Summary:
Janet Yellen, President of the Federal Reserve Bank of San Francisco on the current economic situation and the outlook for the financial markets and commodities. Three witches: housing market, financial markets and commodity prices. Attributes the problems in the financial markets to three key drivers: securitisation, leading to incentive problems, moral hazard and conflicts of interest; risk management failure, through excessive reliance of flawed risk assessments; and de-intermediation/leverage, through over-reliance on debt and lack of equity financing. Yellen believes the rise and commodity prices is due to supply constraints in combination with demand growth and does not believe speculation is the cause. Arguments against speculation are that non-futures traded commodities have risen just as fast, and there is no evidence of inventories build-up. (Published: 07/07/08)
Notes:
(excerpts)
- on the current economic situation
- "It is a bit like the opening of Macbeth, with the three ghastly witches brewing up trouble amid thunder and lightning—only here, the three troublemakers are the housing market, the financial markets, and commodity prices."
- On the financial markets
- "Securitization was a key driver of the credit expansion. Financial institutions originated loans that they then bundled into securities and sold to other investors. With hindsight, it is clear that this originate-to-distribute model suffered severe incentive problems - the originator had insufficient incentive to ensure the quality of the loans, since someone else ultimately held them. Conflicts of interest and moral hazard problems also are nested in the many other linkages in the securitization process. Before private-label mortgage securitization can recover, financial markets must design mechanisms to align the incentives of originators with the interests of the ultimate investors."
- "Second, there was a widespread failure of risk management, both in terms of liquidity and credit risk. An important shortcoming in credit risk management was an excessive reliance on what turned out to be flawed assessments of risk by rating agencies of certain asset-backed securities. Investors, even large sophisticated financial institutions, did not take adequate steps to assess risk independently. The lack of transparency in the credit process and the complexity of many of the newer financial products did not help."
- "Third, even with changes in contracting and financial modeling, the re-intermediation process and deleveraging more generally is likely to continue. Re-intermediation involves a larger share of financing held in the portfolios of institutions such as commercial banks and less by other investors holding securitized assets. The re-intermediation is part of deleveraging - that is less reliance on debt and more on equity financing - to the extent banks tend to hold more capital than other less regulated financial institutions."
- The encouraging news is that large commercial banks, investment banks, and mortgage specialists have, to some extent, been able to issue new equity capital and to rebuild capital positions that have come under pressure from a combination of losses and growth in assets.
- The balance-sheet pressures, and broader financial market dislocations, are likely to be with us for some time. My expectation is that market functioning will improve markedly by 2009. But things could get worse before they get better
- On commodities
- demand side growth: booming economic activity in developing countries has boosted their appetite for commodities
- supply side constraints: oil production has become more expensive, major discoveries are increasingly difficult to find, and spare capacity to supply more oil in the short run has been declining.
- As a result, energy supplies have not kept pace with growing worldwide demand
- not yet persuaded that speculation, rather than the fundamentals of global supply and demand, has played an important role in driving up prices
- it should be harder to speculate and take positions on commodities that are not easy to trade on futures markets and are not included in index funds
- however: the prices of individual commodities that are not in index funds have risen just as fast as those that are.
- in addition, if speculators were important in driving prices up, then, at the high prices now prevailing, demand by nonspeculative end users would fall short of current supply, causing inventories to rise
- however: inventories appear to have been declining in most commodity markets
