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Wednesday, April 04, 2007

Fed's Fisher on Risk

by Calculated Risk on 4/04/2007 03:50:00 PM

Dallas Fed President Fisher: Risk Is a Many Splendored Thing: Lessons Learned. Excerpt on subprime and Alt-A:

Thus far, the damage from the subprime market has been largely contained, as many of my Federal Reserve counterparts have been saying. Why do we say so? To begin with, quality problems have risen primarily for adjustable-rate subprime loans, which are only about 8.5 percent of home mortgage debt outstanding. Also, much of this debt was packaged into private-label mortgage-backed securities with the downside risk spread out over a diverse group of investors. Nevertheless, because 40 percent of homebuyers last year were nonprime (subprime and Alt-A) borrowers, housing markets may feel some short-term pain, making it less clear whether housing construction has bottomed and how long the housing downturn may last. Fortunately, the financial system and the economy are strong enough to weather this storm.

While the subprime damage is largely contained, I do not mean that the market will or should refrain from punishing those who neglected time-proven rules of prudence. Nor am I suggesting that the neglect of prudent practices has not bled into other types of credit—such as the Alt-A market. Indeed, it would be atypical for lax lending standards in one area of credit not to lead to laxity in others. Nor am I placing excessive faith in models that have yet to be tested by real developments.

The subprime situation may well be a blessing in disguise. It reminds us that history does have the capacity to repeat itself. The old financial axioms—levelheaded notions such as “know your customer” (or your counterparty) and “there is a difference between price and value”—remain valid. I expect market discipline to reassert itself, swiftly punishing those who pressed the limits of imprudence or suffered selective amnesia, hopefully doing so in a way that staves off the impulse for lawmakers and regulators to interfere disproportionately.