shrunk significantly since last July. Rates for fixed-rate conforming loans have dropped to close to 6 percent. But even there, the good news is tempered somewhat because, with delinquencies on prime mortgages rising, the government-sponsored enterprises have tightened their standards for conforming loans and added fees for borrowers with lower credit scores and less collateral. All prominent measures of house prices are now showing declines. Although lower prices would eventually help bolster housing demand, the expectations of further declines in prices may currently be exacerbating the difficulties in housing markets.

In this environment, homebuilders have made only limited progress in reducing the very large overhang of unsold new homes despite having cut starts to a level not seen since early 1991. Single-family starts fell to an annual rate of 690,000 in April; the pace of new activity has now dropped by a 1/2 million units in each of the past two years. The supply of existing homes on the market also remains quite high and is likely to be augmented in coming months by rising foreclosures. As a result, further cuts in construction appear to be in train.

The sharp contraction in housing was at the center of the slowdown in economic activity that began late last year. By early this year, however, the spillovers from the housing market correction onto other sectors of the economy began to show through more clearly; consumer and business spending, which had slowed at the end of 2007, has remained on a shallow trajectory since then.

In particular, spending on consumer goods, including new motor vehicles, has been soft. Since last fall, rising prices for energy and food have made a significant dent in the purchasing power of consumers' incomes. Moreover, despite some improvement in the stock market recently, households' net worth has deteriorated since the beginning of the year as the prices of homes have declined; and credit conditions have tightened. In reaction to these adversities, households seem to have become extremely downbeat about prospects for jobs and income.

Business spending for equipment and software edged down in the first quarter, and the environment for capital spending remains difficult; businesses are uncertain about the economic outlook, and lenders have adopted more stringent lending standards. However, while conditions are quite tight for riskier firms, credit does appear to be more readily available to investment-grade businesses.

More difficult financing conditions also seem to be leaving an imprint on nonresidential construction, which now appears to be softening after a couple of years of sharp gains. According to our April Senior Loan Officer Opinion Survey on Bank Lending Practices, a large majority of banks, which are the largest provider of commercial mortgages, reported tightening standards on commercial real estate over the preceding three months.² The issuance of securitized commercial real estate loans, which funds a little more than one-fourth of all outstanding commercial mortgages, has slowed to a trickle. Sales of commercial properties fell sharply in the first quarter, and late last year prices appeared to have begun to decline.

A bright spot has been the external sector. Although the pace of real activity in some foreign economies also appears to be slowing, the overall rate of expansion in our trading partners--especially emerging Asian economies such as China--remains solid. Some of the pullback in U.S. demand has been absorbed by declines in imports, and the decline in the dollar has made U.S. firms more competitive in export markets, though it has also accentuated inflation concerns.

The deceleration in economic activity has been reflected in the labor market, where layoffs have risen and hiring has slowed. Payroll employment has now fallen for four consecutive months. The combination of job losses and the greater difficulty in finding jobs has pushed the unemployment rate up to 5 percent in recent months.

Financial Market Developments
As I've just noted, the tightening of financial conditions as a result of stresses in financial markets has been an important factor in the recent slowdown of the U.S. economy. In recent weeks, however, U.S. financial markets have improved somewhat. Equity prices have risen noticeably since mid-March. Spreads on both investment-grade and speculative-grade corporate bonds have generally narrowed over the same period, and investment-grade companies, including financial institutions, have been able to raise funds in credit markets. Financial intermediaries have also tapped equity markets to bolster capital depleted by the recognition of losses on loans and securities.

Clearly, some of the extraordinary increase in risk aversion that we saw earlier this year has been reversed. Apparently, a combination of factors has contributed to a perception that financial markets and the economy are less likely than some had feared to experience very adverse outcomes: Among those factors were Federal Reserve actions to bolster liquidity and ease monetary policy, the success of a number of financial institutions in raising capital, and incoming economic data and earnings reports that were not as weak as market participants had expected.

Still, the persistence of relatively wide spreads in many markets suggests that investors continue to be worried about credit quality; the issuance of speculative-grade bonds has been scant this year; and securitization markets for many types of mortgages continue to be impaired. In addition, term bank funding markets remain under pressure as banks and other lenders in these markets conserve capital and liquidity and limit risk-taking. Banks have further tightened lending standards across a wide range of business and consumer loans.

These findings generally suggest that market participants remain wary, and in that environment, improvements in financial markets are vulnerable to negative news on the economy or the extent of credit losses. I expect further, but gradual, improvement in financial markets. Credit flows need to be re-channeled and re-intermediated with less leverage, less rollover risk, and greater compensation for taking risk than before the turmoil began last year. Securitized assets need to be simpler, more transparent, and less reliant on the imprimatur of a credit rating agency. Lenders and other investors need to gain greater confidence that they understand the extent and incidence of the losses arising from the lax lending practices of recent years and the current economic slowdown. Those processes are likely to be slow and they may be set back from time to time, but they will ultimately succeed in giving us a more robust financial system than we had a year ago.

The Economic Outlook
Although the current financial and economic situation remains quite difficult, I believe that the most likely scenario over the next year or so is one in which economic activity firms during the second half of this year and then gathers some strength in 2009. In the near term, consumer spending is likely to receive a boost from the rebates that are now flowing to taxpayers. Although the timing and the magnitude of the spending response are uncertain, economic studies of the previous experience suggest that a noticeable proportion of households respond reasonably quickly to temporary cash flows. Of course, the stimulus to domestic production will depend on the extent to which the additional demand is met by a temporary drawdown of inventories or an increase in imports rather than by an expansion in domestic output. But to date, businesses appear to be keeping tight control on inventories, and a reasonable assumption is that we will see a temporary lift to the economy in coming months.

The pace of activity should continue to improve next year, with an important part of the gains coming from the abatement of the forces currently restraining activity. That said, a number of factors suggest that the recovery could be relatively moderate. I've already mentioned my expectation that financial market functioning and risk appetites will continue to improve, but that recuperation will require some time. As all that happens, the policy easing the Federal Reserve has put in place over recent months will begin to show through more in reductions in the cost of capital and the greater availability of credit. The demand for housing is not likely to rebound substantially for a while after this episode, but the drag on growth from declining activity and prices in the housing market will ebb as excess inventories are worked off and affordability improves. Consumption should pick up along with the improvement in jobs and income, though a gradual increase in the saving rate would be expected now that households will no longer be counting on increases in the value of their homes to finance retirement or other future spending. With a lag, business investment should turn up as prospects for a sustained expansion of economic activity become clearer. And both households and businesses should benefit from a leveling-off in the prices of energy and other commodities along the path implied by futures markets.

As with any forecast, mine is subject to a number of uncertainties. One is the extent of the housing correction ahead of us. If the retrenchment in house prices becomes deeper than anticipated, its effect on lenders and financial markets could further damp overall economic activity. We are in uncharted waters when the financial system becomes so disrupted, though we should consider ourselves fortunate that we have very few similar historical episodes on which to base our judgments. In such circumstances, uncertainty about how credit conditions will evolve and how businesses and households will react to changing terms and conditions means that we can have even less confidence than usual in our economic forecasts.

Inflation
Another area of concern is the implications for inflation as a result of the recent run-up in the prices of energy, food, and other commodities. The recent news on inflation has been mixed. Core inflation has moderated a little so far this year. However, we have seen no relief from the pressures of rising prices for energy and food; thus headline inflation has been quite elevated. These prices have continued to rise despite slowing demand in the United States and, to a lesser extent, in other countries. Over the past few years, emerging market economies have increased demand for many of these commodities, and world supply has not kept pace with this growing demand. For oil, non-OPEC production, particularly in the North Sea and in Mexico, has proved disappointing, and OPEC production has remained restrained. As for food prices, bad weather has combined with higher production costs to restrain supplies. Consequently, agricultural inventories have been drawn down to low levels and have not been available to absorb the rising demand. Furthermore, higher energy prices have affected agricultural prices not only through higher costs of production but also by boosting the demand for biofuels.

Some observers have questioned whether the news on fundamentals affecting supply and demand in commodities markets has been sufficient to justify the sharp price increases in recent months. Some of these commentators have cited the actions of the Federal Reserve in reducing interest rates as an important consideration boosting commodity prices. To be sure, commodity prices did rise as interest rates fell. However, for many commodities, inventories have fallen to all-time lows, a development that casts doubt on the premise that speculative demand boosted by low interest rates has pushed prices above levels that would be consistent with the fundamentals of supply and demand. As interest rates in the United States fell relative to those abroad, the dollar declined, which could have boosted the prices of commodities commonly priced in dollars by reducing their cost in terms of other currencies, hence raising the amount demanded by people using those currencies. But the prices of commodities have risen substantially in terms of all currencies, not just the dollar. In sum, lower interest rates and the reduced foreign exchange value of the dollar may have played a role in the rise in the prices of oil and other commodities, but it probably has been a small one.

The rise in commodity prices presents particular challenges for monetary policy because such increases both add to near-term inflationary pressures and damp demand. A tendency for increases in commodity prices to become a factor in ongoing pricing and wage-setting more generally would be a worrisome development that would over time tend to undermine economic welfare.

