Thank you, Mr. Chairman. I’ll be referring to the handout that you have in front of you. In my mind, there are three key questions. First, how did the problems in the subprime mortgage area—with losses that probably will ultimately turn out to be in a range of $100 billion to $200 billion—lead to such broad market distress? Second, what is the cause of the dysfunction in U.S. and European money markets? Third, how far along are we in terms of the adjustment process—in other words, when might we anticipate a resumption of normal market function?
Turning to the first question, the losses in subprime mortgages had wide-ranging effects because the poor investment performance made investors much less willing to invest in structured-finance products more generally. Investors lost confidence because highly rated securities that referenced subprime assets performed poorly and because investors found it difficult to value complex structured-finance products. This loss of confidence triggered several broader developments: the inability of mortgage originators to securitize nonconforming mortgage loans; the rapid contraction of the asset-backed commercial paper (ABCP) market; the virtual shutdown of the collateralized debt obligation (CDO) and collateralized loan obligation (CLO) markets; the sharp shifts we saw into and out of Treasury-only versus prime money market mutual funds, which in turn disrupted the Treasury bill market; and the anticipated pressure on bank balance sheets and the upward pressure on term funding rates.
The pressure on bank balance sheets is coming from three major sources. First, investor demand for securitized non-agency mortgage-backed securities has dried up. Bank originators now have to hold such loans in their bank portfolios. Second, bank backstop liquidity facilities have been triggered as investor appetite for asset-backed commercial paper has fallen sharply. Third, banks are expected to have difficulty syndicating the bridge loans that they provided to finance leveraged buyouts.
Of these three sources of pressure, the rollup of ABCP programs has been, in my view, the most important. The magnitude of the potential funding requirement is the largest, and how much will come back onto bank balance sheets is very uncertain. The constraint on mortgage loan origination can be seen most visibly in the widening of the spread between fixed-rate prime jumbo mortgage loan rates and conforming mortgage loan rates. As you can see in exhibit 1, the spread has widened from around 25 basis points to around 100 basis points in recent weeks. The sharp contraction in the ABCP market began when commercial paper investors became aware that their investments could be vulnerable to loss but were uncertain as to the extent of their exposure in particular programs. This fear of loss had a legitimate basis for those ABCP programs that finance mortgage-related assets without full bank credit enhancement. An inability to roll over these programs in the current market would force the liquidation of the assets. In the current market, that could lead to investor losses. The problem started in extendable commercial paper market programs, where the credit enhancement backstop by banks was typically either absent or less than 100 percent. The problem then quickly migrated to structured-investment vehicle (SIV) programs, which suffered from similar shortcomings. From there, the problem spread as risk-averse investors started to shun the entire asset class. Asset-backed commercial paper rates rose for those programs that were able to roll over their outstanding commercial paper. This is shown in exhibit 2, which compares unsecured and secured commercial paper rates. The volume of outstanding asset- backed commercial paper shrank sharply as some issuers were unable to roll over their maturing paper. Exhibit 3 illustrates the downtrend in the volume of outstanding ABCP. Exhibit 4 shows the maturity structure of outstanding asset-backed commercial paper and highlights the high proportion of paper that is now being rolled on an overnight basis. The pressure on the asset-backed commercial paper market was temporarily exacerbated by the behavior of money market mutual fund investors, who shifted funds last month from prime money market funds to Treasury-only money market funds (see exhibit 5). Because the total assets in money market mutual funds are nearly four times the size of outstanding Treasury bills, these flows led to a large, albeit mostly transitory fall in Treasury bill yields. That is shown in exhibit 6.
The good news is that the money flows into the prime money mutual funds have stabilized. This reflects greater discernment among investors about the risks associated with different types of asset-backed commercial paper and the widening yield differentials between prime and Treasury-only money market funds. It is noteworthy that those areas of the asset-backed commercial paper market with underlying structural problems—primarily the extendable, SIV, and SIV-lite portions of the market—represent only a small proportion of total asset-backed commercial paper outstanding. For example, as shown in exhibit 7, SIV programs represented only about 7 percent of the asset-backed commercial paper market before the recent sharp contraction. Moreover, as shown in exhibit 8, much of the asset-backed commercial paper market does not finance residential mortgage asset-backed securities, so there is less uncertainty about the underlying value of the assets. Also, much of the market has solid credit support, with 100 percent bank credit enhancement. This suggests that, as time passes, investors will gradually be able to distinguish between the different types of the ABCP programs and stability will return to the multi-seller, bank-sponsored programs. Already, the pace of contraction of the overall ABCP market has slowed significantly. However, the extendable and SIV programs are likely to continue to be under pressure.
