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Speech
Governor Randall S. Kroszner

At the Conference of State Bank Supervisors Annual Conference, Amelia Island Plantation,
Florida

Governor Kroszner presented identical remarks to the Banco Central do Brasil Annual
Seminar on Banking, Financial Stability, and Risk, on May 27, 2008
May 22, 2008

Prospects for Recovery and Repair of Mortgage Markets
As all of you well know, it was just about one year ago that the turmoil in the mortgage and
financial markets emerged. Today I will offer my perspective on the prospects for recovery and
repair of the mortgage markets, which I believe will be a gradual process that requires both market
and regulatory discipline.
Greater transparency and less complexity in credit instruments will help to promote broader scrutiny
of credit risk. Investors with more and better information from the originators and sponsors of credit
products will be able to more easily conduct proper due diligence and verify evaluations of credit
risk. Financial institutions that develop and hold these instruments and that have similar or
correlated exposures through various business lines should also strengthen risk-management
practices. As supervisors, we must insist on effective risk management and take the steps necessary
to ensure that changes are implemented where needed.
Although any assessment at this stage about the recovery and repair of mortgage markets is
preliminary, I will outline some steps, many of which are already in train, that can foster the
rehabilitation process. As part of this discussion, I will highlight what the Federal Reserve is doing
to facilitate improvements in the mortgage markets, some of which involve important collaborations
with the Conference of State Bank Supervisors (CSBS).
Background
As you know, the initial shock to financial markets was essentially a rapid deterioration in the
performance of subprime and so-called alt-A mortgages in the United States, particularly among
such loans that were originated after the middle of 2005. A large share of those mortgages were
funded through structures known as mortgage-backed securities (MBS), and many of those
structures were, in turn, funded by other structures called collateralized debt obligations (CDOs), in
which subprime and alt-A MBS represented the collateral.
These CDOs were ultimately held by a wide range of investors and financial institutions. Much of
the issuance of these securities over the past few years occurred in an environment of tightly
compressed risk spreads--that is, the difference between the yields on what were perceived as
relatively safe and relatively risky assets was much smaller than usual. Indeed, many of the
structures seemed to be created to satisfy investors' strong demand for securities that carried
investment-grade ratings but that might provide slightly higher yields than other investment-grade
securities, such as corporate bonds. In many cases, however, investors seem to have been attracted
to these structured securities without a thorough understanding of the underlying risk profiles.
Although MBS and CDOs had been around for many years, the more recent structures were
significantly different and more complex than their earlier counterparts. Investors' earlier experience

with CDOs, for example, was mainly limited to cases in which primary securities, such as corporate
bonds, business loans, or other simple securities, formed the underlying collateral. In contrast, the
more recent CDOs frequently were themselves backed by structured securities, resulting in so-called
two-layer securitizations in which structured products are used to fund other structured products.
These two-layer securitizations are inherently more complex and are more exposed to tail risk than
their earlier one-layer counterparts. Indeed, in its recent report on credit-risk transfer, the Joint
Forum--an international collaboration of financial supervisors--noted a cliff effect that is associated
with the distribution of returns that can be realized on the more senior tranches of two-layer
securitizations.1 Simply put, the cliff effect refers to the fact that investors of higher-rated tranches
of complex securities can expect to receive a small positive return in most circumstances, but they
are vulnerable to extremely large losses in those rare events of widespread financial stress.
Despite the greater complexity, it seems that many investors assumed that the evaluations of creditrating agencies would work well and be sufficient for the new structured securities. Investors ended
up relying too heavily on those assessments rather than requiring ample information about the
underlying assets and demanding extra transparency in order to estimate projected risk-return tradeoffs.
Role of Information and Transparency in Corporate Bond Market
To illustrate how important information and transparency will be in the recovery and repair process
of the securitization markets going forward, it might be helpful to review a case in which, on the
whole, market functioning has held up relatively well. I'm thinking specifically about the market for
corporate bonds issued by investment-grade nonfinancial firms.
To be sure, over the past year, growing concerns about individual firms' earnings and about the
overall macroeconomic outlook have contributed to significantly wider risk spreads on corporate
bonds. Nonetheless, investment-grade nonfinancial companies in the United States have been able
to issue a sizable volume of traditional debt instruments rather consistently, even as demand for
some other types of securities has been substantially curtailed. In addition, on the whole, liquidity in
the secondary markets for corporate bonds has been perceived to be much better than liquidity for
non-agency mortgage-backed securities and for more-complex structured securities. Part of the
reason that the markets for high-grade nonfinancial bonds have continued to function relatively well
is that those securities have not experienced widespread ratings downgrades or defaults.
The extensive amount of data available about nonfinancial corporations and the performance of
corporate bonds over time has made it easier and less costly for investors to conduct due diligence-or to put it another way--to trust but verify credit-risk evaluations. The same cannot be said of many
residential MBS created over the past couple of years and the many complex structured products
that held MBS as collateral, where the complexity of the pay-off structures (including so-called cliff
effects) made expected returns and risks more difficult to model.
Recovery and Repair Going Forward
As I have said, recovery in the mortgage market will take time and will require more market and
regulatory discipline. I would now like to discuss this process in further detail as it relates to the
credit-rating agencies, the originate-to-distribute model for mortgage lending, the important role of
the new Basel II framework, and improvements in risk-management practices that financial
institutions will need to make in several key areas.
Credit-Rating Agencies
As I mentioned, establishing sound and thorough independent risk evaluations is costly, particularly
for complex structured products that have only recently been created. To address problems with risk
evaluations, the President's Working Group on Financial Markets (PWG) has recommended, among
other things, that the credit-rating agencies themselves should display greater skepticism when they
are presented with complex and opaque instruments to rate.2 The PWG also suggested that the
credit-rating agencies would better serve investors by providing greater transparency about the
models, estimation methods, and assumptions used to evaluate credit risk for complex structured

