Credit Markets: How'd We Get In This Mess?

As financial wizards introduced ever-more-complex (and -opaque) ways to slice and dice debt for sale to yield-hungry investors, many of those investors—too many, as it turns out—failed to fully understood what they were buying.

Instead, they abrogated their responsibilities to credit-rating agencies, many of which—too many, as it turns out—failed to fully understood what they were rating.

That was the gist of a speech today by Federal Reserve Governor Randall S. Kroszner to the Institute of International Bankers in Washington.

"In some financial markets," he said, "the price discovery process appears to have actually broken down."

He singled out the markets for structured credit products—notably collateralized loan obligations and collateralized debt obligations, which he described as "complex and opaque"—and the asset-backed commercial paper that is backed by those assets.

Why did the price discovery process break down? "A number of investors failed to exercise due diligence and relied on rating agency assessments," he said. The size of that mistake was not immediately apparent because of the "complexity and lack of transparency" of the securities.

"Put simply," he concluded, "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."

Okay, but how soon can markets recover and loosen up? Kroszner's opinion: Be patient. "While we have seen more normal price discovery activity slowly returning to some markets," he said, "the recovery may be a relatively gradual process."

As the consequences of these events ripple through the broad economy, making investors more chary about buying debt, Kroszner said the Fed will "act as needed to support the effective functioning of these markets and to foster sustainable economic growth and price stability."

He emphasized that the goal of Fed intervention is "not to insulate financial institutions from the consequences of their business decisions, but rather to facilitate the orderly function of markets more broadly in the face of risks to the overall economy."

Sounds like assumptions of another rate cut later this month are pretty well-founded.

by Mark Stein