US financial crisis: Why the Fed rushed to the rescue

Timothy Geithner, president and chief executive officer of the Federal Reserve Bank of New York, testified before the US Senate Banking Committee last week on the US financial crisis. Below is an excerpt of his testimony.

THE intensity of the crisis we now face in United States and global financial markets is a function of the size and character of the financial boom that preceded it.

This was a period of rapid financial innovation - particularly in credit risk transfer instruments such as credit derivatives and securitised and structured products. There was considerable growth in leverage, greater reliance on ratings on structured credit products and a marked deterioration in underwriting standards.

The innovation in financial products was accompanied by a dramatic increase in the amount of financial intermediation occurring outside the core banking system. The importance of securities broker-dealers, hedge funds and mutual funds in the financial system rose steadily. Off-balance-sheet vehicles of various forms proliferated, and increased concentrations of longer-dated assets were held in funding vehicles with substantial liquidity risk.

The deterioration in the US housing market last summer precipitated a sharp rise in uncertainty about the value of securitised assets. Demand for these assets contracted dramatically and the securitisation market for mortgages and other credit assets stopped working. This increased funding pressures for a diverse mix of financial institutions. Uncertainty about the magnitude and the level of losses for financial institutions fuelled concern about credit risk in exposure to those institutions.

Part of the dynamic at work was that banks were forced to provide financing for - or take over - the assets in a range of structured investment vehicles and conduits financed by asset-backed commercial paper. As some investors attempted to liquidate their holdings of these assets, many of the traditional providers of unsecured funding to banks pulled back from their counterparties in anticipation of the potential withdrawals of funds by their own investors.

Market participants’ willingness to provide term funding even against high-quality collateral declined dramatically. As a result, the cost of unsecured term funding rose precipitously and the volume shrunk. Banks were funding themselves at shorter and shorter maturities. As unsecured term funding markets deteriorated, the premium on liquid marketable collateral - such as Treasury securities - rose considerably.

Even with the dramatic actions by the Federal Reserve and other central banks to address these liquidity pressures, the strains in financial markets persisted. In many respects, conditions worsened in February and last month.

Credit spreads on financial institutions widened, equity prices declined and market functioning deteriorated. By the early part of last month, the threat of a disorderly adjustment was growing.

What we were observing in US and global financial markets was similar to the classic pattern in financial crises. Asset price declines - triggered by concern about the outlook for economic performance - led to a reduction in the willingness to bear risk and to margin calls.

Borrowers needed to sell assets to meet the calls; some highly leveraged firms were unable to meet their obligations and their counterparties responded by liquidating the collateral they held.

This put downward pressure on asset prices and increased price volatility.

Dealers raised margins further to compensate for heightened volatility and reduced liquidity. This, in turn, put more pressure on other leveraged investors. A self-reinforcing downward spiral of higher haircuts forced sales, lower prices, higher volatility and still lower prices.

This dynamic poses a number of risks to the functioning of the financial system. It reduces the effectiveness of monetary policy, as the widening in spreads and risk premiums worked to offset part of the reduction in the Fed funds rate. Contagion spreads, transmitting waves of distress to other markets, from sub-prime to prime mortgages and even to agency mortgage-backed securities, to commercial mortgage-backed securities and to corporate bonds and loans. In the current situation, effects were felt in the municipal and student loan markets.

The most important risk is systemic: If this dynamic continues unabated, the result would be a greater probability of widespread insolvencies, severe and protracted damage to the financial system and, ultimately, to the economy as a whole. This is not theoretical risk, and it is not something that the market can solve on its own. It carries the risk of significant damage to economic activity.

Absent a forceful policy response, the consequences would be lower incomes for working families; higher borrowing costs for housing, education and the expenses of everyday life; lower value of retirement savings; and rising unemployment.

I believe that the Federal Reserve System’s response has helped reduce the risk of systemic damage to the financial system, and thereby helped mitigate a potential source of downside risk to growth. This in turn has helped mitigate the risks to the broader economy.

It is important to recognise that a substantial adjustment, recognition of losses and reduction in risk have already taken place. And a range of different prices of financial assets now reflects a very cautious view of the future.

The severity of the pressures in markets evident over the last few months is in part a reflection of the speed and force with which markets and institutions in our financial system adapt to fundamental changes in the outlook. This capacity to adjust and adapt is one of the great strengths of our system.

Nevertheless, we still face a number of challenges ahead. The seeds of this crisis took a long time to build up, and they will take some time to work through.

Source : Straits Times - 8 Apr 2008