securities. In addition, it is important for the rating agencies to clarify that a given rating applied to a
complex structured credit product may have a different risk than the same rating applied to a simple
security, such as a corporate bond.
Originate-to-Distribute Approach to Mortgage Lending
The growth of the originate-to-distribute approach in the mortgage market played an important role
in the rapid expansion of mortgage lending in the United States until the onset of the recent market
turbulence. That expansion was concentrated in the subprime and alt A segments of the mortgage
market, where underwriting deteriorated at the point of origination. To an ever-increasing extent
from around the middle of 2005 until about a year ago, originators made loans that layered multiple
sources of credit risk, including low documentation of borrower income, very high combined loanto-value ratios, and loans with nontraditional payment schedules that sometimes allowed principal
and interest payments to be deferred. In an environment of compressed risk spreads, investors have
more difficulty signaling concerns about credit risk, which may have reduced the incentives for
originators to maintain strict underwriting.
I would expect the originate-to-distribute model to continue to be an important part of the modern
financial market landscape, but, I hope, in a much stronger form. The model works best when the
resulting credit instruments are less complex and opaque, as analysts and investors can evaluate the
underlying risks with greater certainty. And originate-to-distribute is most effective when the
incentives of originators and investors are closely aligned and when market pricing reinforces
incentives for originators to perform careful underwriting. Firms surveyed about their riskmanagement practices by a group of supervisory agencies from France, Germany, Switzerland, the
United Kingdom, and the United States--known as the Senior Supervisors Group (SSG)--have
emphasized the importance of understanding the quality of new credits that their businesses
originate or purchase from others.3
The process of recovery and repair in non-agency mortgage securitization markets would also be
aided by more clarity and consistency in underwriting standards. This would provide more certainty
to the mortgage market, thereby helping to revive investor confidence in this market and to promote
the flow of credit to borrowers. Both to protect consumers and to foster the revival of these markets,
the Federal Reserve has proposed stricter underwriting rules for high-cost mortgages under the
Home Ownership and Equity Protection Act (HOEPA), which could also help to increase the
transparency and improve the quality of underlying assets in private mortgage pools.
The Federal Reserve's proposed rules would better protect consumers from a range of unfair or
deceptive mortgage lending and advertising practices. Our proposal includes four key protections
for higher-priced mortgage loans secured by a consumer's principal dwelling: (1) creditors would be
prohibited from engaging in a pattern or practice of extending credit without considering borrowers'
ability to repay the loan; (2) creditors would be required to verify the income and assets they rely
upon in making a loan; (3) prepayment penalties would only be permitted if certain conditions are
met, including the condition that no penalty will apply for at least sixty days before any possible
payment increase; and (4) creditors would have to establish escrow accounts for taxes and
insurance. We are working toward issuing final regulations in July.
Role of Basel II
Individual institutions are responsible for maintaining sound risk-management practices. But
supervisors, of course, also have a role to play in both promoting effective risk management and
offering incentives for bankers to make improvements to their practices.
The new Basel II framework is a substantial supervisory initiative that seeks to improve riskmanagement practices at banking organizations. The framework more closely aligns regulatory
capital requirements with actual risks, which should lead institutions to make better decisions about
extending credit, mitigating risks, and determining overall capital needs. For example, unlike under
Basel I, the risk weights applied to first-lien residential mortgages will be subject to a more refined
differentiation depending on whether the borrower has low or high credit risk. Similarly, Basel II
attempts to more fully capture risks in securitization transactions.

