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Governor Frederic S. Mishkin

At the Caesarea Forum of the Israel Democracy Institute, Eliat, Israel
July 2, 2008

Global Financial Turmoil and the World Economy
It is a great pleasure to be back in Israel. I last was here in 1971 and can see that much has changed
since then. And it is a great honor to be introduced by the professor who taught me monetary theory
at the Massachusetts Institute of Technology in the 1970s. Let me also say that over the past year, as
we at the Federal Reserve have had to deal with the recent problems in financial markets, I have
gained an even deeper appreciation for the many contributions you made as the first deputy
managing director of the International Monetary Fund, guiding its response to the Mexican crisis,
the Russian default, the Asian crisis, the collapse of Long-Term Capital Management, Brazil's
devaluation, and the early stages of the Argentine crisis. Your expertise in managing financial crises
is surely unparalleled, and having you in the central banking world right now helps us all sleep
better at night.
As you well know, financial markets in the United States and Europe have been under considerable
strain for almost a year now. Speaking as a central banker soon to return to the relatively tranquil
ivory tower of Columbia University, I don't think it is far off the mark to characterize the turmoil of
the past year as one of the worst financial shocks that the United States has confronted since the
Great Depression. However, although the U.S. economy clearly has slowed, aggressive actions by
the Federal Reserve and other central banks as well as fiscal stimulus have helped us weather the
storm better than we would have otherwise.
Let me start with a brief overview of the financial market turmoil, and then I'll briefly discuss what
central banks have done to help restore health to the financial system. Finally, I'll turn to the
implications for monetary policy and the economic outlook.1
The Financial Turmoil
Well-functioning financial markets are crucial to maximizing sustainable economic growth because
they channel funds to the people with the most productive investment opportunities. However,
financial markets can do their job well only when they solve information problems that would
otherwise impede the efficient allocation of credit to worthy borrowers. The history of financial
development can be characterized as a process in which innovation tends to lead to improvements in
the quality of information, and this, in turn, enables new financial products and markets to develop.
Indeed, in the past decade or so, technological innovations and financial market liberalization
improved the flow of information and capital to broader groups of people. For example, the
microfinance revolution in developing countries has made capital available to many poor, small
entrepreneurs. In the United States, financial innovation has recently manifested itself partly in the
development of the market for subprime mortgages. While that market had serious weaknesses that
eventually imposed large costs on many borrowers and their communities, it also brought
considerable benefits to many others who were able to take advantage of responsible products never
before available. As a result, they found themselves far better off financially than they probably
would have been otherwise. As this recent experience suggests, financial liberalization and
innovation bring many benefits but can also create information and incentive problems that lead to
mistakes. When mistakes of this nature become evident, financial markets can seize up, with
potentially significant adverse consequences for the economy.

Advances in information technology and financial innovations in recent decades encouraged new
lending products and faster securitization of debt. This lowered transaction costs and contributed to
a "democratization of credit"--that is, the extension of credit to a wider spectrum of possible
borrowers than in the past. In the United States, a potential customer with an Internet connection
could quickly fill out an online form, and a mortgage broker could rapidly price a loan with the help
of credit-scoring technology. The resulting mortgages were bundled together to produce mortgagebacked securities, which could then be sold off to investors. Advances in financial engineering took
the securitization process even further by carving mortgage-backed securities into more-complicated
structured products, such as collateralized debt obligations (CDOs), or even CDOs of CDOs, with
an eye to tailoring the credit risks of various types of assets to risk profiles desired by different kinds
of investors. All seemed well as long as the economy--particularly, the housing market--was
booming, and credit became more and more available. But when the housing market turned down,
substantial problems were exposed.
The subprime crisis exposed problems with the securitization of mortgages. In particular, it became
painfully clear how poor the underwriting and credit-risk analysis were for a wide range of products.
Some appraisers, brokers, and investment banks were motivated by transaction fees and had little
stake in the ultimate performance of the loans they helped to arrange. Many securitized products
were complex, and the ownership structure of the underlying assets was opaque. Investors relied
heavily on credit ratings instead of conducting due diligence themselves, and credit rating agencies
failed to fulfill their raison d'etre. The result has been rising defaults, particularly in the subprime
mortgage markets, with losses to both investors and financial institutions.
The ultimate losses from the recent residential mortgage-market meltdown have been estimated by
Wall Street analysts at about $500 billion--less than 3 percent of the outstanding $22 trillion in U.S.
equities.2 Why did a relatively small amount of losses on subprime mortgage loans lead to such
broad-based financial disruption? After all, a 3 percent decline in stock market prices sometimes
happens on a daily basis with hardly a ripple in the U.S. economy.
In part, the outsized impact of mortgage losses on broader financial markets probably stems from
the fact that they exposed a more extensive set of problems in financial intermediation that were not
limited to the original subprime loans. The liquidity shock that hit us in August has been described
by one of my colleagues as a global margin call on virtually all leveraged positions.3 The liquidity
shock quickly brought an end to the credit boom that preceded it, as a striking loss of confidence in
credit ratings and an accompanying revaluation of risks led investors to pull back from a wide range
of securities, especially structured credit products. Along the way, the inadequacies of the business
models of many large financial institutions were exposed, and these models are now in the process
of significant re-examination and rehabilitation.
As has happened in the past, the long-run benefits of financial innovations were easier to anticipate
than the problems. The originate-to-distribute model of securitization, unfortunately, created some
severe incentive problems--or agency problems--in which the agent (the originator of the loans) did
not have the incentives to act fully in the interest of the principal (the ultimate holder of the loan).
Notably, the incentive structures often tied originator revenue to loan volume rather than to the
quality of the loans being passed up the chain. These agency problems resulted in lower
underwriting standards, giving borrowers with weaker financial positions access to larger loans than
they should have had. Investors in mortgage-backed securities apparently ignored the importance of
these agency problems and did not adequately understand the risk characteristics of the securities
they were holding. The practices in place to align the incentives of the originators, securitizers, and
resecuritizers with the underlying risks proved to be woefully inadequate.
In retrospect, it is clear that investors were too reliant on credit ratings: Because many of the
securities were rated very highly by the credit rating agencies, investors did not understand the
underlying risk and had a false sense of safety. Many structured finance products experienced
multiple-tier downgrades, a development that is unheard of for more traditional securities such as
corporate bonds. This episode was a jarring wake-up call to investors regarding the risk properties of
all structured finance products. The credit ratings agencies' failure to correctly assess these

