Friday, April 13, 2012

Bernanke: "Some Reflections on the Crisis and the Policy Response"

by Bill McBride on 4/13/2012 01:20:00 PM

Note: Bernanke didn't discuss current monetary policy.

From Fed Chairman Ben Bernanke: "Some Reflections on the Crisis and the Policy Response"

On the originate-to-distribute model:

Private-sector risk management also failed to keep up with financial innovation in many cases. An important example is the extension of the traditional originate-to-distribute business model to encompass increasingly complex securitized credit products, with wholesale market funding playing a key role. In general, the originate-to-distribute model breaks down the process of credit extension into components or stages--from origination to financing and to the postfinancing monitoring of the borrower's ability to repay--in a manner reminiscent of how manufacturers distribute the stages of production across firms and locations. This general approach has been used in various forms for many years and can produce significant benefits, including lower credit costs and increased access of consumers and small and medium-sized businesses to capital markets. However, the expanded use of this model to finance subprime mortgages through securitization was mismanaged at several points, including the initial underwriting, which deteriorated markedly, in part because of incentive schemes that effectively rewarded originators for the quantity rather than the quality of the mortgages extended. Loans were then packaged into securities that proved complex, opaque, and unwieldy; for example, when defaults became widespread, the legal agreements underlying the securitizations made reasonable modifications of troubled mortgages difficult. Rating agencies' ratings of asset-backed securities were revealed to be subject to conflicts of interest and faulty models. At the end of the chain were investors who often relied mainly on ratings and did not make distinctions among AAA-rated securities. Even if the ultimate investors wanted to do their own credit analysis, the information needed to do so was often difficult or impossible to obtain.
CR Note: This wasn't just for subprime. Even worse were the Alt-A loans! Also I don't think Bernanke spent enough time on the failure of regulators to recognize the very loose lending.

I think the housing bubble (and subsequent bust) can be understood very well by looking at each step of originate-to-distribute model, and also at the willful lack of regulatory oversight. Bernanke suggests housing was just the trigger, but if the regulators couldn't see that loaning people 100+ LTV, with stated income, and a low teaser rate would end poorly, then there was no way they could see the systemic risk!

Bernanke concludes:
The financial crisis of 2007-09 was difficult to anticipate for two reasons: First, financial panics, being to a significant extent self-fulfilling crises of confidence, are inherently difficult to foresee. Second, although the crisis bore some resemblance at a conceptual level to the panics known to Bagehot, it occurred in a rather different institutional context and was propagated and amplified by a number of vulnerabilities that had developed outside the traditional banking sector. Once identified, however, the panic could be addressed to a significant extent using classic tools, including backstop liquidity provision by central banks, both here and abroad.
I disagree that the crisis "was difficult to anticipate". I think the potential for the housing bust to lead to a financial crisis was fairly obvious (I first mentioned the possibility of a financial crisis as a result of the then coming housing bust in 2005).

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