The third source of balance sheet pressure stems from the sharp contraction in CDO and CLO issuance. As can be seen in exhibit 9, CDO and CLO issuance volumes have plummeted in recent months. The virtual closure of the CDO market has led, in turn, to a virtual cessation of high-yield debt issuance—illustrated in exhibit 10. These developments have created uncertainty for commercial and investment banks about their ability to syndicate the large volume of loan and debt commitments that they have made to finance private equity buyouts. These institutions are faced with the prospect that they may have to carry such loans on their books for an extended period at a discount to par value. Syndication will be more difficult because the ability to transform a large proportion of these obligations into marketable investment-grade products through the alchemy of structured finance is not currently an available option.
This pressure on bank balance sheets—both existing and anticipated—has led to significant dysfunction in financial markets. In particular, primary dealers have pulled back in their willingness to finance the security positions of investment banks, hedge funds, and other leveraged investors. Exhibit 11 illustrates the median repurchase-rate bid-asked spread by primary dealers for three types of collateral— GSE MBS, prime MBS, and high-yield corporate debt—at overnight, one-week, and one-month maturities. As can be seen, there has been an upward trend in bid-asked spreads, especially at the one-month maturity. Exhibit 12 illustrates the median haircuts applied against such collateral. Again, there has been an increase, which has been particularly pronounced at the one-month maturity.
At the same time, this balance sheet pressure and worries about counterparty risk have led to a significant rise in term borrowing rates. Banks that are sellers of funds have shifted to the overnight market to preserve their liquidity, and this shift has starved the term market of funds, pushing those rates higher. As shown in exhibit 13, the spread between the one-month LIBOR and the one-month interest rate swap rate has widened sharply, and the one-month LIBOR has generally traded considerably above the anticipated level of the overnight federal funds rate. The same pressure on funding rates has been also evident in euribor rates (see exhibit 14). The rise in term rates has pushed banks that depend on funding from the interbank market into the overnight market. In addition, these depository institutions have turned to the Federal Home Loan Bank system as a source of term funding. For example, FHLB advances rose $110 billion in August. In contrast, despite the 50 basis point reduction in the spread between the discount rate and the federal funds rate target, the dollar value of discount window borrowings remains modest, as shown in exhibit 15. This reflects the lower cost of FHLB advances, the ability to borrow at longer terms from the FHLB, and the lack of stigma in using such advances as a source of funding.
So where do we go from here? Clearly, the adjustment process is far from over. Asset-backed commercial paper programs are still being rolled up, and there is considerable uncertainty about how difficult it will be to roll some of this paper over quarter-end. Moreover, it remains unclear what proportion of leveraged loan commitments commercial and investment banks will be able to syndicate and at what price. Despite the big backlog and the end of the August doldrums, there has, as yet, been little syndication activity. The good news, of course, is that as time passes, the uncertainty about bank balance sheet pressures and funding requirements should lessen. Moreover, investors’ ability to distinguish between “good” and “bad” ABCP programs and structured-finance products should continue to improve. The bad news is that the stress caused by the forcible deleveraging of the nonbank financial sector could lead to further losses accompanied by headlines that could further damage investor confidence. Moreover, the increased reliance by banks on overnight funding increases rollover risk and may limit the willingness of banks to expand their balance sheets to accommodate the deleveraging of the nonbank financial sector. In the mortgage sector, depository institutions will undoubtedly—at the right price—take up the slack in the prime jumbo mortgage market. But nondepository institutions are unlikely to be able to originate and securitize nonconforming mortgages in appreciable volume for some time.
The tone in financial markets has improved a bit in recent days. Nevertheless, we still appear to be in an environment in which the dominant theme is risk aversion. This can be seen in a matrix that measures the correlation among the price movements in the major asset classes (see exhibit 16). In times when markets are calm and untroubled, the correlation coefficients are generally low. As you can see in the exhibit, which examines these correlations since the August 7 FOMC meeting, the correlation coefficients have been very high recently.