In the near term, headline inflation is likely to continue to be boosted by the direct effects of the recent increases in the prices of energy and food. If, as futures markets suggest, those prices level off later this year, prospects seem reasonably good for headline inflation to move back in line over time with core inflation. And I expect core inflation to ease off slowly as commodity prices level out and as economic slack creates competitive conditions that inhibit increases in labor costs and prices. Despite the elevated headline inflation of the past four years, we have seen little evidence of faster wage inflation. And healthy gains in productivity have helped to hold down labor cost pressures on prices.

My expectations for moderating inflation and limited spillover effects from commodity price increases depend critically on the continued stability of inflation expectations. In that regard, year-ahead inflation expectations of households have increased this year in response to the jump in headline inflation. Of greater concern, some measures of longer-term inflation expectations appear to have edged up. If longer-term inflation expectations were to become unmoored--whether because of a protracted period of elevated headline inflation or because the public misinterpreted the recent substantial policy easing as suggesting that monetary policy makers had a greater tolerance for inflation than previously thought--then I believe that we would be facing a more serious situation.

Monetary Policy
The Federal Open Market Committee will be monitoring inflation developments closely for any sign that our longer-run objective of promoting price stability is threatened. At the same time, we also need to continue to carefully assess whether, after a period of near-term softness in economic activity, the economy is likely to be on track for sustained economic expansion over time. With the information now in hand, it is my judgment that monetary policy appears to be appropriately calibrated for now to promote both rising employment and moderating inflation over the medium term. But a large measure of uncertainty surrounds that judgment and as the economy evolves, so will the appropriate stance of policy.

Lessons for Public Pension Systems
Now let me shift my focus to what pension fund managers might glean as lessons learned from the recent turmoil in financial markets and some of the structural challenges that lie ahead. From what we have seen so far, public pension systems generally appear to have avoided the worst of the damage resulting from the recent tumult. For example, while a number of public funds evidently held structured credit products such as collateralized debt obligations, the overall level of exposure to those products appears to have been relatively small.

Nonetheless, the recent experience does point up some serious considerations as pension funds address the challenges in meeting their obligations in coming years. One is that public pension systems--like all investors--need to be diligent about understanding and managing the risks on their balance sheets. Too many investors seem to have placed too much faith in credit rating agencies, and too few seem to have developed their own views of the risks embedded in their holdings. Of course, developing such views is no small undertaking. But if ever a demonstration of the value of doing so were needed, the recent episode certainly provides it.

Perhaps the biggest challenge facing public pension systems is inadequate funding. Even by current measures of liability, which themselves may not be fully revealing, last year about three-fourths of public pension systems were underfunded, and about one-third were funded at less than 80 percent. Lengthening life expectancies and tight public budgets are making existing pension promises ever more difficult to keep--and the problem is significantly magnified if promised health benefits are included.

The funding situation puts systems under a great deal of pressure to reach for higher returns by investing in riskier assets. But as has been so clearly and forcefully demonstrated over the past year, there is no free lunch with risk-taking: The price is volatility, the extent of which should be well disclosed and the implications of which should be well understood.

The generally high weight on equity and real estate investments in the typical public pension fund portfolio has increased in recent years. Part of that exposure has come from increased investment in private equity, real estate investment trusts, and hedge funds. Indeed, some funds have allocated 25 percent or more of their portfolios to these "alternative" categories.

With exposures like those, public pension systems should maintain formal risk-management procedures that are independent of the selection and evaluation of managers and that are carefully designed to minimize conflicts of interest that can weaken the risk-management function.

I mentioned earlier that current measures of pension liabilities might be less than fully revealing. Why might that be so? The chief reason is that public pension benefits are essentially bullet-proof promises to pay. We all have read about instances in which benefits were lost when a private-sector pension sponsor declared bankruptcy and terminated the plan. In the public sector, that just hasn't happened, even when the plan sponsor has run into serious financial difficulty. For all intents and purposes, accrued benefits have turned out to be riskless obligations. While economists are famous for disagreeing with each other on virtually every other conceivable issue, when it comes to this one there is no professional disagreement: The only appropriate way to calculate the present value of a very-low-risk liability is to use a very-low-risk discount rate.

However, most public pension funds calculate the present value of their liabilities using the projected rate of return on the portfolio of assets as the discount rate. This practice makes little sense from an economic perspective. If they shift their portfolio into even riskier assets, does the value of the liabilities backed by their taxpayers go down? Financial economists would say no, but the conventional approach to pension accounting says yes. Unfortunately, the measure of liabilities that results from this process has a real consequence: It pushes the burden of financing today's pension benefits onto future taxpayers, who will be called upon to fund the true cost of existing pension promises.

Another challenge that everyone involved in public pensions faces is the issue of transparency. Unlike private pension funds, public pension systems do not account for liabilities in a standardized way. As a result, public employees, taxpayers, municipal bond investors, credit rating agencies, and other market participants have a hard time comparing funding levels across systems and over time.

What steps can pension funds take to improve transparency and help clarify their long-run challenges? Ideally, they would disclose a standardized measurement of funding status, using consistent and appropriate measures of liability. They might also disclose how their asset allocation affects the volatility of the returns on their assets and how their funding ratios and cash flow might be affected by various outcomes in the financial markets. Such practices almost surely would be welcomed externally. But they might also pay dividends internally, because the funds might find that the information about the volatility built into their systems changes their views about the amount of risk they want to shoulder.

Public pension funds hold more than $3 trillion in assets and cover nearly 20 million workers and retirees. Those funds are clearly vital to the business of state and local governments across the country as well as to the public employees they cover. The potential improvements I have touched on today--adhering to best practices with regard to risk management and grappling with some of the difficult structural issues that currently face public pension systems--would help strengthen public pension systems and should minimize the risks to public employees, the governments that employ them, and the taxpayers that finance them both now and in the future.

Footnotes

1. Paul Smith, David Wilcox, and Joyce Zickler, of the Board's staff contributed to the preparation of these remarks. The views expressed are my own and do not necessarily represent the views of other members of the Board or the Federal Open Market Committee. Return to text

2. Board of Governors of the Federal Reserve System (2008), "The April 2008 Senior Loan Officer Opinion Survey on Bank Lending Practices" (April). Return to text

Chairman Ben S. Bernanke

At the Federal Reserve Bank of Chicago's Annual Conference on Bank Structure and Competition, Chicago, Illinois

May 15, 2008

Risk Management in Financial Institutions

The financial and credit market turmoil that began last summer has raised a number of significant issues of public policy, including questions concerning the maintenance of financial stability, the supervision and regulation of financial institutions, and the protection of consumers in their financial dealings. Obviously, I cannot hope to address all the relevant issues today; moreover, events continue to unfold. Still, some of the implications of what has transpired since August are becoming clearer. My remarks today will focus on the lessons of the recent experience for risk-management practices in financial institutions as well as the supervisory oversight of those practices. My comments are based on the experiences and observations of supervisors in both the United States and other countries and thus are intended to be fairly general, applying across regulatory structures and to financial firms of varying scope and size.

Origins of the Current Turmoil
To provide some background, I will begin with a brief discussion of the origins of the financial turmoil. Although many factors played a role, to a considerable extent, the financial stress we continue to experience arose from the problematic implementation of the so-called originate-to-distribute approach to credit extension.  In principle, and indeed often in practice, the originate-to-distribute model spreads risk and reduces financing costs, offering greater access to capital to a wide range of borrowers while allowing investors greater flexibility in choosing and managing credit exposures.

However, weaknesses in the application of the originate-to-distribute model became increasingly apparent last year, resulting ultimately in a broad retreat from this method of credit extension last summer.  A report released just this March by the President's Working Group on Financial Markets (PWG), of which I am a member, and an even more recent study issued in April by the international Financial Stability Forum (FSF), in which the Federal Reserve plays an active role, document the nature of these weaknesses.¹ These reports emphasize that substantial improvements in the originate-to-distribute model as practiced over the past few years are necessary if its potential benefits are to be realized.

The reports pointed out that problems occurred at each step of the credit-extension chain. First, at the point of origination, underwriting standards became increasingly compromised in recent years. The most notorious example is, of course, U.S. subprime mortgages. In this case, as in others, the incentives faced by originators were an important source of the breakdown in underwriting. The revenues of the originators of subprime mortgages were often tied to loan volume rather than to the quality of the underlying credits, which induced some originators to focus on the quantity rather than the quality of the loans being passed up the chain. However, the problems with subprime mortgage underwriting were disguised for a time by the continued appreciation in home values. As long as house prices kept rising, subprime borrowers saw their home equity increase and were often able to refinance into more-sustainable mortgages. But when house prices began to stagnate and then fall, many subprime borrowers found themselves trapped in mortgages they could not afford. Because subprime loans were frequently securitized and incorporated into complex structured products, the resulting losses spread throughout the financial system.

