Kevin M Warsh: The end of History?
Speech by Mr Kevin M Warsh, Member of the Board of Governors of the US Federal Reserve System, to the New York Association for Business Economics, New York, 7 November 2007.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal Reserve System’s website.
"...After several years of strong domestic and global growth, financial markets appeared highly accommodative for issuers and investors. Many willing investors purchased complex financial products convinced that they would achieve outsized returns because the future would look like the recent past. On the other side of the trade, originators operated under the presumption that secondary markets would remain liquid. And the resulting market-clearing prices across a range of asset classes were predicated on a world of modest risk premiums, low credit spreads, and plentiful liquidity. Market confidence ultimately begot complacency (Warsh, 2007).
By mid-summer, complacency was upended. What followed was a rapid period of retrenchment, the first phase of financial market turmoil. As concerns about losses on subprime mortgages and securitized products intensified, investors withdrew liquidity and markets became impaired. Investors revisited, almost anew, the quality of the information about their assets. Financial intermediaries also pulled back from making markets in many products, and the engines of financial innovation were all but turned off. As the strains in financial markets intensified, many of the largest financial institutions became jealously protective of their liquidity and balance sheet capacity. Amid heightened volatility and diminished market functioning, they became more concerned about the risk exposures of their counterparties and other potential contingent liabilities. For some, that process lasted days and weeks; for others, it may yet continue for many months.
In the second phase – reliquification – financial institutions decided on the new liquidity levels and capital ratios at which they were prepared to conduct business. Many banks became markedly less willing to provide funding to customers, including other banks. Given reduced confidence in their ability to quantify and price risks, balance sheet capital remained a scarce commodity. As a result, both overnight and term interbank-funding markets were pressured considerably. Even today, some banks face potentially large needs for dollar funding, and their efforts to manage their liquidity may be contributing to pressures in global money markets and foreign exchange swap markets. More broadly, many financial institutions appear hesitant to put opportunistic capital to work.
The next phase – revaluation – requires that the new prices be established in accordance with the new financial environment. The process of price discovery appears to be quicker and more assured among corporate credits. Think, for example, of the markets for high-yield and leveraged loans, in which risk spreads have returned to more moderate levels. We have seen significant evidence that the process of revaluation in other previously disrupted markets is also under way. Investors are differentiating risks, for example, among asset-backed commercial paper programs, and many spreads have moderated. Revaluation, however, may be a slower, tougher slog in the mortgage markets for those vintages in which the underlying asset quality is less certain. How quickly asset markets substantially complete the revaluation phase depends on the speed with which stakeholders regain comfort in their ability to value these assets.
Financial markets rarely normalize in a steady, linear fashion. More often, as market sentiments sway between fear and greed, asset prices fluctuate and seek support (volume) before establishing new trading ranges. That pattern is particularly pronounced when the underlying economic fundamentals are less certain. Hence, the next phases – review and refinement – are the hardest to predict with precision. As circumstances dictate, some financial institutions will review and refine their capital ratios, risk metrics, and business imperatives and proceed forward. Others may find that, in the course of review, they return to the phases of retrenchment and reliquification. Central bankers are prudent to stay alert to these changes....."