In the foreign exchange markets, two developments are worth noting. First, the turmoil in money markets did impair the functioning of the foreign exchange swap market. This made it more difficult for banks in Europe that are structurally short of dollars to obtain the dollar funding needed to fund their assets. In recent days, this market function has improved. Second, the dollar has weakened. As shown in exhibit 17, the dollar has fallen to a record low against the euro. But don’t be too impressed by that headline. On a broad trade-weighted basis, the decline of the dollar has been modest, with a decline of less than 1 percent from the last FOMC meeting and a fall of slightly more than 4 percent from the start of the year. Moreover, this softness in the dollar does not appear to signal any fundamental shift in the willingness of foreign investors to hold dollar-denominated assets. Instead, it appears to be driven mainly by changing interest rate expectations. As shown in exhibit 18, the exchange rate of the dollar versus the euro has continued to track changes in expected short-term interest rate differentials between the United States and Europe.
Not surprisingly, our dealer survey reveals a large decline in short-term rate expectations. Exhibits 19 and 20 compare the dealer surveys before the August 7 FOMC meeting and before the current FOMC meeting. The green circles represent the average of the dealer forecasts, and the blue circles represent the range sized by the number of dealers at each value. As can be seen, the average of the dealer modal forecasts for mid-2008 has fallen more than 60 basis points. Market expectations—as reflected by the solid bold lines—have declined about the same amount and remain below the average dealer modal forecasts. With respect to the outcome of this meeting, a slight majority of dealers expect a 25 basis point reduction in the target federal funds rate rather than a 50 basis point cut. Only one dealer expects no change in the federal funds rate target. Uncertainty about the short-term interest rate path has also increased. This is evident both in the dealer survey and in the probability distribution of rate outcomes implied by options prices on Eurodollar futures. As can be seen in exhibit 21, the probability distribution of rate outcomes has become much broader since the August 7 FOMC meeting.
Finally, open market operations since the last FOMC meeting warrant some discussion. As you know, in early August, following persistent upward pressure on the federal funds rate and an extraordinarily large reserve-adding provision by the ECB, we aggressively added reserves on August 10. That provision of reserves did break the upward pressure on the federal funds rate, and the federal funds rate traded notably soft over the remainder of that two-week reserve maintenance period. Since that time, we have attempted to pull back on our provision of reserves in order to push the federal funds rate back up toward its target. Notice that the blue bars in exhibit 22, which measure daily excess reserves before borrowing, have been generally in negative territory over the past month. Although we have had some success in pushing the effective federal funds rate higher, it has generally traded over the past month below the 5¼ percent target.
Our efforts to push the federal funds rate back toward the target have been undermined by several factors. First, expectations about the possibility of an intermeeting cut in the federal funds rate target have caused the federal funds rate to trade somewhat soft. Also, in recent days, the effective rate has been held down somewhat by expectations of a rate cut at today’s meeting. Second, the narrower margin between the discount rate and the federal funds rate target makes it more difficult to push up the effective federal funds rate. The upper band of the corridor above 5¼ percent is now half as wide as before even as the lower bound for the federal funds rate remains at 0 percent. The lower discount rate acts as a cap on how high the federal funds rate can climb when reserves are tight. Third, we have had bad luck in the sense that most of our forecasting misses in terms of autonomous factors that affect reserves—such as float, Treasury balances, currency demand, and borrowings at the window—have caused us to inadvertently leave more reserves in the banking system than we had intended. Our difficulty in pushing up the effective rate can be illustrated by our experience last Wednesday, the last day of the two-week reserve maintenance period. Despite a consistently stingy provision of reserves that resulted in $5 billion of overnight primary credit borrowing for the day and $7.2 billion in total borrowing, the effective rate for that Wednesday was 5.18 percent. I would note, though, that in the past two days we have actually pushed the funds rate effectively up to its target.
There were no foreign exchange operations during this period. I request a vote to ratify the operations conducted by the System Open Market Account since the August 7 FOMC meeting. Of course, I am very happy to take questions.