Although subprime mortgages are the most well-known instance of underwriting failure and were in some sense the trigger of the turmoil, the loosening of credit standards and terms occurred more broadly, even as market risk premiums contracted. For example, investors were willing to purchase so-called leveraged loans--used to finance mergers or buyouts--with few covenants or other protections. The PWG concluded that investors often took insufficient care in evaluating the risks of credit products, in part because they relied too much on evaluations provided by the credit rating agencies. Unfortunately, the methodologies, data, and assumptions the agencies used to rate structured credit products proved deficient in many cases.  When rising delinquencies and losses on mortgages forced the agencies to sharply downgrade many of these products, investors lost confidence in those ratings and became unwilling to provide new funds. As financing disappeared, the markets for structured credit products and for related investments seized up.

Another significant factor contributing to the financial turmoil was risk-management weaknesses at large global financial institutions that created and held complex credit products. I will return to this topic shortly, but for now, suffice it to say that a result of poor risk management at some financial institutions was that the spreading of risk, one of the purported benefits of the originate-to-distribute model, proved to be much less extensive than many believed. When investors were no longer willing or able to finance new structured credit products, many of the largest financial institutions had to fund instruments they could not readily sell or had to meet contingent funding obligations for which they had not adequately planned. The combination of unanticipated losses, which ate into capital cushions, and severe liquidity pressures has reduced the ability and willingness of some large financial institutions to make markets and to extend new credit, with adverse effects for the financial system and for the economy.

Both the PWG and the FSF reports highlighted the important role played by financial regulators in overseeing and helping to strengthen risk-management practices in the firms they supervise, and the reports recommended that the regulators review their own policies, guidance, and supervisory practices to identify areas in which improvements could be made. I will discuss some regulatory and supervisory responses to the recent developments later in my remarks.

Lessons for Risk Management at Financial Institutions
With that brief diagnosis of our financial market turmoil as background, I turn now to some of the lessons learned thus far regarding the risk-management practices of financial institutions. The financial turmoil presented difficult challenges that were not fully anticipated by either financial institutions or regulators, but firms did vary in how well they were able to deal with those challenges. By comparing how some key firms fared during the recent period, we can better understand what worked well and what did not work so well.

Many of the points I will make are drawn from a report published in early March by a group of supervisory agencies from France, Germany, Switzerland, the United Kingdom, and the United States--including the Federal Reserve--known as the Senior Supervisors Group, or SSG.²  This report employed a methodology similar to that used in the so-called horizontal reviews regularly conducted by U.S. bank supervisors. We begin these reviews by identifying particular activities or practices that merit study. We then gather comparable information from a core set of institutions, with the objectives of identifying the principal differences in practice across firms and determining how those differences are related to subsequent performance. Finally, we provide feedback to the institutions involved and often share the insights gained with other institutions not in the study. Horizontal reviews can involve major commitments of time and resources, but they help both managers of financial institutions and supervisors by revealing the range of practice in the industry and by providing useful information about the strengths and weaknesses of alternative approaches. When focused on large, internationally active organizations, as was the case with the SSG report, these reviews can offer insights that bear not only on the safety and soundness of individual companies but also on the maintenance of overall financial stability. Although the SSG report covered a group of the largest banking and securities firms, based on our own supervisory experience at the Federal Reserve, I believe the lessons of that report have relevance for financial organizations of all sizes and scope.

In reviewing these lessons, I will concentrate on four categories of risk-management practices:  risk identification and measurement, valuation practices, liquidity risk management, and senior management oversight.

Risk Identification and Measurement
For risks to be successfully managed, they must first be identified and measured. Recent events have revealed significant deficiencies in these areas. Notable examples are the underestimation by many firms of the credit risk of subprime mortgages and certain tranches of structured products. Other firms did not fully consider the linkages between credit risk and market risk, leading to mismeasurement of their overall exposure. Firms differed in their susceptibility to these problems; however, some were more disciplined in their approaches to identifying and measuring risks and thereby gained a better understanding of the risks of some complex securities, particularly in highly stressed environments. This fuller appreciation of the risks involved led these firms to limit their purchases of such securities or to provide additional capital and liquidity backstops.

The SSG report notes that some institutions took an excessively narrow perspective on risk with insufficient appreciation of the need for a range of risk measures, including both quantitative and qualitative metrics. For example, some firms placed too much emphasis on the mechanical application of value-at-risk or similar model-based indicators.  Sophisticated quantitative tools and models play an important role in good risk management, and they will continue to do so. But no model, regardless of sophistication, can capture all of the risks that an institution might face. Those institutions faring better during the recent turmoil generally placed relatively more emphasis on validation, independent review, and other controls for models and similar quantitative techniques. They also continually refined their models and applied a healthy dose of skepticism to model output.

Stress tests and related exercises are a good way to augment models and other standard quantitative techniques for risk management. They can provide a valuable perspective on risks falling outside those typically captured by statistical models, such as risks associated with extreme price movements and those associated with scenarios not reflected in what are sometimes very short data series. Stress testing forces practitioners to step back from daily concerns to think through the implications of scenarios that may seem relatively unlikely but could pose serious risks to the firm if they materialized. For stress tests to be useful, they should be relevant to the business at hand, change with market and risk positions, and, of course, have an impact on management's decisionmaking. In an encouraging finding, the SSG report noted that the surveyed institutions already broadly recognize the need to enhance their stress-testing capabilities.

Recent events illustrate the potential usefulness of stress tests. For example, several institutions made what proved to be optimistic assumptions about the correlation of returns between tranches of collateralized debt obligations. Appropriate stress testing might have allowed a better understanding of how these instruments would perform under extreme market conditions. Applying stress tests to several business lines at the same time is operationally challenging, but for several firms, exercises of this type could have revealed previously undetected firmwide risk concentrations that cut across the banking book, the securities portfolio, and counterparty exposures. Some institutions successfully applied stress testing, with corresponding benefits for the bottom line. For example, some risk managers recognized the risk that certain off-balance-sheet exposures might present should they need to be brought back on the balance sheet and tested scenarios to evaluate the potential firmwide impact. This work allowed their firms to be better prepared when the scenarios became reality.

Valuation
Valuation practices are a second area that supervisors' comparative reviews identified as critical. The SSG report indicates that those firms that paid close attention to the problems associated with the valuation of financial instruments, particularly those for which markets were not deep, fared better. These more-successful institutions developed in-house expertise to conduct independent valuations and refrained from relying solely on third-party assessments. They also tested their estimated valuations in various ways, for example, by selling a small portion of the asset in question to test the market or by undertaking an extensive review of the market prices of similar products.  Some more-successful firms also consistently embedded market liquidity premiums in their pricing models and valuations. In contrast, less-successful firms did not develop adequate capacity to conduct independent valuations and did not take into account the greater liquidity risks posed by some classes of assets.

Liquidity Risk Management
Another crucial lesson from recent events is that financial institutions must understand their liquidity needs at an enterprise-wide level and be prepared for the possibility that market liquidity may erode quickly and unexpectedly.

Weak liquidity risk controls were a common source of the problems many firms have faced.  For example, some firms' treasury functions were not given information from all business lines about either expected liquidity needs or contingency funding plans, in part because managers of individual business lines had little incentive to compile and provide this information. As is now widely recognized, many contingency funding plans did not adequately prepare for the possibility that certain off-balance-sheet exposures might have to be brought onto the firm's balance sheet. Unexpected balance sheet expansions subsequently added to funding pressures as well as to pressures on capital ratios. In contrast, the more-successful institutions worked to develop firmwide strategies for liquidity risk management that incorporated information from all business lines. In the best cases, firmwide strategies included consideration of the liquidity risks associated with structured investment vehicles, which led to more limited involvement in these activities.

Senior Management Oversight
Effective oversight of an organization as a whole is one of the most fundamental requirements of prudent risk management. The SSG report highlighted solid senior management oversight and engagement as a key factor that differentiated firms' performance during the recent events. Senior managers at successful firms are actively involved in risk management, which includes determining the firm's overall risk preferences and creating the incentives and controls to induce employees to abide by those preferences. To manage risk at an enterprise-wide level, successful senior managers also ensure that they have the necessary information, which in turn requires appropriate policies and information systems as well as robust methods for identifying and measuring risks.

The failure to appreciate risk exposures at a firmwide level can be costly.  For example, during the recent episode, the senior managers of some firms did not fully appreciate the extent of their firms' exposure to U.S. subprime mortgages. They did not realize that, in addition to the subprime mortgages on their books, they had exposures through the mortgage holdings of off-balance-sheet vehicles, through claims on counterparties exposed to subprime, and through certain complex securities.  Successful senior managers also worked to ensure that critical information was transmitted horizontally as well as vertically; the SSG report noted that, at some firms, business lines did not share vital information relevant to risk positions and business tactics, with adverse implications for profitability.

Culture and governance affect the quality of risk management. The leaders of well-managed institutions of all sizes generally seek to have strong and independent risk functions.  Such functions support clear, dispassionate thinking about the entire firm's risk profile. In addition, the institution benefits when senior managers encourage risk managers to dig deep to uncover latent risks and to point out cases in which individual business lines appear to be assuming too much risk.

Supervisory Responses
Supervisors too have learned from the recent experience, including the need for careful self-assessment, and the PWG and the FSF reports offer some helpful recommendations.  We are still conducting such an assessment, but I can offer some preliminary conclusions.

