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The Federal Reserve sees the latest bout of financial market turmoil as driven by two factors: a wave of rating downgrades of housing-related credits and increased fear over economic fundamentals, above all the outlook for the housing market.
Underlying all this is the same “information problem” that has plagued markets since the credit crisis began at the end of July: noone knows how large the losses will ultimately be, or how they will be distributed among financial entities.
Since mid-October, the value of supposedly safe AAA-rated tranches of collateralised debt obligations with mortgage exposure has fallen sharply, driven by rating downgrades, worsening conditions in housing and further increases in mortgage delinquency rates.
Some renewed weakness in the markets was not surprising to policymakers, who were bemused by how bullish investors were in early October. But the extent of the latest declines in higher-rated CDOs disappointed some officials, who hoped that the market had already discounted the looming downgrades and further housing weakness.
Policymakers say it is difficult for them to determine in real time whether investors are ahead of the curve or behind the curve in pricing securities to reflect the economic outlook and future rating actions. However, it is now clear investors fell behind the curve by mid-October and have since been racing to catch up with financial and economic developments.
Commercial and investment banks hold a lot of higher-rated CDOs and were exposed to mark-to-market losses when their value fell.
However, Fed officials believe that the fall in banks’ stock prices also reflects their inability to dispel a cloud of doubt that hangs over their credibility. After a short-lived burst of confidence triggered by early disclosure of losses, further bad news punctured faith in banks’ ability to value their complex holdings and offsetting hedges, and to communicate the full extent of likely losses.
A Wall Street Journal report that Merrill Lynch did deals with hedge funds to postpone write-downs on mortgage-related securities likely heightened these concerns. The company said it had no reason to believe “inappropriate transactions occurred”.
The Fed has no evidence financial institutions have tried to conceal the extent of their credit exposures, and believe the US regulatory system – tightened after the dotcom crash and corporate scandals of the early 2000s – provides strong incentives not to do this. But officials know they cannot be sure, in part because the underlying credit instruments are so complex.
Policymakers are focused on institutions with potential systemic importance – including the big banks, such as Citigroup, and major investment banks such as Merrill Lynch – but also the monoline insurers that provided insurance against the risk that CDOs would not pay out.
Officials must be concerned about the decline in the shares of Citigroup and other banks, which makes it more difficult for them to raise additional capital if needed to offset losses or set against loans coming back on balance sheet from off-balance sheet vehicles.
Some officials also worry about the deterioration in their long-term earning power in a world in which there is less demand for lucrative financial engineering. This would limit their ability to rebuild capital organically.
However, officials take some comfort in the fact that the big banks went into the crisis with strong capital cushions, and the resilient outlook for the non-housing economy – and therefore their non-housing loans.
For now the Fed, which cut interest rates this week, is monitoring developments, but not taking any additional actions to boost liquidity. Policymakers see nothing unusual about this week’s large open market operations, which were designed to roll over maturing paper rather than increase the overall amount of liquidity in the market.