Thank you, Mr. Chairman. As many of us have discussed around this table and many of you already mentioned today, it has finally happened. Per earlier discussions, the much-anticipated repricing of risk is upon us, and I think what we all have quickly recognized, then and now, is that the diagnosis was the easy part. More difficult is to figure when the symptoms would manifest themselves; harder still is to understand the second- and third-order consequences; and perhaps most difficult is to determine whether any treatment is needed or whether, as the Hippocratic oath suggests, the patient will recover on its own. Even orderly repricings have fat tails, as Governor Kohn mentioned, and what we find in the marketplace is complacency replaced very quickly by deep concern. Certainly, this recent market turmoil looks particularly pronounced in contrast to previous periods when trees appeared to grow to the sky and markets were priced for perfection in a world that seemed to most of us to be decidedly imperfect. Let me discuss two distinct matters—first, the state of the financial markets, building on the presentation from Bill, Tim, and others, and then the harder part, the impact on the broader economy—before trying to summarize the situation.
The financial markets have really provided wind at the back of the broader economy throughout this most recent period, even until a month ago. I think the open question, and the hardest, is whether those financial markets will prove sufficiently resilient—that is, whether the underlying shocks to the economy that might occur are exacerbated by this financial market situation or whether the worst of the outcomes are made less severe by the financial markets. Perhaps it is best to review the dynamics of different asset markets to assess their implications for credit availability during the forecast period. The threat is that these different asset classes increasingly look correlated, particularly in times of distress. Certainly, the events of recent weeks culminating in trading late Thursday and Friday of last week are troubling, driven by a combination of factors: first, symbolized perhaps by one financial institution that has unwittingly called its own liquidity into some question; second, a function of a reduction in confidence in markets themselves—a pullback in liquidity—with considerably less trust in underlying valuations, underlying collateral, and the underlying structure of markets themselves; and third, an expectation, at least in the mortgage markets, that there is still another leg down and so one way bets, at least for a period, appear insufficient to bring other opportunistic capital in at this point. The pullback was manifested in the difficulty of rolling over extendable commercial paper, as Bill and others have said, a lack of bid for anything mortgage related, a lack of trust in credit ratings, and a fear of using financial institutions as counterparties. The next period in my judgment holds out some promise, but not a guarantee, of opportunistic capital. Certainly, there are big fund raisings by investment banks and other private pools of capital at remarkable leverage levels, giving the potential that the pools of liquidity that are on the sidelines could quickly find their way back into the game.
Let me now turn to different asset markets to try to assess when we will know how they will figure themselves out and make sure that we are able to get some judgments before it is too late. So I will spend a moment on the bank and leveraged-loan markets, a couple of moments on the subprime market, and another moment on a third bucket of assets, which might be everything else, as we are trying to figure out whether there is real spreading. First, in the bank and leveraged-loan market, the volume of loans, as many of you know, is somewhere between $220 billion and $320 billion of committed capital in the pipeline. The underlying credits still appear quite strong, and I will tell you that I have a reasonably high degree of confidence that, in spite of the distress, these markets should work themselves out between now and the next FOMC meeting. We certainly won’t see any return to the markets that people have gotten used to over the past several months and years, but I would be surprised if we didn’t see opportunistic capital coming into these markets and bidding prices. Just to give you some idea, off that denominator of capital committed, we might see losses on the order of $30 billion or $50 billion. I would say that’s a fairly conservative estimate. Bank debt, which is the most secured, might have discounts of 3 to 5 percent, should bids find their way into the market in the coming days; leveraged loans and high yields, discounts of about 10 percent; and second lien mortgages, discounts of 15 to 20 percent. Almost all of these are largely related to risk premiums, not credit quality. Real money is still in these businesses. Some of the hot money that was discussed earlier, some of these CLO buyers, are no doubt gone for some time. I think the most encouraging thing is the new funds that have begun capital-raising campaigns, even over the past weekend, looking to buy the distressed securities, market-force the commercial institutions that have been having it on their books, and mark it to market. Remarkably, many of the same commercial banks are prepared to stand behind these new leveraged investments with leverage of about 4 to 1. So I would expect that market to increase pretty quickly. Market functioning there is thus, in my judgment, likely to improve. Some deals are certainly likely to blow up, relieving some of these banks of their commitments. But in this market, because there are multiple gatekeepers and because valuing the underlying credit strikes me as not that time-intensive or taxing a process, it is likely in my judgment that, come fall, we will come to some new equilibrium.