underlying risks further undermined investor confidence and worsened market worries about when
the next shoe might drop.
When these problems came to light, investors--including leveraged financial institutions--took large
losses as the values of mortgage-related assets were marked down in anticipation of higher defaults
on the underlying collateral. The market for newly issued subprime and alt-A mortgage-backed
securities virtually closed, and the availability of jumbo mortgages dried up. Banks were caught
with assets they couldn't securitize, which put further pressure on their capital positions.
Central Bank Actions
As the liquidity crisis began in August, central banks immediately responded by pumping large
amounts of funds into overnight markets. The Federal Reserve conducted several large operations in
the federal funds market, and the European Central Bank (ECB) conducted special operations to
inject overnight liquidity at the same time, as did the Bank of Japan, the Bank of Canada, and many
other central banks. The Federal Open Market Committee also began to ease monetary policy in
September as it grew concerned about the impact that the contraction in housing activity and a
possible credit crunch could have on economic growth more broadly. These actions quickly brought
overnight interest rates down, but financial institutions remained reluctant to lend to each other for
any but the very shortest maturities, prompting central banks to take several extraordinary steps to
help support longer-term funding markets.
Many central banks increased their longer-maturity lending and expanded the set of assets they
accepted as collateral to further help banks that found themselves with suddenly illiquid assets. The
ECB, which had regularly auctioned longer-term funds, increased both the size and frequency of
those auctions. The Bank of England and the Bank of Canada conducted similar term funding
operations in their own currencies. The Federal Reserve announced the creation of the Term
Auction Facility (TAF) to provide secured term funding to eligible depository institutions, and it
also established swap lines with the ECB and the Swiss National Bank, which provided dollar funds
that those central banks could lend in their jurisdictions.
As market conditions once again worsened in March and investors pulled back from lending against
all but the safest assets, the Federal Reserve established the Term Securities Lending Facility, which
allows primary dealers to swap a range of less-liquid assets for Treasury securities in the Federal
Reserve's portfolio for terms of about one month.4 The Bank of England introduced a similar type of
facility in April as the U.K. mortgage market showed increasing signs of stress, unveiling a plan to
swap securities backed by mortgages for government bonds for a period of up to three years.
Finally, when the liquidity position of Bear Stearns deteriorated rapidly in mid-March, the Federal
Reserve, in close consultation with the Treasury Department, judged that it was appropriate to use
its emergency authority to provide secured funding to Bear Stearns through JPMorgan Chase. To
address liquidity at other primary dealers, the Federal Reserve again used its emergency lending
authority to create the Primary Dealer Credit Facility (PDCF), which provides a backstop source of
liquidity to primary dealers similar to that available to depository institutions through the discount
window. Borrowing from the PDCF to date has been fairly substantial. Weekly-average borrowing
levels peaked at about $37 billion in late March but have subsequently declined.
In sum, the Federal Reserve and other major central banks have taken aggressive actions that have
helped us through some uncharted territory. Well-functioning, liquid financial markets are essential
to economic prosperity. Had the Federal Reserve and other central banks not stepped in and acted
with appropriate vigor to provide liquidity, the consequences for the real economy very likely would
have been quite severe. Public liquidity, however, is only an imperfect substitute for private
liquidity. Although it is critical that the Federal Reserve acts as a lender of last resort when financial
stability is threatened, the efficient allocation of capital is best promoted by competitive financial
markets and institutions. However, the flow of credit has been impeded by the developments I
outlined previously. Financial markets and institutions will be able to resume their proper roles in
allocating capital and supporting economic growth only when confidence in them recovers. And it is
clear that financial institutions have some way to go toward reforming business models and