Given the central role of effective, firmwide risk management in maintaining strong financial institutions, it is clear that supervisors must redouble their efforts to help organizations improve their risk-management practices. Accordingly, we have increased supervisory attention to this issue.  We have focused on the institutions in most need of improvement, but we will continue to remind the stronger institutions of the need to remain vigilant, particularly in light of the ongoing fragility of market conditions.

We are also considering the need for additional or revised supervisory guidance regarding various aspects of risk management, including further emphasis on the need for an enterprise-wide perspective when assessing risk. Much of our work is being conducted in close consultation with supervisors in other countries. For example, we are working through the Basel Committee on Banking Supervision to develop enhanced guidance on the management of liquidity risks. We are also seeking to promote better disclosures by banking institutions with the goal of increasing transparency, thereby strengthening market discipline.

As you know, a major ongoing development is the implementation of the international Basel II capital accord in the United States. Basel II is intended to enhance the quality of risk management by tying regulatory capital more closely to institutions' underlying risks and by requiring strong internal systems for evaluating credit and other risks. Although Basel II will by no means eliminate future episodes of financial turbulence, it should help to make financial institutions more resilient to shocks and thus enhance overall financial stability. At the same time, we must ensure that the Basel II framework appropriately reflects the lessons of recent events. The Basel Committee has been evaluating how the framework might be strengthened in areas such as the capital treatment of off-balance-sheet vehicles and the use of credit ratings to determine capital charges. The relatively lengthy transition to Basel II will allow more opportunity to absorb the lessons of the financial turmoil and make necessary adjustments to the framework.

Conclusion
To summarize, the turmoil in credit markets underscores some important principles for bank risk management, including the value of proper risk identification and measurement, the need for robust and objective valuation methods, the importance of preparing for liquidity disruptions, and the critical role of strong oversight by senior managers. With renewed attention to these principles and the restoration of strong incentives for sound risk management, institutions should be able to overcome the difficulties we have seen in the recent application of the originate-to-distribute model and begin to use it successfully again. Equally important, improvements in banks' risk management will provide a more-stable financial system by making firms more resilient to shocks. Supervisors must insist on effective risk management and provide as much support as possible for the implementation of needed changes.

Recent events have also demonstrated the importance of generous capital cushions for protecting against adverse conditions in financial and credit markets. I have been encouraged by the recently demonstrated ability of many financial institutions, large and small, to raise capital from diverse sources.  Importantly, capital raising and balance sheet repair allow for the extension of new credit, which supports economic expansion. I strongly urge financial institutions to remain proactive in their capital-raising efforts. Doing so not only helps the broader economy but positions firms to take advantage of new profit opportunities as conditions in the financial markets and the economy improve.

Footnotes

1.  President's Working Group on Financial Markets (2008), "Policy Statement on Financial Market Developments," March 13; Financial Stability Forum (2008), “Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience ," April 7.  Return to text

2.  The report, "Observations on Risk Management Practices during the Recent Market Turbulence," provides a summary and analysis of a joint survey and review, initiated this past autumn, of risk-management practices during the recent financial stress.  Return to text

Governor Frederic S. Mishkin

At the Wharton Financial Institutions Center and Oliver Wyman Institute's Annual Financial Risk Roundtable, Philadelphia, Pennsylvania

May 15, 2008

How Should We Respond to Asset Price Bubbles?

Over the centuries, economies have periodically been subject to asset price bubbles--pronounced increases in asset prices that depart from fundamental values and eventually crash resoundingly. Because economies often fare very poorly after a bubble bursts, central bankers need to think hard about how they should address such bubbles. This issue has become especially topical of late because of the rapid rise and subsequent decline in residential housing prices this decade. The recent drop in house prices in many markets around the country has been accompanied by increasing rates of defaults on mortgage loans and home foreclosures. These developments have created hardship for the families who are forced to leave their homes and have disrupted communities; in addition, the developments have contributed to a major shock to the financial system, with sharp increases in credit spreads and large losses to financial institutions. As many have pointed out, the damage to households' credit and the financial disruption have been a drag on the U.S. economy, which has led to a slowing of economic growth and a recent decline in employment.

In my remarks today, I would like to return to the issue of how we should respond to possible asset price bubbles.¹ I will first focus on the conceptual framework I use to evaluate these issues, based on a core set of scientific principles for monetary policy.² My framing of the issues highlights the following three questions:

• Are some asset price bubbles more problematic than others?
• How should monetary policy respond to asset price bubbles? and
• What other types of policy responses are appropriate?

My discussion of these conceptual issues is followed by a summary of several historical examples that illustrate the importance of focusing on the principles I have outlined. As usual, these remarks reflect only my own views and are not intended to reflect those of the Federal Open Market Committee or of anyone else associated with the Federal Reserve System.

Are Some Asset Price Bubbles More Problematic Than Others?
In order to consider how monetary and other policies should address asset price bubbles, we must first examine how asset prices influence inflation and aggregate economic activity. These influences act through several channels; in particular, asset prices provide signals regarding profitable investments, affect the wealth of households, and influence the cost of capital to firms and households. For example, higher equity prices, whether driven by fundamentals such as lower interest rates or faster productivity growth or by bubble-type factors like "irrational exuberance," boost business investment by lowering the cost of capital and raise household demand by generating increased wealth. Other fluctuations in asset prices act similarly. The resulting fluctuations in resource utilization lead to changes in inflation.³

The influences of asset prices on demand and inflation through traditional wealth and cost-of-capital channels fall directly within the traditional concerns of monetary policy, a point to which I will return shortly. However, not all asset price bubbles are alike, and some bubbles raise issues outside the direct responsibility of monetary policy but within the policy concerns of the broader regulatory framework governing our financial system. In particular, some asset price bubbles can have more-significant economic effects, and thus raise additional concerns for economic policymakers, by contributing to financial instability. Financial history reveals the following typical chain of events: Because of either exuberant expectations about economic prospects or structural changes in financial markets, a credit boom begins, increasing the demand for some assets and thereby raising their prices.⁴ The rise in asset values, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more. This feedback loop can generate a bubble, and the bubble can cause credit standards to ease as lenders become less concerned about the ability of the borrowers to repay loans and instead rely on further appreciation of the asset to shield themselves from losses.

At some point, however, the bubble bursts. The collapse in asset prices then leads to a reversal of the feedback loop in which loans go sour, lenders cut back on credit supply, the demand for the assets declines further, and prices drop even more. The resulting loan losses and declines in asset prices erode the balance sheets at financial institutions, further diminishing credit and investment across a broad range of assets. The decline in lending depresses business and household spending, which weakens economic activity and increases macroeconomic risk in credit markets.⁵ In the extreme, the interaction between asset prices and the health of financial institutions following the collapse of an asset price bubble can endanger the operation of the financial system as a whole.⁶

To be clear, not all asset price bubbles create these risks to the financial system. For example, the bubble in technology stocks in the late 1990s was not fueled by a feedback loop between bank lending and rising equity values; indeed, the bursting of the tech-stock bubble was not accompanied by a marked deterioration in bank balance sheets. But potential for some asset price bubbles to create larger difficulties for the financial system than others implies that our regulatory framework should be designed to address the potential challenges to the financial system created by these bubbles.

How Should Monetary Policy Respond to Asset Price Bubbles?
In order to think about how central banks should respond to asset prices, we need to first remember the objectives of monetary policy. The ultimate purpose of a central bank should be to promote the public good through policies that foster economic prosperity. Research in monetary economics describes this objective in terms of stabilizing both inflation and economic activity. Indeed, these objectives are exactly what is embodied in the dual mandate that the Congress has given the Federal Reserve.⁷

Because of their effects on prices and employment, macroeconomic fluctuations due to asset price movements are a concern for monetary policy makers. However, the macroeconomic consequences of asset price fluctuations are unlikely to have long-lasting and severe consequences for the economy as long as monetary policy responds appropriately. Whether an asset price bubble is occurring or not, as asset prices rise and boost the outlook for economic activity and inflation, monetary policy should respond by moving to a more restrictive stance. After a bubble bursts and the outlook for economic activity deteriorates, policy should become more accommodative.⁸ As I pointed out in a paper that I presented at the Federal Reserve Bank of Kansas City's Jackson Hole conference in September, if monetary policy responds immediately to the decline in asset prices, the negative effects from a bursting asset price bubble to economic activity arising from the decline in wealth and increase in the cost of capital to firms and households are likely to be small.⁹ More generally, monetary policy should react to asset price bubbles by looking to the effects of such bubbles on employment and inflation, then adjusting policy as required to achieve maximum sustainable employment and price stability.

To be clear, I think that in most cases, monetary policy should not respond to asset prices per se, but rather to changes in the outlook for inflation and aggregate demand resulting from asset price movements. This point of view implies that actions, such as attempting to "prick" an asset price bubble, should be avoided.

