This Turmoil Shall Pass

Families unexpectedly losing their homes, businesses unable to get much-needed loans, banks reporting major losses and other stories of financial gloom and doom dominate today's headlines. Is the frenzied swirl of facts, figures and sound bites really as chaotic and threatening as it sounds?

The short answer is that we are in the midst of a phenomenon painfully familiar to Americans. From the gold rush to the Internet bubble, cycles of innovation, excess, adaptation and recovery to a point of even greater prosperity have defined America's economic progress. In the present situation, we are seeing the rough edges of the same recent financial innovation that has brought enormous benefits to many investors, businesses and consumers. But these net benefits are of little consolation to the Americans whose lives are being seriously disrupted by the current financial-market turmoil. In response, policymakers in the United States and around the world are taking aggressive and targeted actions to stabilize financial markets, reduce the impact of markets on the U.S. economy and protect against the same mistakes' being repeated.

We don't know exactly how, or when, this turmoil will end. But like other periods of market instability, it will end. Though we face difficult times, we are taking steps to ensure that the flexibility, resilience and strength of U.S. capital markets will eventually prevail. In the meantime, as we act to minimize the impact on the overall economy, we must avoid overreacting with regulations or policy responses that stifle innovation or distort the natural self-correcting forces of markets. As we work through this experience, we will learn, adapt and emerge stronger.

How did we come to this point? An abnormally long period of benign economic conditions marked by low interest rates, low inflation and less volatile asset markets led many to ignore the "risk" half of the risk-reward equation at the heart of financial markets. Investors around the world, who in preceding years had enjoyed above-historical returns on most types of investments, continued reaching for ever-higher gains. The financial-services industry created a variety of complicated new products to meet this demand. Regulators and investors alike showed a growing complacency toward risk. These factors blended into a dangerous cocktail of underlying conditions ripe for instability.

This imbalance between risk and reward was perhaps most evident in the U.S. housing market, where lenders significantly loosened credit standards—particularly for a new generation of adjustable-rate mortgages with low teaser rates, interest-only features and low or no down payments. Yet aggressive financial innovation went well beyond mortgages. Banks and brokers created an alphabet soup of products with simple names like CDOs, CLOs and SIVs, which were in fact complex and opaque investment products and structures. They relied on bundling assets, particularly mortgages, to better distribute the investment risk, and the greater use of leverage or borrowing to generate higher returns. Credit-rating agencies responsible for assessing and rating these assets, as well as investors who purchased them, failed to question the chances of these underlying investments' going bad.

Last summer these new vulnerabilities in our financial system became clear. Looser credit standards in the housing market, combined with an end to rapid home-price appreciation, led to a significant rise in delinquent mortgages. This in turn contributed to immediate and unexpected losses for investors and a reconsideration of the risk-reward relationship—first in housing, and soon after, across all asset classes. The shaken investor confidence in housing assets had a domino effect throughout world markets, ratcheting up demand for cash and liquidity, and curtailing the pace of the new lending and investment necessary for strong growth to continue.

U.S. policymakers, and others around the world, have responded aggressively to stabilize the markets, reduce the turmoil's impact on the real economy and address the underlying regulatory gaps and policy weaknesses that these challenges have exposed. The U.S. Federal Reserve and other central banks have taken focused, and sometimes coordinated, actions to protect the financial system from severe disruption by ensuring that markets have access to financing. These steps have helped address the near-term borrowing needs of financial institutions and improved confidence in the markets. Treasury Secretary Henry Paulson and other authorities have called on banks not only to recognize and quickly report their losses, but also to raise additional capital to strengthen their balance sheets and allow for continued lending. In recent months, global financial institutions, many from the United States, have done just that—reporting turmoil-related losses of more than $300 billion and raising over $200 billion in additional capital.

The U.S. government also acted quickly to invigorate the economy through fiscal policy. The $150 billion bipartisan stimulus package will provide temporary tax relief and support the creation of more than half a million additional jobs this year. Policymakers have launched a series of housing-market initiatives to help millions of Americans by increasing the availability of affordable mortgage financing and preventing avoidable foreclosures. There is still more to be done, and the administration has called on Congress to quickly pass Federal Housing Administration modernization that would help as many as 250,000 more homeowners.

As the immediate remedies take effect, we have also begun to focus on the weaknesses in business practices of financial institutions that this experience has revealed, and on fragmented U.S. and European regulatory structures that had difficulties guarding against or responding to modern challenges. U.S. and international policymakers are acting in a targeted but comprehensive way to address the causes of current market instability with steps including strengthening the oversight of risk management and reporting practices of global financial institutions; enhancing disclosure of and the process for setting values for complex products; changing and clarifying the role and use of credit ratings; strengthening the process by which national authorities monitor and respond to risk, and reforming the mortgage-origination process. In each of these broad categories, the specific proposals are concrete, widely accepted and, in a number of cases, already being implemented by national or international authorities as well as by the private sector.

As examples, firms need to improve the way they assess and manage risk, be clearer about the risks to which investors are exposed and give better estimates of the fair value of complex investment products at the core of much of the current market uncertainty. Regulators need to improve their guidelines to firms for how to manage and monitor risk and provide specific guidance regarding their disclosures to investors of complex investment structures and products. Regulators should also improve their cooperation and information-sharing across national borders, including the assessments of financial stability, particularly for the largest, most complex global financial institutions. Credit-rating agencies need to clearly differentiate the ratings schemes for complex products and improve the quality of the information they use for their ratings that is shared with investors.

There is no silver bullet to place financial markets on a sound footing or prevent past excesses from recurring, but each of these specific proposals represents an important step toward addressing the challenges we face. Taken together, they constitute a clear and significant response to the underlying weaknesses that contributed to the turmoil in global financial markets.

Our friends around the world should gain confidence from the fact that U.S. policymakers and their international counterparts are taking aggressive, targeted actions to stabilize the financial markets, to reduce their impact on the economy and the individuals negatively affected by the turmoil and to protect against the same mistakes' being repeated. There are already some early indicators that these actions are beginning to have the desired effect, as markets appear to be gaining confidence and the availability of credit has improved modestly.

Flexibility and resilience in the face of such unexpected financial-market turmoil and economic hardship are among America's greatest strengths. Our objective is to help individuals and markets recover as quickly as possible, while avoiding actions that cause new problems that would hurt our economy in the long run. This storm, too, shall pass, and the United States will emerge, as it always has, as a driver of growth and innovation for the global economy.