practices. Large financial institutions in the United States and Europe have reported credit losses
and asset write-downs amounting to more than $375 billion and have been working to repair their
balance sheets by raising new capital from a wide range of sources. This process will take time, but
at least we can see some progress.
This discussion brings us up to the present moment. The period of extreme stress seems to have
abated, and financial markets are showing some tentative signs of revival. Reflecting pressures in
short-term bank funding markets, London interbank offered rates over comparable-maturity
overnight index swap rates rose to near record highs in March and April; although these spreads
remain high by historical standards, they have narrowed somewhat over the past two months, one
indication that conditions may be improving. Spreads between yields on corporate bonds and yields
on Treasury securities have also narrowed since March, as have spreads on credit default swaps for
nonfinancial firms across a wide range of industries. However, significant strains persist. Banks are
tightening their lending standards, and conditions could worsen again should the economic outlook
deteriorate further.
The Economic Outlook
Let me now turn to a brief discussion of the current economic outlook and how the financial turmoil
we have recently been experiencing has affected it. Unfortunately, just as the problems in financial
markets have begun to abate, commodity prices have reached new heights, which clearly could take
a toll on the U.S. economy as well as on the economies of our major trading partners.
U.S. inflation has risen recently, largely because of these sharp increases in global commodity
prices. However, thus far, the high costs of energy and other primary commodities have not led to
much increase in core inflation, partly because of slackening domestic demand, and there is little
evidence that these costs are feeding a wage-price spiral. Nevertheless, the latest spike up in energy
and food prices has raised the upside risk to inflation and inflation expectations, which we are
closely monitoring and seeking to contain.
In the United States, weakness in the housing market, which has been exacerbated by the financial
turmoil, has been a substantial drag on the growth of real gross domestic product (GDP) since early
2006. Declines in real residential investment subtracted about 1 percentage point from the pace of
GDP growth last year, and the demand for homes has remained weak so far this year. Residential
construction continues to contract, and the overhang of unsold new homes remains quite large
relative to sales, although it has not risen too much further in recent months. Different measures tell
somewhat different stories, but it seems clear that U.S. home prices began decelerating a while back
and have been posting outright declines in recent quarters. Mortgage defaults and foreclosures are at
record highs and delinquency rates are at their highest level in 29 years, which could keep
downward pressure on prices for some time to come.
An adverse feedback loop has emerged in the housing sector, as severe difficulties in the mortgage
markets have significantly limited the availability of mortgage finance for many borrowers. The lack
of mortgage credit, in turn, appears to have further driven down home sales and contributed to the
decline in house prices. However, some of the slowdown in mortgage lending has been warranted.
There is a distinction to be made between a normalization of credit conditions from the very easy
conditions that prevailed through mid-2007 (which is a good thing from a medium-term perspective)
and a full-blown credit crunch in which many clearly qualified borrowers are not provided access to
credit. Notably, these sorts of results are also seen in Europe. Surveys by both the ECB and the
Bank of England have indicated that banks are tightening lending standards, although credit is still
flowing to at least some firms and households.
Recent data suggest that the U.S. economy has proved more resilient than some had anticipated.
Although the labor market has softened and consumer sentiment has declined sharply since last fall,
consumer spending has thus far held up better than expected. The economy should be supported by
monetary and fiscal stimulus, a reduced drag from residential construction, further progress in the
repair of financial and credit markets, and still-solid demand from abroad. However, the economy
faces challenges. With housing construction continuing to decline and energy prices continuing to

