June 2010
Moderator: Welcome to Research Insights, an occasional podcast from the Federal Reserve Bank of Atlanta. We're talking today with Paula Tkac, assistant vice president and senior economist with the Atlanta Fed. Earlier this month [May], Paula helped organize the Atlanta Fed's 2010 Financial Markets Conference. Good to see you, Paula.
Paula Tkac: Hello, Bill.
Moderator: For our podcast today, Paula is here to talk about some of the highlights of the conference. And the first question is, What were some of the broad themes of this year's conference?
Tkac: Well, this year we chose to tackle four topics that are central to the ongoing evolution of financial markets in the aftermath of the recent crisis. We know that institutions, business models, markets, and regulations will not return to some precrisis conception of normality. And while financial markets are always changing, the term "new normal" is often used as shorthand for the fundamentally changed world that we will find ourselves in. This new normal is now being shaped as institutions, policymakers, and regulators learn lessons from the crisis and adapt their actions accordingly.
The topics we chose to focus on were structured finance, or securitization markets; the market for financial information, including a discussion of rating agencies; the problem of too-big-to-fail institutions; and the role of macroprudential supervision. While the interaction between market participants and regulators or policymakers was an important aspect of all our sessions, the first two topics really focus relatively more on how markets and institutions are changing their behavior while the latter two address the role of regulators in reshaping the rules of this new financial landscape.
Moderator: You mentioned issues with credit ratings. Tell us about that discussion. How do things need to change in that area?
Tkac: Credit rating agencies—or nationally recognized statistical rating organizations [NRSROs], as they're more technically known—have been the subject of much scrutiny and criticism. These are firms such as Standard and Poor's, Moody's, and Fitch. They were important players in the crisis because they were the firms providing the analysis and ratings for the AAA subprime mortgage-backed securities that were spread around the world and, notwithstanding their safe-sounding ratings, experienced severe losses. It's natural then to ask questions about how this happened. Were the rating agencies somehow at fault? Did they have bad models? Or is the fact that securities issuers pay for the ratings, and can shop around for them, somehow to blame? Why did investors rely on these ratings? And, of course, in line with the theme of our conference, how will or should the new role of these agencies change and adapt?
Professor John Hull's paper in the structured finance session focused on assessing the complex models used by the rating agencies while Professor Chester Spatt's paper framed a discussion on how to think about the larger market for this type of financial information. Investors rely on information intermediaries like these rating agencies because of the economies of scale in analyzing information; doing your own due diligence can be very costly. As the crisis unfolded, investors learned that they could not rely on a AAA rating to mean "safe." They learned the value of looking under the hood and finding out more about how models were used and ratings were calculated.
A particularly interesting aspect of this discussion was the institutionalization of ratings by both private markets and federal regulations. Investment guidelines that render non-AAA securities as ineligible for investment by pension funds and incorporated into money market mutual fund regulations add value to this AAA rating by increasing the pool of investors who could and would invest in such a highly rated security. Indeed, even the Federal Reserve, in its liquidity facilities, used ratings by the NRSROs when defining eligible collateral.
While most participants acknowledge an already increased demand for detailed information by investors as they begin to increase the amount of analysis they undertake on their own, we also heard about how rating agencies are adapting their models. Finally, we discussed the difficulties with some regulatory alternatives to rating agency ratings such as utilizing market-based measures like credit default swaps. We've all learned that credit rating agencies are not infallible, but neither is there a clearly superior, and inexpensive, alternative.
Moderator: Interesting. Well, in the aftermath of the crisis, we've heard a lot about securitization, both for private mortgage securities and more generally. Why hasn't this market returned to precrisis levels, and why is this important?
Tkac: Following up on the last question, the securitization market shut down precisely because investors realized that they couldn't rely on ratings as accurate measures of risk. When a security becomes hard to value, like collateralized debt obligations made up of subprime mortgage-backed securities, investors demand a higher risk premium to hold them, which translates into a much lower price. During the crisis there was disagreement about the value of securities; the owners of them didn't want to sell at fire sale prices, and the buyers were unwilling to buy at anything but. This is a market shutdown.
As we move forward investors are demanding much more information about the securities underlying these structured products as they ramp up their own analysis and due diligence.
On the supply side, it is now no longer profitable for some institutions to issue structured securities. Changes in accounting rules now require that they bring them onto the balance sheet and hold capital against them.
So what types of securities can we expect to see in the future? Well, there's a definite demand for simpler securities, ones that are easier to value. And the bread and butter of asset-backed securitization has restarted and is likely to survive—securitizations of credit card receipts, consumer loans, things like that. It's important to note that, despite all of the negative press that structured products have received, securitization is a very efficient means of allocating risk across investors. The financial intermediation it provides generates benefits for both household borrowers as well as investors and savers.
Moderator: Well, a couple of other issues that we hear about in the discourse on financial markets—those issues would be macroprudential supervision and too big to fail. How did the conference advance those difficult topics as we deal with them in practice?
Tkac: Professor Mark Flannery and Charles Goodhart contributed the excellent discussion papers for these sessions. Both sessions included interesting and important insights on conceptual problems as well as discussions on concrete proposals to address these challenges. Macroprudential supervision is the idea that, rather than solely focusing on the safety and soundness of individual institutions (which we term microprudential supervision), regulators also need to address the stability of the overall financial system. This means comparing institutions, as was done last year with the stress tests of major banks, as well as monitoring the interconnections between firms, the spread of risk throughout the system, and markets for innovative securities.
Too big to fail is a situation that also focuses on potential damage to the entire financial system—in this case due to the failure of one particular institution.
In both of these cases, a general conceptual issue is raised: how do we want to design regulations to support the goal of financial stability? Should we focus on minimizing the probability of failure or minimizing the loss due to failure if it occurs? The first approach is often used to argue for more monitoring and regulatory enforcement actions across a wide array of firms and markets to prevent risks from building. The latter can be thought of as increasing the resiliency of the system to a negative event, although the two are not mutually exclusive.
More concretely, participants debated using new securities such as contingent capital (a bond which would transform into equity if an institution was in financial distress). Institutions could then become recapitalized automatically and lower the probability of failure. But what would the triggers for such a transformation be? How costly would this financing be for institutions? How would the introduction of these securities potentially change the dynamics of a firm's stock price, especially in a distress situation? These are the type of details that stand between the conception of an idea and its implementation.
In the case of macroprudential supervision more generally, there are also controversial operational aspects of proposed solutions: capital and liquidity ratios, tax policy, and limitations on activities such as those proposed in the Volcker Rules. In addition, there are important organizational and governance details such as, Which agency will have the authority to monitor and enforce such regulations? The central bank (in the United States, the Federal Reserve) is the lender of last resort, and some argue this function should not be separated from macroprudential supervision. But if so, then how does pursuing financial stability interact with the price stability objective of monetary policy? Finally, an issue that we only touched on but lurks behind all of these questions are the really difficult challenges to be overcome in terms of cross-border regulatory coordination.
Moderator: Okay, Paula, thank you for that summary.
Tkac: Glad to be here, Bill.
Moderator: We've been speaking with Paula Tkac, senior economist with the Atlanta Fed. This concludes our Research Insights podcast on the Atlanta Fed's 2010 Financial Markets Conference. All the papers and presentations Paula mentioned will be on the Atlanta Fed's Web site at frbatlanta.org. Thanks for listening, and please return for more podcasts.