I take this view for (at least) three important reasons.¹⁰ First, asset price bubbles can be hard to identify. As a result, tightening monetary policy to restrain a bubble that has been misidentified can lead to weaker economic growth than is warranted. In addition, central bank actions to influence asset prices when the central bank is uncertain about the presence or extent of a bubble can interfere with the role of asset prices in allocating resources.¹¹

Second, even if asset price bubbles could be identified, the effect of interest rates on asset price bubbles is highly uncertain. Although some theoretical models suggest that raising interest rates can diminish the acceleration of asset prices, raising interest rates may be very ineffective in restraining the bubble, because market participants expect such high rates of return from buying bubble-driven assets.¹² Other research and historical examples (which I will discuss later) have suggested that raising interest rates may cause a bubble to burst more severely, thereby increasing the damage to the economy.¹³ Another way of saying this is that bubbles are departures from normal behavior, and it is unrealistic to expect that the usual tools of monetary policy will be effective in abnormal conditions. The bottom line is that we do not know the effects of monetary policy actions on asset price bubbles.

Third, there are many asset prices, and at any one time a bubble may be present in only a fraction of assets. Monetary policy actions are a very blunt instrument in such a case, as such actions would be likely to affect asset prices in general, rather than solely those in a bubble.

All told, research suggests that monetary policy that does not try to prick bubbles, but instead responds solely to the inflation and aggregate demand outlook, is likely to lead to better outcomes even when bubbles might arise.¹⁴

Are Other Types of Policy Responses Appropriate?
I would now like to return to the effect of asset price bubbles on the stability of the financial system. As I highlighted earlier, some, but clearly not all, asset price bubbles create risks to the financial system that could have large negative effects on the macroeconomy. As a result, it is important to examine the potential for government policies to address the type of bubble in which there is feedback between asset prices and financial stability. I would like to emphasize the importance of regulatory policy. Monetary policy--that is, the setting of overnight interest rates--is already challenged by the task of managing both price stability and maximum sustainable employment. As a result, it falls to regulatory policies and supervisory practices to help strengthen the financial system and reduce its vulnerability to both booms and busts in asset prices.

Of course, some aspects of such policies are simply the usual elements of a well-functioning prudential regulatory and supervisory system. These elements include adequate disclosure and capital requirements, prompt corrective action, careful monitoring of an institution's risk-management procedures, close supervision of financial institutions to enforce compliance with regulations, and sufficient resources and accountability for supervisors.

More generally, our approach to regulation should favor policies that will help prevent future feedback loops between asset price bubbles and credit supply. A few broad principles are helpful in thinking about what such policies should look like. First, regulations should be designed with an eye toward fixing market failures. Second, regulations should be designed so as not to exacerbate the interaction between asset price bubbles and credit provision. For example, research has shown that the rise in asset values that accompanies a boom results in higher capital buffers at financial institutions, supporting further lending in the context of an unchanging benchmark for capital adequacy; in the bust, the value of this capital can drop precipitously, possibly even necessitating a cut in lending.¹⁵ It is important for research to continue to analyze the role of bank capital requirements in promoting financial stability, including whether capital requirements should be adjusted over the business cycle or whether other changes in our regulatory structure are necessary to ensure macroeconomic efficiency.¹⁶ Finally, in general, regulatory policies are appropriately focused on the soundness of individual institutions. However, during certain periods, risks across institutions become highly correlated, and we need to consider whether such policies might need to take account of these higher-stress environments in assessing the resilience of both individual institutions and the financial system as a whole in the face of potential external shocks.

Some policies to address the risks to financial stability from asset price bubbles could be made a standard part of the regulatory system and would be operational at all times--whether a bubble was in progress or not. However, because specific or new types of market failures might be driving a particular asset price bubble, some future bubbles will almost certainly create unanticipated difficulties, and, as a result, adjustments to our policy stance to limit the market failure contributing to a bubble could be very beneficial if identified and implemented at the appropriate time.

Earlier, I pointed out that a bubble could be hard to identify. Indeed, I think this is especially true of bubbles in the stock market. Central banks or government officials are unlikely to have an informational advantage over market participants. If a central bank were able to identify bubbles in the stock market, wouldn't market participants be able to do so as well? If so, then a bubble would be unlikely to develop, because market participants would know that prices were getting out of line with fundamentals.

However, although I believe that stock market bubbles might be hard to identify because they are typically not driven by credit booms (which also makes them less harmful because their collapse is less likely to lead to financial instability), when asset prices are rising rapidly at the same time that credit is booming, there may be a greater likelihood that asset prices are deviating from fundamentals, because laxer credit standards may be driving asset prices upward.¹⁷ In this case, financial regulators at central banks and other institutions may have a greater likelihood of identifying that a bubble is in progress; for example, they might have information that lenders have weakened their underwriting standards and that credit extension is rising at abnormally high rates.

The reasoning here suggests that a rapid rise in asset prices accompanied by a credit boom provides a signal that should lead central bankers and other financial supervisors to carefully scrutinize financial developments to see if market failures might be driving the asset price boom. The resulting analysis of financial developments might then lead policymakers to consider implementing policies to address the imperfections behind the market failures and thereby help reduce the magnitude of the bubble.

Some Historical Examples
I would like to now turn to a few examples from U.S. history and international experience that highlight the interaction between asset price bubbles, financial stability, and the policy framework.

The Stock Market Boom of the 1920s
The Roaring Twenties and the onset of the Great Depression present a particularly drastic example. The U.S. economy thrived during the 1920s as new technologies, financial innovations, and improved business practices were introduced and contributed to a general sense of optimism. As you all know, the stock market experienced a dramatic rise during that decade until it burst during the Great Crash of 1929.

A popular account of that period attributes the stock market boom to easy credit and rising speculation; the period ended with panic selling on Wall Street and triggered the beginning of the Great Depression.¹⁸ According to this view, the Federal Reserve was incorrect in letting the rise in equity prices develop and should have raised interest rates to stem stock market speculation. You will guess from my proposed set of principles for monetary policy that I view this approach as mistaken.

It is first very difficult to assess the extent to which the stock market was driven by nonfundamental forces at the time; by some accounts, the stock market bubble started only in March 1928.¹⁹ Nonetheless, the rise in equity prices took a more prominent place during policy discussions at the Fed beginning in 1927, with Board member Adolph Miller pressing fervently for an increase in interest rates to stop the speculative use of credit. This approach was opposed by Benjamin Strong, the influential Governor of the Federal Reserve Bank of New York who feared a negative impact on the economy: "…any effort through higher rates directed especially at stock speculation would have an unfavorable effect upon business…"²⁰ However, Strong's death in 1928 opened the door for a more restrictive monetary policy aimed at curbing excesses in the stock market, even as signs of economic weakness became visible.

The tightening cycle that ended in August 1929 weakened an already deteriorating economy and paved the way for the collapse of the stock market in October. The Federal Reserve's mistake in attempting to burst the bubble directly was made worse by its refusal to change course rapidly after the market collapsed and the banking system got into trouble, thereby allowing deflation to set in, which raised real interest rates to extremely high levels and further depressed growth.

Japan's Asset Price Boom and the Lost Decade
An asset price bubble also confronted the Bank of Japan (BOJ) with tough decisions starting in the mid- to late 1980s. The extent of the asset price boom in Japan in the late 1980s can be gauged by the fact that the land surrounding the Imperial Palace in Tokyo was estimated to be worth more than the whole of California at that time. Without a doubt, the 1980s was a prosperous decade in Japan with high growth, low unemployment, little inflation, and an envied business model. During that decade, equity prices rose more than 600 percent and land prices boomed more than 400 percent.

Soaring equity and land prices during the 1980s, combined with relatively low interest rates, eased financing conditions for investment substantially.²¹ The ratio of bank loans to gross domestic product surged, and investment spending became the main driver of economic activity. Because of financial deregulation, banks' risk-taking behavior also increased as they channeled more funds to real-estate-related sectors and to small firms, accepting property as collateral.²² Trusting in a rising real estate market, some banks went as far as lending more than 100 percent of a property's appraisal value.

As at the Fed during the Roaring Twenties, the BOJ was concerned about the rapid rise in asset prices in the mid-1980s and the possibility that a bubble was in progress. In 1989, as asset prices continued to soar and inflation moved upward, the BOJ decided to start raising rates. The stock market collapsed at the beginning of 1990, but land prices continued to rise, and the BOJ kept tightening policy. Monetary policy only gradually reversed course in the summer of 1991 as growth declined and inflation and land prices started to move down. The subsequent decade has been termed "the lost decade." During that time, Japan suffered from anemic growth and repeated bouts of very low inflation and deflation.

Japan's experience re-emphasizes the importance of regulatory policies that may prevent feedback loops between asset price bubbles and credit provision. Indeed, during the boom, Japanese regulations that allowed banks to count as capital unrealized gains from equities may have contributed to banks' appetite for equities during the stock market run-up and to financial instability as the stock market collapsed.  After the bursting of the bubble, policymakers did not quickly resolve the fragility of the banking sector, thereby allowing conditions to worsen as banks kept lending to inefficient, debt-ridden, so-called zombie firms.

