Thursday, April 10, 2008

Bernanke - another speech

All in all a very disappointing speech. It offers nothing really new, just more of the old adage of responsible market-driven oversight. While it is not difficult for Bernanke, and for everybody else who is interested in that matter, to provide a correct diagnosis of the current illness in financial markets, it seems it is all but impossible for him to see the painful truth. He still believes that the securitization model can be revived. Originate-to-distribute can survive if only the originator and the investor get access to more transparency and have the right incentives for prudent risk management in the future. He puts his fate back into the pocket books of investors who failed us so badly in the first place. It is always the Marxwellian problem: It works in theory but the praxis proves it wrong. Bernanke has the diagnosis right:

"In retrospect, the breakdown in underwriting can be linked to the incentives that the originate-to-distribute model, as implemented in this case, created for the originators......However, in the recent episode, some originators had little capital at stake, reducing their exposure to the risk that the loans would perform poorly."

Where he fails again is the solution. The originate-to-distribute model seeks to override the credit risk-to-maturity risk paradigm that is inherent in all term financial transactions. As a matter of fact securitization can be seen as a new paradigm invented to make term financial transactions infallible. The current market turmoil proves that this new paradigm is not working and no oversight, nor prudent risk management can obscure this fact.

Here are some of his recommendations:

"These problems notwithstanding, the originate-to-distribute model has proven effective in the past and with adequate repairs could be so again in the future."

"But better consumer protections and disclosures, as well as greater supervisory scrutiny of the processes that originators follow and the incentives they face, are also needed. In the mortgage area, the PWG recommended action at both the federal and state levels, including, for example, stronger nationwide licensing standards for mortgage brokers and more consistent government oversight for all originators. In particular, the PWG recommended that the Federal Reserve use its authority to strengthen consumer protection rules and enhance required disclosures for mortgage originations."

"More transparency about the risks and other characteristics of securitized credits on the part of their sponsors would obviously help. But more generally, investors must take responsibility for developing independent views of the risks of these instruments and not rely solely on credit ratings."

"Narrowly, these recommendations should help to improve and strengthen the originate-to-distribute model, which, despite recent problems, seems likely to remain an important component of our system of credit provision."

He got one thing right. In the future investors will be more responsible. They will demand a wider risk spread, which renders the securitization model redundant. The days of easy credit are over and they will not come back anytime soon.

source: Addressing Weaknesses in the Global Financial Markets: The Report of the President's Working Group on Financial Markets
Ben Bernanke

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