Govenor Randall S. Kroszner Discusses Market Recovery
In a meeting Monday morning at the Institute of International Bankers Annual Breakfast Decalogue in Washington D.C. Kroszner discussed an overview of the market, what happened and what needs to happen.
Randall S Kroszner joined the Federal Reserve Board in 2006 and was previously a member of the President’s Council of Economic Advisers from 2001 to 2003.
Kroszner stated on Monday that many of the problems that we are having right now are related to “price discovery”. Essentially, price discovery is the process by which buyers and sellers preferences result in the discovery of a price that will balance supply and demand and provide signals to market participants about how most efficiently to allocate resources. The buyers in this case would be the investors that were loaning money to the different mortgage markets. The sellers would essentially be the consumers that are getting the mortgage. Several financial markets had the price discovery process actually break down.
Kroszner states that there are two reasons behind this breakdown. First is that many investors may not have done sufficient due diligence with regard to complexly structured products. Before the fall of the subprime market investors did not demand sufficient information from the sellers, they simply just accepted investment ratings of securities as a substitute for their own research. Once the delinquencies started to emerge the rating agencies rapidly downgraded these securities, investors lost confidence in the quality of these ratings, and pulled out of the markets for more secure investments.
His second related factor that contributed to the breakdown in the price discovery is that investors realized the complexity and lack of transparency in the securities themselves. This means that it is very difficult and costly to to identify where the risks were lodged. The bottom line is that “Investors suddenly realized that they were much less informed than they originally thought. In these circumstances, it is not necessarily surprising that investors pulled back from purchasing certain instruments at any price” Kroszner added.
Market recovery will come when this price discovery process returns. This recovery will be a gradual process that has started slowly returning to some markets. Both investors and sellers will need to take steps for the price discovery process to be re-established in these markets. Investors should use independent due diligence when it comes to researching these products, especially for newer and more-complex products compared to more traditional ones. They should also have enhanced systems to monitor existing loans to better understand their risk profile, especially under stress conditions. Lastly investors must ensure that they have enough people to interpret, understand, and act appropriately on the results of the analysis.
As in previous Federal Reserve meetings he ended the meeting by stating that the Federal Reserve decisions to lower the federal funds rate was an attempt to help offset the potential effects of the financial market turmoil on real economic activity. He emphasized that the purpose of these actions were not to insulate financial institutions from the consequences of their business decisions, but to facilitate the orderly function of markets more broadly in the face of risks to the overall economy.
To read the transcript from the Federal Reserve meeting on October 22nd head on over to the Federal Reserve’s website.