Fed s Warsh says market turmoil not a sure sign of subprime contagion

BY

Federal Reserve Board Governor Kevin Warsh today said market turmoil over the last few weeks may not be a sign that problems in the subprime market will spread to other markets, and instead could indicate that the subprime meltdown is prompting market participants to ponder how they value a broad range of assets.

Warsh, who spoke at the State University of New York in Albany, said he believes problems in the subprime market triggered volatile markets, but said this turmoil does not have to mean that broader markets will falter.

"It may be that investors fundamentally lost confidence in their ability to value a broad range of assets," he said in remarks that were distributed in Washington. "The resulting investor skepticism about the accuracy of ratings, combined with mounting losses at mortgage lenders, caused investors to pull back from a broad range of structured products, even though unrelated to mortgages."

As evidence of this theory, he said markets relying less on the securitization of mortgages have fared better in recent weeks, and the stock market is still near its high.

Warsh also said the speed at which the market regains its footing "may depend on the speed with which investors and counterparties gain comfort in their abilities to value assets."

At the same time, Warsh warned that there is still a risk of further credit risks.

"What originated as a liquidity shock could potentially give rise to increases in credit risk," he said. "The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to meet our dual mandate, fostering price stability and economic growth."

Warsh also advanced the theory that over-confidence in assets that were riskier than first assumed could mean that markets, for a time, can become "too liquid."

"In this case, markets may appear to function smoothly, but the risk-based pricing that lies at the heart of how financial markets efficiently allocate capital is impaired," he said. "It seems increasingly apparent that many investors and financial intermediaries became so content with the benign economic conditions and robust financial markets that they tended to act with confidence greater than warranted by the fundamentals."

More generally, Warsh said the mission of the Fed is to ensure the US economy remains on an "even keel" by ensuring maximum employment and price stability. He defined price stability as keeping inflation "sufficiently low."

Warsh said markets work best when they are liquid, which is defined as occurring when "investors are confident and willing to assume risks." He said he believed in June that markets were liquid, but said this liquidity started to deteriorate in mid-July, particularly in the subprime market.

While the Fed s half-point cut in both the federal funds and the discount rate was seen by some as a market bailout, Warsh rejected this idea by saying he does not believe the Fed should ever seek to save market participants from their decisions.

"We should be extremely wary of protecting financial institutions and their various stakeholders from incurring losses," he said. "Such actions distort asset prices and critically impair the efficiency of capital allocation."

"The desire for well-functioning markets does not require us to insulate asset prices or individual financial institutions from the buffeting of the marketplace," he added.