I can be far less confident, however, about the subprime mortgage market. My base case assessment there has a much lower confidence level, both in terms of timing and in terms of outcome. The subprime market has about $1.4 trillion in outstandings, and there is considerably less certainty about the underlying credit. It is harder to measure and appraise the underlying pools. Recovery rates will be still harder to find. As a final note, which might have struck the markets last week, apparently more fraud is endemic to these pools, making valuation increasingly difficult. As a result, I am less comfortable about suggesting what the underlying losses might be. They might be $100 billion. They could be considerably more. I’m also less confident that there will be opportunistic capital coming back to these markets over the next thirty or sixty days. With another leg down, it could take considerably longer. As a result, I am quite a bit less confident that the market functioning will return as rapidly as we would hope. I am more concerned that, unlike the multiple gatekeepers we find in the leveraged-loan markets, for those that relied on the single gatekeepers, the credit-rating agencies, given that their credibility has been shot, it is much harder to see that this market will unwind itself in a rather calm and comforting environment, at least over the balance of 2007.
The final set of asset markets I’d speak a moment about is “everything else.” What about everything else that is subject to structured products? What about everything else that is subject to complex financial instruments? Some questions arose late last week about the market integrity regarding those. I think it is just too hard to judge how that is going to work out. We are seeing losses showing up in some very unlikely places. I’d like to say that what we have witnessed over the past week is transitory, but for that set of asset markets, it is probably hardest for me to come to a broader judgment.
So what are the effects, then, on the broader economy? I agree with the point that President Stern made earlier that this judgment is extremely hard to make. I also agree with Governor Kohn’s judgment that there is a very real downside risk if some of these financial market turmoil issues persist. If I look at some of the credit channels and at financial intermediaries and ask whether they are under stress, I see more dispersion of risk among similarly situated institutions. Some commercial banks may well be under more distress than others. I have no doubt that some investment banks are under more distress than others. We see some of this dispersion in credit default swaps and some of it in equity prices, but my sense is that the underlying fundamentals of their core businesses are very different from each other and from their competitors than they’ve been at any point in this cycle. For some of them to take losses on their own balance sheets of $3 billion, $4 billion, or $5 billion, as an investment bank, might not be hard to do when many of them have been picking up market share and using their own proprietary trading and agency businesses to steal customers and revenue from others. But for the balance, I think it is unclear how it is going to result. With many of the investment banks’ quarters ending in August, the markets are going to put genuine pressure on them to come clean with their losses. I expect most, if not all, of them to do so. So I think come mid- September we’ll have a clearer sense of what their own marked-to-market models suggest. What about the broker-dealers? Again, not principally their regulators but I suspect the markets are going to push them to come clean with what their losses are. Large financial institutions I would expect, though with less confidence, to take writedowns of their portfolios of leveraged loans and writedowns to some extent of their mortgage products to try to assure the investing community of their financial positions. I hope that the process would work out this fall, but as I mentioned, I’m less comfortable that we’re going to get that kind of transparency with the regulated commercial banks than with some others.
Private pools of capital are also undergoing a real shakeout. For those with liquidity pressures, which will tend not to be the largest hedge funds or private equity funds, we will read about their problems, and we will read about their closings, over the coming weeks and months. The good news is that the largest among them have used the period of strong liquidity over the past year to more or less have quasi-permanent capital to term out their loans and provide capital so that they could take advantage in this period. I understand that there has been very little spike in margin calls where most of the assets rest in the hedge fund community. So for many of us who have talked about hedge funds bringing resilience to these markets, this is really a time of testing. I think the early news for the largest among them is quite positive.
Many of you have talked about what the other transmission mechanisms are for having GDP effects. The wealth effect is real. We have lost about $1 trillion in market capital in the past twenty trading days, and that can’t be discounted. Questions about board room confidence and cap-ex in the second half of this year are equally real. My sense is that we are going to finally use that excess cash on balance sheets that many of us have long talked about. Finally, with respect to consumer confidence, though I think the recent data suggest that it’s positive, I suspect that the next set of data we get will show a retreat from those numbers. It is very hard to judge how real consumers are going to react here.
Let me make two final comments. Opportunistic capital is a key here to a smooth transition. It’s key to ensuring that what happened in the financial markets doesn’t seep its way into the real economy. Of the equity investors that were using loose credit markets to get equity returns, the most sophisticated are focusing on and looking for equity returns in the debt markets. So many investors previously investing in equity are now looking to the debt markets, where they see a risk-reward tradeoff that is better than it has been in a long time. That gives me some confidence that opportunistic capital will come back to some of these markets. That said, rating- sensitive buyers will no doubt pull back given that ratings are less authoritative. So I will end where I began, which is looking at economic fundamentals. I think Governor Kohn talked about how the capital markets, the financial markets, and the labor markets have proven to be absolutely core to the resilience of the broader economy. To the extent that there is now an unfortunate timing between weakness in the financial markets and some potential weakness in underlying credit, we can rely less on the financial markets to come to the rescue, should that circumstance occur. Thank you, Mr. Chairman.