Just as lessons learned from recent events can help bankers improve risk- management practices,
they can also help supervisors further increase the effectiveness of the Basel II framework. For
example, the Basel Committee on Banking Supervision plans to strengthen the resiliency of Basel II
by revising it to establish higher capital requirements for certain complex structured credit products,
such as CDOs of asset-backed securities, among other enhancements.4
Improvements in Risk-Management Practices
Studies of last year's events have concluded that part of the reason that the problems with subprime
and alt-A mortgages led to much wider financial market turmoil was weaknesses in the riskmanagement practices at some large global financial firms that created and held complex credit
products. Recent events have highlighted the need for risk-management improvements in four
fundamental areas: risk identification and measurement, liquidity risk management, governance and
risk control, and valuation practices.
First, for risk identification and measurement, as all of you here know, good information is the
lifeblood of sound risk management. A good risk-management structure is designed to identify the
full spectrum of risks across the entire firm, gathering and processing information on an enterprisewide basis in real time. In short, you cannot manage your risks if you do not know what they are.
Recent events have illustrated that many large, complex institutions had exposures to subprime
mortgages that ran across independent business lines, through off-balance-sheet conduits such as
structured investment vehicles, and with respect to numerous counterparties such as monoline
financial guarantors. But too few institutions fully recognized their aggregate exposure to risks that
turned out to be highly correlated. Latent risks from certain complex products and certain risky
activities are particularly problematic because they can manifest themselves when market turbulence
sets in. Stress testing and scenario analysis are essential because they can reveal potential risk
concentrations that may not be apparent when using information gleaned from normal times.
The second fundamental area is liquidity risk management. Because of its central role in the
business of banking, liquidity risk requires rigorous and effective management. Recent events have
shown that during times of systemwide stress, liquidity shocks can become correlated, so that the
same factors that can lead to liquidity problems for the bank's assets or off-balance-sheet vehicles
can simultaneously put pressure on a bank's own funding liquidity. Because risk concentrations have
the potential to manifest themselves during times of stress and at that time adversely affect capital
positions, it is particularly important that firms assess how liquidity events could place pressure on
capital levels.
The third fundamental, governance and risk control, has been a key factor that has differentiated
performance across financial institutions during the recent turmoil. Firms that operated with the two
main ingredients for solid governance and controls--thorough information and strong incentives-have come through this tumultuous period in better condition.
Lastly, supervisors' comparative reviews also identified valuation practices as critical. The SSG
reported that those firms that paid close attention to the problems associated with the valuation of
financial instruments, particularly those for which markets were not deep, fared better. These moresuccessful firms developed in-house expertise to conduct independent valuations and refrained from
relying solely on third-party assessments.
Federal Reserve's Mortgage Initiatives
I would now like to discuss some of the actions the Federal Reserve is taking to address the ongoing
challenges in the mortgage market. The Federal Reserve's decisions regarding monetary policy and
our efforts to promote financial stability affect mortgage and housing markets, of course. But, we
are also working on these issues more directly on a number of fronts as we are very concerned about
the high rate of mortgage foreclosures.
We are contributing to initiatives already under way at the local and national level, as well as
collaborating with other regulators, community groups, policy organizations, financial institutions,