rise, risks to growth still appear, to my eye, to be to the downside. Households face significant
headwinds, including falling house prices, tighter credit, a softer job market, and higher energy
prices. Businesses are also facing challenges, including rapidly escalating costs of raw materials and
weaker domestic demand, although the strength of foreign demand for U.S. goods and services has
offset the slowing of domestic sales to some extent. All that said, we seem to have avoided some of
the worst possible outcomes so far.
The economy has been quite resilient to the adverse shock from the recent financial turmoil, but the
analysis of its sources I outlined earlier suggests that it will take a substantial amount of time to
complete the cleanup of the financial mess and to get the financial system fully back on its feet.
Although some of the most complex structured-finance products may be gone for good,
securitization will only recover fully when new business models solve the agency problems that
were inadequately dealt with in recent years. Development of these business models by lenders,
dealers, regulators, and the credit rating agencies will take time. Furthermore, in my view, financial
institutions, particularly banks, will probably play a crucial role in this process. They have the
ability to originate loans and make sure that there are incentives for accurate credit assessment of the
underlying risks. To restore the public's faith, they need to show that sufficient mechanisms are in
place to reasonably assure investors that financial institutions have the incentives to issue good
credits. Only when they have rebuilt the confidence that investors previously had in them will banks
be able to distribute securities backed by these loans.
There is a catch in all of this, however. Financial institutions cannot expand their activities in these
markets without having the capital to do so. Unfortunately, the losses they have experienced
recently have put pressure on their capital positions, and, although they are now actively raising
capital, getting sufficient capital to fully take advantage of this new business will take some time.
The resulting slow recovery of financial markets that I think is likely suggests that the U.S.
economy will be subject to substantial headwinds for some time. Indeed, the situation may be
comparable to what happened in the early 1990s when the weakened condition of the banking
industry in the United States led to a relatively slow recovery in economic activity. Thus, growth
could continue to be quite weak, though I would hope it would pick up next year.
As I've already mentioned, the impacts of the events I've been discussing have not been limited to
the United States. Although European growth has held up well so far, it now appears to be slowing,
in part because the financial strains and rising commodity prices have weighed on consumer and
business confidence and have weakened spending, but also as Europe's housing markets cool,
especially in the United Kingdom, Ireland, and Spain. The headwinds from the financial turmoil I
have described may affect them as well. In addition, monetary policy in Europe has eased
considerably less as inflation has continued to rise above central banks' targets, largely driven by
continued sharp increases in commodity prices.
One important factor behind developments in recent years has been the rapid growth in emerging
market economies such as China. On the one hand, rapid growth in Asia has stimulated strong
increases in import demand, cushioning the slowdowns in the United States, Europe and Japan, but
on the other hand, the rapid growth in demand has pushed up prices for commodities that are in
short supply. Thus, inflation rates in many emerging economies have risen sharply. The central
banks in most parts of the world are at a crucial juncture: We must all be vigilant to keep inflation
expectations anchored and inflation low.
The recent financial turmoil has brought the Federal Reserve into uncharted waters. We found it
necessary to build some lifeboats, but we seem to have steered clear of the worst weather. The
measures taken by the Federal Reserve and other central banks seem to have helped keep the
economy afloat, but this episode of financial distress has raised important questions about the
structure of financial regulation and the appropriate role of the lender of last resort. We expect to
strengthen the financial system with an array of regulatory changes, which includes strengthening of
capital and liquidity rules, more disclosure requirements, closer supervision of the measurement and

management of firm-wide risks, and steps to increase the transparency and resilience of the financial
infrastructure. Private investors and other market participants clearly also have crucial roles to play
in strengthening the financial system.
While the current turmoil is not yet over, we have seen some signs of improvement. We have
learned much from this episode. I am confident that it will be studied for some time to come, and
that we will forge a better financial system as a result.
Greenlaw, David, Jan Hatzius, Anil K. Kashyap, and Hyun Song Shin (2008). "Leveraged Losses:
Lessons from the Mortgage Market Meltdown (203 KB PDF)," presentation delivered at the U.S.
Monetary Policy Forum, New York, February 29.
Warsh, Kevin (2008). "Financial Market Turmoil and the Federal Reserve: The Plot Thickens,"
speech delivered at the New York University School of Law Global Economic Policy Forum, New
York, April 14.

1. David Bowman, Fang Cai, Linda Kole, Michael Palumbo, and Dan Sichel, members of the
Board's staff, contributed to the preparation of these remarks. The views expressed are my own and
do not necessarily represent the views of other members of the Board or the Federal Open Market
Committee. Return to text
2. These figures are taken from Greenlaw and others (2008). Return to text
3. Warsh (2008). Return to text
4. Primary dealers are banks and securities broker-dealers that trade in U.S. government securities
with the Federal Reserve Bank of New York. On behalf of the Federal Reserve System, the New
York Fed's Open Market Desk engages in the trades to implement monetary policy. Return to text
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