On the other hand, Japan's experience does not support the need for preemptive monetary policy actions to deflate a bubble, as some commentators have suggested.²³ The tightening of monetary policy during the bubble period does not appear to have led to better economic outcomes. Moreover, the BOJ did not reverse course sufficiently or rapidly enough in the aftermath of the crisis.²⁴ Research suggests that it was the slow response of monetary policy to the deterioration in the economic outlook and fall in inflation following the bursting of the bubble that contributed to the onset of deflation.²⁵

The Recent U.S. Experience
As highlighted in my introduction, the issues I have discussed today are especially salient because of the recent experience with house prices in the United States. It is too early to draw firm conclusions regarding all of the factors that have contributed to the rise and decline of house prices and the impact of these developments on our financial system and the macroeconomy. But the Federal Reserve and other government agencies have already begun to address some weaknesses that emerged during this period. For example, problems arose in recent years in the chain linking the origination of mortgages to their distribution to investors through structured investment products like mortgage-backed securities. Underwriting standards became increasingly compromised at origination. In retrospect, the breakdown in underwriting can be linked to the incentives that the originate-to-distribute model, as implemented in this case, created for the originators. Notably, the incentive structures often tied originator revenue to loan volume rather than to the quality of the loans being passed up the chain. This problem was exacerbated by the bubble in house prices: Lenders began to ease standards as further appreciation in house prices was expected to ensure that risk was low, and investors failed to perform the research necessary to fully appreciate the risks in their investments, instead relying on further house price appreciation to prevent losses. The interaction between lenders' and investors' views and house prices illustrates the pernicious feedback loop I highlighted earlier.

These problems became apparent only in retrospect, in part, because the growth of the originate-to-distribute model for mortgages was an ongoing innovation in financial markets; as a result, neither the market nor regulators had sufficient information for evaluating the nature of the risks involved. Looking forward, efforts to improve scrutiny of the processes that originators use and the incentives they face, better information for consumers, improved performance of the credit rating agencies, and a number of other reforms that have been recommended by the President's Working Group on Financial Markets will be important in preventing a future bubble like that in the most recent experience--steps highlighted by Chairman Bernanke in remarks earlier this year.²⁶

Conclusion
Let me conclude by reiterating the main points of the analysis here. First, not all asset price bubbles are alike. Asset price bubbles that are associated with credit booms present particular challenges, because their bursting can lead to episodes of financial instability that have damaging effects on the economy.

Second, monetary policy should not try to prick possible asset price bubbles, even when they are of the variety that can contribute to financial instability. Just as doctors take the Hippocratic oath to do no harm, central banks should recognize that trying to prick asset price bubbles using monetary policy is likely to do more harm than good. Instead, monetary policy should react to asset price bubbles by looking to the effects of asset prices on employment and inflation, then adjusting policy as required to achieve maximum sustainable employment and price stability. This monetary policy response should prove sufficient to prevent adverse macroeconomic effects of some types of asset price bubbles.

Third, because asset price bubbles can arise from market failures that lead to credit booms, regulation can help prevent feedback loops between asset price bubbles and credit provision. Our regulatory framework should be structured to address failures in information or market incentives that contribute to credit-driven bubbles. Moreover, we should aim to monitor the health of the financial system overall and ensure that our regulatory approach takes account of risks across institutions that are highly correlated and thus affect the strength of the financial system as a whole.

We have learned many lessons from past experience in the United States and in other countries, and I am confident that continued research in these areas will help us address the new tests that will undoubtedly arise as financial innovation and the evolving structure of our financial markets present new challenges.

References

Ahearne, Alan, Joseph Gagnon, Jane Haltimaier, Steve Kamin, Christopher Erceg, Jon Faust, Luca Guerrieri, Carter Hemphill, Linda Kole, Jennifer Roush, John Rogers, Nathan Sheets, and Jonathan Wright (2002). "Preventing Deflation: Lessons from Japan's Experience in the 1990s," International Finance Discussion Papers 2002-729. Washington: Board of Governors of the Federal Reserve System, June.

Bernanke, Ben S. (2002). "Asset-Price 'Bubbles' and Monetary Policy," speech delivered at the New York Chapter of the National Association for Business Economics, New York, October 15.

_________ (2008). "Addressing Weaknesses in the Global Financial Markets: The Report of the President's Working Group on Financial Markets," speech delivered at the World Affairs Council of Greater Richmond's Virginia Global Ambassador Award Luncheon, Richmond, Va., April 10.

Bernanke, Ben S., and Mark Gertler (2001). "Should Central Banks Respond to Movements in Asset Prices?"  American Economic Review, vol. 91 (May), pp. 253-57.

Bernanke, Ben S., Mark Gertler, and Simon Gilchrist (1999). "The Financial Accelerator in a Quantitative Business Cycle Framework," in J. B. Taylor and M. Woodford, eds., Handbook of Macroeconomics, vol. 1C. New York: Elsevier Science--North Holland, pp. 1341-93.

Dupor, Bill (2005). "Stabilizing Non-fundamental Asset Price Movements under Discretion and Limited Information,"  Journal of Monetary Economics, vol. 52 (May), pp. 727-47.

Galbraith, John Kenneth (1954). The Great Crash 1929. Boston: Houghton Mifflin Company.

Goodhart, Charles, Boris Hofmann, and Miguel Segoviano (2005). "Bank Regulation and Macroeconomic Fluctuations,"  Oxford Review of Economic Policy, vol. 20 (January), pp. 591-615.

Goodhart, Charles (2008). "The Regulatory Response to the Financial Crisis,"  CESifo Working Paper No. 2257 . Munich: CESifo, March.

Gordy, Michael B., and Bradley Howells (2006). "Procyclicality in Basel II: Can We Treat the Disease Without Killing the Patient?"  Journal of Financial Intermediation, vol. 15 (July, Basel II: Accounting, Transparency and Bank Stability), pp. 395-417.

Greenspan, Alan (2002). "Economic Volatility," speech delivered at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyo., August 30.

Gruen, David, Michael Plumb, and Andrew Stone (2005). "How Should Monetary Policy Respond to Asset Price Bubbles?"  International Journal of Central Banking, vol. 1 (December), pp. 1-31.

Ito, Takatoshi, and Frederic S. Mishkin (2006). "Two Decades of Japanese Monetary Policy and the Deflation Problem," in Takatoshi Ito and Andrew Rose, eds., Monetary Policy Under Very Low Inflation in the Pacific Rim, NBER East Asia Seminar on Economics, vol. 15. Chicago: University of Chicago Press, pp. 131-93.

Kashyap, Anil, and Jeremy C. Stein (2004). "Cyclical Implications of the Basel II Capital Standards (69 KB PDF)," Federal Reserve Bank of Chicago, Economic Perspectives, vol. 28 (First Quarter), pp. 18-31.

Kindleberger, Charles P. (2000). Manias, Panics, and Crashes: A History of Financial Crises. New York: Wiley.

Kohn, Donald L. (2006). "Monetary Policy and Asset Prices," speech delivered at "Monetary Policy: A Journey from Theory to Practice," a European Central Bank Colloquium held in honor of Otmar Issing, Frankfurt, Germany, March 16.

Meltzer, Allan H. (2003). A History of the Federal Reserve. Chicago: University of Chicago Press.

Mishkin, Frederic S. (1991). "Asymmetric Information and Financial Crises: A Historical Perspective," in R. Glenn Hubbard, ed., Financial Markets and Financial Crises. Chicago: University of Chicago Press, pp. 69-108.

_________ (2007a). "Monetary Policy and the Dual Mandate," speech delivered at Bridgewater College, Bridgewater, Va., April 10.

_________ (2007b). "Will Monetary Policy Become More of a Science?" Finance and Economics Discussion Series 2007-44. Washington: Board of Governors of the Federal Reserve System, September.

_________ (2007c). "Systemic Risk and the International Lender of Last Resort," speech delivered at the Tenth Annual International Banking Conference, Federal Reserve Bank of Chicago, Chicago, September 28.

_________ (2007d). "Financial Instability and the Federal Reserve as a Liquidity Provider," speech delivered at the Museum of American Finance Commemoration of the Panic of 1907, New York, October 26.

_________ (2007e). "Financial Instability and Monetary Policy," speech delivered at the Risk USA 2007 Conference, New York, November 5.

_________ (2007f). "The Federal Reserve's Enhanced Communication Strategy and the Science of Monetary Policy," speech delivered to the Undergraduate Economics Association, Massachusetts Institute of Technology, Cambridge, Mass., November 29.

_________ (2007g). "Housing and the Monetary Transmission Mechanism," Finance and Economics Discussion Series 2007-40. Washington: Board of Governors of the Federal Reserve System, August.

_________ (2008). "Does Stabilizing Inflation Contribute to Stabilizing Economic Activity?" speech delivered at East Carolina University's Beta Gamma Sigma Distinguished Lecture Series, Greenville, N.C., February 25.

­­­­­­­­­­­­Mishkin, Frederic S., and Eugene N. White (2003). "U.S. Stock Market Crashes and Their Aftermath: Implications for Monetary Policy," in William Curt Hunter, George G. Kaufman, and Michael Pomerleano, eds., Asset Price Bubbles: The Implications for Monetary, Regulatory, and International Policies. Cambridge, Mass: MIT Press, pp. 53-79.