and public officials in an effort to identify ways to prevent unnecessary foreclosures and the
associated negative effects on local communities. In doing so, we are taking advantage of the
decentralized geographic structure of the Federal Reserve System, which consists of the Board of
Governors in Washington, D.C., and the twelve Federal Reserve Banks that each represent a region
of the country.
In recent months, for example, I have had the opportunity to get a firsthand look at what is
happening in various parts of the country. I have met with local community groups, bankers,
housing advocates, counseling agencies, and state and local government officials in Cincinnati,
Minneapolis, Philadelphia, Boston, Miami, and Las Vegas. The Reserve Banks representing those
areas have helped facilitate these meetings, which have enhanced my understanding of the
challenges being faced across the country and of how policymakers should think about these issues
at both the local and national levels.
We are engaged with mortgage servicers to understand impediments they may face when modifying
loans or offering other alternatives to foreclosure. We have encouraged the mortgage industry to
increase their efforts to work with troubled borrowers, to develop guidelines and templates for
reasonable standardized approaches to various loss-mitigation techniques, and to adopt transparent
reporting standards. Clear disclosures of loan modifications will not only make it easier for
regulators, the mortgage industry, and community groups to assess the effectiveness of foreclosureprevention efforts, but they will also foster greater transparency, and hence greater confidence, in
the securitization market.
We are also using our analytic resources to conduct research that the Reserve Banks can disseminate
to local community groups, counseling agencies, financial institutions, and others who are working
to help troubled borrowers and communities. Earlier this month, we announced a new partnership
with the nonprofit NeighborWorks America to develop materials, tools, and training programs to
help communities and others acquire and manage vacant properties. The goal is to support the
provision of affordable rental housing and new homeownership opportunities in low- and moderateincome neighborhoods.
The Federal Reserve has collaborated with the CSBS on several interagency initiatives to help
struggling homeowners and to enhance the functioning of the mortgage markets. The federal
banking agencies and the CSBS last fall issued guidance urging lenders and servicers to pursue
workout arrangements, when feasible and prudent, as an alternative to foreclosure. Reaching
borrowers before they fall too far behind in their payments is important to effecting a sustainable
workout and may help more borrowers remain in their homes. In some cases, temporary adjustments
to payments may not be sufficient, and more-permanent reductions in interest rates or an extension
of the loan term may be called for. In some situations, lenders and servicers may want to consider
using principal writedowns as a way to reduce re-default risk or to facilitate a refinancing.
We are also coordinating with the CSBS, the American Association of Residential Mortgage
Regulators (AARMR), and other federal agencies on consumer compliance reviews of nondepository mortgage lenders with significant subprime mortgage operations. These reviews, which
began earlier this year, are aimed at evaluating underwriting standards, risk-management strategies,
and compliance with certain consumer protection laws.
The Federal Reserve is also working cooperatively with the states to provide data and analysis on
subprime mortgage loan performance to inform the states' policies in this area. These efforts will be
supported by the new system for registering and tracking mortgage brokers that the CSBS and the
AARMR launched earlier this year. The Nationwide Mortgage Licensing System should better
protect borrowers by bringing greater consistency across the states to the supervision of mortgage
lenders. Nationwide licensing should prevent lenders who run afoul of authorities in one state from
simply relocating their business to another state.
Conclusion
As market participants take steps to foster greater transparency and to reduce the complexity of

structured credit instruments, I believe that recovery and repair in the mortgage markets will take
hold over time. Moreover, as financial institutions strengthen risk-management practices and as
supervisors ensure that the necessary actions are taken, I expect the financial system as a whole to
become more resilient. A number of efforts are under way by the Federal Reserve, jointly and
independently with the CSBS and other organizations, to help prevent avoidable foreclosures and to
promote responsible mortgage lending.

Footnotes
1. The Joint Forum (2008), Credit Risk Transfer--Developments from 2005 to 2007
Switzerland: Bank for International Settlements). Return to text

(Basel,

2. President's Working Group on Financial Markets (2008), "Policy Statement on Financial Market
Developments (1.36 MB PDF)" (Washington: Department of the Treasury). Return to text
3. The report, "Observations on Risk Management Practices during the Recent Market Turbulence,"
is available at:
http://www.newyorkfed.org/newsevents/news/banking/2008/rp080306.html Return to text
4. For further discussion of plans to strengthen the resiliency of the framework, refer to Randall S.
Kroszner (2008), "Risk Management and Basel II," speech delivered at the Federal Reserve Bank of
Boston AMA Conference, May 14. Return to text
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