Okina, Kunio, Masaaki Shirakawa, and Shigenori Shiratsuka (2001). "The Asset Price Bubble and Monetary Policy: Japan's Experience in the Late 1980s and the Lessons,"  Monetary and Economic Studies, vol. 19 (February, Special Edition), pp. 53-112.

Posen, Adam (2003). "It Takes More Than a Bubble to Become Japan (346 KB PDF),"  in Asset Prices and Monetary Policy, Reserve Bank of Australia Annual Conference. Sydney: Reserve Bank of Australia, pp. 203-49.

White, Eugene N. (1990). "The Stock Market Boom and Crash of 1929 Revisited,"  Journal of Economic Perspectives, vol. 4 (Spring), pp. 67-83.

Footnotes

1. I would like to thank Michael Kiley, Sylvain Leduc, Andrew Levin, Jon Greenlee, Robin Lumsdaine, David Palmer, and William Treacy of the Board's staff for their excellent assistance in preparing these remarks. Return to text

2. I discuss these principles in detail in Mishkin (2007b, 2007f). Return to text

3. Of course, asset price bubbles have additional implications for economic efficiency. Departures of asset prices from levels implied by economic fundamentals can lead to inappropriate investments that decrease the efficiency of the economy by diverting resources toward economic activities that are supported by the bubble (for example, see Dupor, 2005). For example, during the bubble in tech stocks in the late 1990s, there was overinvestment in some types of high-tech infrastructure. Similarly, the bubble in housing prices led to too many houses being built. These distortions to activity across sectors of the economy are a drag on efficiency and hence are a matter of concern above and beyond fluctuations in overall economic activity and inflation. Return to text

4. See, for example, Mishkin (1991) and Kindleberger (2000). Return to text

5. I have previously discussed the interaction of financial markets and macroeconomic risk (for example, Mishkin, 2007d, 2007e). Return to text

6. See my earlier remarks on the subject (Mishkin, 2007c). Return to text

7. The Federal Reserve's congressional mandate is actually couched in terms of three goals: maximum employment, stable prices, and moderate long-term interest rates. However, as I have discussed (Mishkin, 2007a), the mandate is more appropriately interpreted in terms of the dual goals of price stability and maximum sustainable employment, and this formulation is what is consistent with stabilizing both inflation and economic activity. Mishkin (2008) discusses how the pursuit of price stability can foster maximum sustainable employment. Return to text

8. Vice Chairman Kohn (2006) presented similar views on the response of monetary policy to asset prices. Return to text

9. See Mishkin (2007g). Return to text

10. An additional reason is that many crashes of asset prices which have become associated with asset price bubbles have had very limited affects on the economy. In a paper I wrote with Eugene White (Mishkin and White, 2003), we studied 15 stock market crashes that occurred in the United States from 1900 to 2001 and found that in most cases they were not followed by episodes of financial instability. Return to text

11. Chairman Bernanke (2002) has discussed this potential problem. Return to text

12. For example, see the discussion in Greenspan (2002). Return to text

13. For example, see Gruen, Plumb, and Stone (2005). Return to text

14. Research supporting this view includes Bernanke, Gertler, and Gilchrist (1999); Bernanke and Gertler (2001); and Gruen, Plumb, and Stone (2005). Return to text

15. For example, see Kashyap and Stein (2004) and Goodhart (2008). Return to text

16. Research to date has not reached unambiguous conclusions. See Goodhart, Hofmann, and Segoviano (2005); Kashyap and Stein (2004); and Gordy and Howells (2006) for a more thorough discussion of related issues. Return to text

17. Stock market bubbles can do more harm if stocks are held by financial institutions and these institutions are allowed to include the market value of stocks in their capital base. As described later in this speech, this practice was a feature of the Japanese bank regulatory system and is one reason why the collapse of the stock market bubble in Japan helped lead to fragility of the banking system and, as a result, was much more damaging to the economy. Return to text

18. See, among others, Galbraith (1954) and Kindleberger (2000). Return to text

19. See, for instance, Galbraith (1954) and White (1990). Return to text

20. See Meltzer (2003, p. 225). Return to text

21. The stance of monetary policy was relatively easy during the mid-1980s as the BOJ attempted to contain the rapid appreciation of the yen following the Plaza Accord of 1985 and stimulated domestic demand to correct external imbalances. Return to text

22. Corporate restrictions on funding in the securities market were lifted in the 1980s, which reduced large firms' reliance on banks' loans. Moreover, interest rate ceilings on bank deposits were also gradually removed. See Okina, Shirakawa, and Shiratsuka (2001). Return to text

23. Posen (2003) provides an extended discussion of the reasons why such a reading of the Japanese experience is mistaken. Return to text

24. For example, see Ahearne and others (2002) and Posen (2003). Return to text

25. See Ito and Mishkin (2006). The slowness with which the imbalances in Japan's banking sector were addressed was another important factor leading to the deterioration in the economic outlook and deflation after the bubble burst. Return to text

26. The speech by Chairman Bernanke on April 10, 2008, provides a more detailed description of the market and regulatory failures during this period and the recommendations of the President's Working Group on Financial Markets. Return to text

Chairman Ben S. Bernanke

At the Columbia Business School's 32nd Annual Dinner, New York, New York

May 5, 2008

Mortgage Delinquencies and Foreclosures

President Bollinger, Dean Hubbard, Co-Chairman Kravis, and distinguished guests, I am very pleased to be here and especially honored to receive the Columbia Business School's Distinguished Leadership in Government Award.  This evening I would like to offer a few thoughts on mortgage markets and the recent increase in the pace of delinquencies and foreclosures.  My particular focus will be on geographic variation in mortgage performance and how that variation can help us better understand and prevent foreclosures.  I will also discuss some initiatives taken by the Federal Reserve to address the foreclosure crisis as well as other policies that might be used to strengthen mortgage and housing markets.

Geographic Variation in Loan Mortgage Performance
As my listeners know, conditions in mortgage markets remain quite difficult, and mortgage delinquencies have climbed steeply.  The sharpest increases have been among subprime mortgages, particularly those with adjustable interest rates:  About one quarter of subprime adjustable-rate mortgages are currently 90 days or more delinquent or in foreclosure.¹  Delinquency rates also have increased in the prime and near-prime segments of the mortgage market, although not nearly so much as in the subprime sector.  As a consequence of rising delinquencies, foreclosure proceedings were initiated on some 1.5 million U.S. homes during 2007, up 53 percent from 2006, and the rate of foreclosure starts looks likely to be yet higher in 2008.  Not all foreclosure starts result in the borrower's loss of the home; sometimes the borrower is able to make up the missed payments or other arrangements are made with the lender.  But, given the number of borrowers in distress and the weakness of the general housing market, the share of foreclosure initiations that ultimately result in the loss of the home seems likely to be higher in the current episode than customarily has been the case.

Many foreclosures are not preventable.  Investors, for example, are unlikely to want to hold onto a property whose value has depreciated significantly, and some borrowers--perhaps because they were put into an inappropriate loan or because personal circumstances have changed--cannot realistically sustain homeownership.  However, if a foreclosure is preventable, and the borrower wants to stay in the home, the economic case for trying to avoid foreclosure is strong.  Because foreclosures impose high costs, including legal and administrative costs as well as the costs of leaving the property vacant for a possibly extended period, both the borrower and the lender often are better off avoiding foreclosure.  Moreover, it is important to recognize that the costs of foreclosure may extend well beyond those borne directly by the borrower and the lender.  Clusters of foreclosures can destabilize communities, reduce the property values of nearby homes, and lower municipal tax revenues.  At both the local and national levels, foreclosures add to the stock of homes for sale, increasing downward pressure on home prices in general.  In the current environment, more-rapid declines in house prices may have an adverse impact on the broader economy and, through their effects on the valuation of mortgage-related assets, on the stability of the financial system.  Thus, finding ways to avoid preventable foreclosures is a legitimate and important concern of public policy.

To determine the appropriate public- and private-sector responses to the rise in mortgage delinquencies and foreclosures, we need to better understand the sources of this phenomenon.  In good times and bad, a mortgage default can be triggered by a life event, such as the loss of a job, serious illness or injury, or divorce.  However, another factor is now playing an increasing role in many markets:  declines in home values, which reduce homeowners' equity and may consequently affect their ability or incentive to make the financial sacrifices necessary to stay in their homes.

On the principle that a picture is worth a thousand words, Federal Reserve staff, using detailed, county-by-county information on mortgage performance, have developed a series of "heat maps," which summarize the incidence of serious mortgage delinquencies across the nation as well as some of the key drivers of loan performance.  As the examples will make clear, the figures (with the exception of one map depicting house price changes) use warmer colors--orange and red--to show counties for which the factor being considered has a higher value or change.  Lower values or changes (again, with the exception of that one map) are indicated by shades of green.  Yellow indicates areas where the factor under consideration has a moderate value or change.

Nationally, as of the fourth quarter of 2007, the rate of serious delinquency, as measured by credit records, stood at 2 percent of all mortgage borrowers, up nearly 50 percent from the end of 2004.²  The fourth quarter of 2004 is a useful benchmark, because general economic conditions were fairly normal and the lax underwriting that emerged later was not yet evident.

Figure 1 shows the national patterns of serious mortgage delinquency in 2004, which, again, I am taking as representative of a relatively normal period, with orange and red indicating the highest rates of delinquency and greens indicating the lowest.  In 2004, the areas of the country with the highest rates of serious delinquency included significant portions of the Southeast; parts of the Midwest, most notably Ohio and Indiana; portions of the Rocky Mountain region; and Texas, Oklahoma, and areas in the Mississippi valley.  In contrast, many parts of the country experienced exceptionally good loan performance at that time, including most of the West Coast, New England, and much of southern Florida.

However, conditions in some areas changed greatly in a relatively short period of time.  Figure 2 shows the pattern of delinquency rates as of the last quarter of 2007.  Many of the areas that exhibited elevated delinquency rates in 2004 continued to show relatively high rates of delinquency in 2007.  But some areas that had low rates in 2004 experienced high rates three years later.  Figure 3 makes this point more sharply by showing the pattern of increases in delinquency rates between 2004 and 2007, with the largest increases shown in red.  The strong regional pattern is evident in the figure.  Although many parts of the country have seen significant increases in mortgage delinquencies and foreclosures, a number of areas--such as California, parts of Nevada, Arizona, Colorado, Florida, portions of the upper Midwest, and New England--have been particularly hard hit.

The regional pattern of the recent rise in mortgage delinquencies and foreclosures requires explanation.  Again, we can use heat maps to examine the underlying relationships across geographic regions between changes in mortgage delinquency rates and factors identified as driving loan performance.  For example, the change in the unemployment rate in a county can be used as a proxy for disruptions in family incomes and subsequent financial stress.  Figure 4 shows changes in average annual unemployment rates across counties between 2004 and 2007, with counties indicated in red experiencing increases or only slight decreases in joblessness.³  The data suggest that increases in unemployment rates account for at least some of the recent increases in mortgage delinquencies.  Parts of New England, states in the Great Lakes region--including Minnesota, Michigan, and Wisconsin--and a number of other states, such as Nevada, show both increased mortgage delinquencies and notable increases in unemployment rates.

However, the behavior of unemployment does not seem sufficient to explain the increased delinquency rates in other areas, including California, Florida, and portions of Colorado, where mortgage delinquencies increased during a period in which unemployment generally decreased.  Another important determinant of loan performance, identified by research at the Federal Reserve and elsewhere, is changes in house prices.⁴  Figure 5 shows the regional pattern of changes in house prices between 2006 and 2007, with unchanged prices and price declines indicated in red.⁵  The figure shows that Florida, California, Nevada, Michigan, and parts of Arizona and Colorado experienced decreases in house prices between the fourth quarter of 2006 and the fourth quarter of 2007 (a pattern which has continued and intensified in 2008).⁶  As I noted, sharp declines in house prices, and thus in homeowners' equity, reduce both the ability and incentive of homeowners, particularly those under financial stress for other reasons, to retain their homes.

Other factors affect foreclosure rates, and once again the heat maps can give us a visual impression.  Figure 6 shows the share of home purchases by non-owner occupiers--investors or purchasers of vacation homes, for example--during 2005 and 2006.⁷  Again, there is some correlation with the increase in delinquencies and foreclosures, as purchases by non-owner occupiers were relatively high in the West, Southwest, and in Florida.  Figure 7 shows the incidence of junior liens (or piggyback loans), often an indicator of little borrower equity at the time of purchase.  The greater use of these mortgages in the West and East Coasts presumably reflects higher house prices in those regions; again, the geographical pattern suggests that the use of piggyback loans may also have contributed to the recent rise in delinquencies and foreclosures.⁸

What are the implications of these relationships, particularly the linkage of mortgage payment problems and falling house prices?  Loan servicers are used to dealing with mortgage delinquencies related to life events such as unemployment or illness, with the most common approaches being a temporary repayment plan or the folding of missed payments into the principal balance.  A widespread decline in home prices, by contrast, is a relatively novel phenomenon, and lenders and servicers will have to develop new and flexible strategies to deal with this issue.  In some cases, when the source of the problem is a decline of the value of the home well below the mortgage's principal balance, the best solution may be a write-down of principal or other permanent modification of the loan by the servicer, perhaps combined with a refinancing by the Federal Housing Administration or another lender.  To be effective, such programs must be tightly targeted to borrowers at the highest risk of foreclosure, as measured, for example, by debt-to-income ratio or by the extent to which the mortgage is "underwater."  Finding the right balance--particularly the need to avoid programs that give borrowers who can make their payments an incentive to default--is difficult.  But realistic public- and private-sector policies must take into account the fact that traditional foreclosure avoidance strategies may not always work well in the current environment.

The Federal Reserve's Homeownership and Mortgage Initiatives
I would like to say a few words about the Federal Reserve's efforts to strengthen homeownership and reduce preventable foreclosures.  The Federal Reserve's decisions regarding monetary policy and our efforts to increase financial stability affect housing and mortgage markets, of course.  But, as an organization with a national presence in the form of regional Federal Reserve Banks and their Branches, we are also working to address these issues more directly.  We are collaborating with other regulators, community groups, policy organizations, lenders, and public officials to identify ways to prevent unnecessary foreclosures and their negative effects on local economies.

Our efforts have taken a variety of forms.  First, we have employed economic research and analysis, a particular strength of the Federal Reserve, to increase the sum of knowledge about mortgage and housing issues.  For example, we are providing community leaders with detailed analyses identifying neighborhoods at high risk of foreclosures, analogous to the heat maps I showed you this evening.⁹  These analyses have helped community organizations better focus their scarce resources, such as deciding where to target counseling services or other intervention efforts.  A Federal Reserve System work group has prepared overviews of the current state of knowledge about housing and mortgage markets, and further research is currently under way to fill in the most important analytical gaps.

Second, we are collaborating with interested parties across the country, taking advantage of our national presence and our existing relationships with local lenders, community groups, government officials, and other stakeholders, to take practical steps to address the causes and consequences of foreclosures.  For example, I mentioned earlier the destabilizing effects foreclosures have on neighborhoods, resulting from factors such as decreased home values and deterioration of vacant properties from neglect.  To help address this problem, the Federal Reserve is joining in a partnership with the nonprofit NeighborWorks America to develop materials, tools, and training programs to help communities and others acquire and manage vacant properties. The goal is to support the provision of affordable rental housing and new homeownership opportunities in low- and moderate-income neighborhoods.  Federal Reserve Banks and Branches have also hosted numerous meetings and workshops to bring together local officials, lenders, community groups, and others to try to find ways to reduce the incidence of foreclosures and mitigate their economic and social effects.

Third, we are engaged with mortgage servicers to understand impediments they may face when modifying loans or offering other alternatives to foreclosure.  Servicers still report difficulty connecting with troubled borrowers, and we have supported efforts to encourage borrowers to contact their lenders or housing counselors.  Working with the Hope Now alliance and independently, we have encouraged the industry to increase their efforts to work with troubled borrowers, to develop guidelines and templates for reasonable standardized approaches to various loss-mitigation techniques, and to adopt uniform reporting standards, such as those sponsored by Hope Now.  Clear disclosures of loan modifications will not only make it easier for regulators, the mortgage industry, and homeowners to assess the effectiveness of foreclosure-prevention efforts, but they will also foster greater transparency, and hence greater confidence, in the securitization market.

Prospectively, we are committed to promoting an environment that supports the homeownership goals of creditworthy borrowers.  To this end, the Federal Reserve Board has proposed new regulations to better protect consumers from a range of unfair or deceptive mortgage lending and advertising practices.  To help ensure that the rules are broadly enforced, we are engaging in a program with other federal and state agencies to conduct consumer compliance reviews of nondepository lenders and mortgage brokers.  These reviews are targeting underwriting standards, risk-management strategies, and compliance with consumer protection laws and regulations.

The Federal Reserve also is continuing its long-standing practice of providing educational and information resources to help consumers make informed personal financial decisions, including choosing the right mortgage.  Through their community affairs offices, Federal Reserve Banks are working to establish foreclosure-mitigation resource centers on their websites to be used by small municipalities, housing counselors, and community groups.  For consumers who have questions about banking procedures and rules or who believe they may have been treated unfairly by their lender, the Federal Reserve Consumer Help Center directs queries to the various regulatory agencies so that a consumer has only one call to make to ask questions or file complaints.¹⁰  

Additional Mortgage Initiatives
Additional government policies can help address problems in the mortgage markets.  The Congress can take an important step by moving quickly to reconcile and enact legislation permitting the Federal Housing Administration (FHA) to increase its scale and improve its management of risks.  Such legislation could help the FHA reach a wider range of borrowers and develop appropriate underwriting and pricing methodologies to deal with any increase in credit risk.  Giving the FHA greater latitude to set underwriting standards and risk-based premiums for mortgage refinancing, as well as more flexibility in product development, would allow it to help still more troubled borrowers.