Fed Chair Ben Bernanke Opines On U.S. Economic Challenges: Past, Present, and Future

This is a momentous time. During the past two and a half years, our nation has endured the worst global financial crisis since the Great Depression, a crisis that in turn helped cause a deep recession both here and abroad. During some of the worst phases of the crisis, a new depression seemed a real possibility.

Fortunately, today the financial crisis looks to be mostly behind us, and the economy seems to have stabilized and is beginning to grow again. But we are far from being out of the woods. Many Americans are still grappling with unemployment or foreclosure, or both. Cities and states are struggling to maintain essential services. And, although much of the financial system is functioning more or less normally, bank lending remains very weak, threatening the ability of small businesses to finance expansion and new hiring.

In my comments today, I will briefly describe the origins of the financial crisis and economic downturn, with a particular focus on the policy response of my institution, the Federal Reserve. I will then turn to some near-term and longer-term challenges facing our country.

Origins of the Crisis

The financial crisis that began in the summer of 2007 was an extraordinarily complex event with multiple causes. Its immediate trigger was a downturn in the national housing market that followed a long period of rapid construction and rising home prices. The housing slump in turn brought to light some very poor lending practices, especially for subprime mortgages extended to less-creditworthy borrowers. Relative to the global financial system, the market for subprime mortgages was quite small, probably less than 1 percent of global financial assets. How, then, did problems in this market appear to have such widespread consequences? One important reason is that the subprime mortgage market was closely linked to a broader framework for credit provision that came to be known as the shadow banking system.

That broader framework, at least as it was structured during the run-up to the crisis, proved deeply flawed.

The innovation underlying the shadow banking system was that it helped provide a wide range of borrowers indirect access to global credit markets. For example, originators of subprime mortgages did not typically retain the loans they made on their own books. Instead, the mortgages were packaged together in complex ways, sometimes with other types of loans, stamped with a seal of approval from one or more credit rating agencies, and sold to investors worldwide, thus-it was thought-broadly dispersing the underlying risks. Credit risks were further dispersed-again, at least in theory-through the use of derivative financial instruments such as credit default swaps.

Importantly, residential mortgage markets were not the only markets caught up in the boom. In part because large flows of capital into the United States drove down the returns available on many traditional long-term investments, such as Treasury bonds, investors' appetite for alternative investments-such as loans to finance corporate mergers or commercial real estate projects-increased greatly in the years leading up to the crisis. These securities too were packaged and sold through the shadow banking system.

As we now know, however, neither the investors, nor the rating agencies, nor the regulators, nor even the firms that designed the securities fully appreciated the risks that those securities entailed. Nor were the risks as widely dispersed as thought: For example, many complex securities were held in off-balance-sheet vehicles financed by short-term loans. When investors lost confidence in the underlying securities and pulled their funding, many firms that sponsored the off-balance sheet vehicles found that they were bound by explicit or implicit promises to stand behind the securities. Together with other direct or indirect exposures to risky debt, these commitments left financial institutions dangerously exposed to rising losses.

These risks grew rapidly in the period before the crisis, in part because the regulators-like most financial firms and investors-did not fully understand or appreciate them. But significant gaps in the regulatory framework itself also contributed to the inadequate government response...

Thus, the stage was set for the unraveling that began in the summer of 2007 and continued throughout 2008. As house prices and the equity of homeowners fell, mortgage delinquencies and defaults soared. As I mentioned, investors-stunned by the resulting losses on mortgage-backed securities and other credit instruments they had believed to be-back from a wide range of credit markets and financial institutions. As funding dried up, losses mounted, and confidence plummeted, a number of major financial firms, both here and abroad, came under severe pressure. In March 2008, the investment house Bear Stearns became the first major firm to come to the brink of failure, nearly collapsing before being purchased, with government assistance, by JPMorgan Chase. In August, the two largest players in the housing market, the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, were taken into conservatorship. In September, the sharply intensifying panic hit the investment bank Lehman Brothers, and soon after, AIG. Much as in a traditional run on a bank, the creditors and counterparties of these companies raced to call in loans or demand extra collateral, ratcheting up the pressure on already shaky firms. Concerted government attempts to find a buyer for Lehman proved unavailing; lacking sufficient collateral to secure a Federal Reserve loan, the company's only option was bankruptcy.

In contrast to Lehman, AIG had sufficient assets to secure credit from the Federal Reserve and thus avoid imminent failure. I have said before that nothing made me angrier during the crisis than the irresponsible decisions at AIG that put our entire financial system and economy at grave risk and left the government with no good options. However, with the financial system already teetering on the brink of collapse, the disorderly failure of AIG, the world's largest insurance company, would have undoubtedly led to even greater financial chaos and a far deeper economic slump than the very severe one we have experienced.

The rapidly worsening crisis soon spread beyond financial institutions into the money and capital markets more generally. Losses on Lehman's commercial paper at a prominent money market mutual fund led to a run on that fund and many others; over the subsequent weeks, fearful money-fund investors withdrew more than $400 billion. Equity prices fell precipitously, large firms and banks hoarded cash, and short-term credit became available, if at all, only at very high interest rates and for very short terms.

As we now know, the financial turmoil dealt an economic body blow that spread worldwide. Businesses slashed production and payrolls, including in countries that had not thus far experienced much effect. International trade collapsed, and many nations dependent on trade experienced even sharper slides in economic activity than the United States.

The Federal Reserve's Policy Response

As the crisis became global, the policy response became global as well. After watershed meetings in Washington of finance ministers and central bank governors on October 10-11, 2008, many countries, including the United States, announced comprehensive plans to stabilize their banking systems. They expanded deposit insurance, injected public capital into banks, guaranteed bank-issued debt, and increased access to funding from central banks. This strong and unprecedented response-a sharp contrast to the failures of international cooperation that helped make the depression of the 1930s so-broadly effective. During the subsequent months the risk of a global financial meltdown and economic collapse receded.

In support of these efforts to stabilize the financial system, and in its traditional central bank role as backstop liquidity provider, the Federal Reserve developed innovative programs to provide well-collateralized, mostly short-term credit to the financial system...

Beyond its actions to help stabilize the financial system, the Federal Reserve also responded to the deepening recession with an aggressive monetary policy, in both conventional and less conventional forms...

Finally, the Federal Reserve also responded to the crisis in its capacity as a bank supervisor. Last spring we led a forward-looking, simultaneous evaluation of the financial conditions and capital positions of 19 of the largest bank holding companies in the United States, with the Treasury committing to provide public capital as needed...

Overall, the policy actions implemented over the past two and a half years by the Federal Reserve and other agencies in the United States and abroad have helped stabilize key global financial markets: Short-term funding markets are essentially back to normal, corporate bond issuance has been strong, and stock prices have partially recovered. Bank lending remains constrained, as I will discuss in a moment, but critically, fears of financial collapse have lessened substantially. Most important, the economy has stabilized and is growing again, although we can hardly be satisfied when one out of every ten U.S. workers is unemployed and family finances remain under great stress.

Toward Better Financial Regulation and Supervision

...With the crisis largely behind us, we as a country must now turn to fixing structural weaknesses in the financial system, in particular in the regulatory framework. We need tough new rules to make financial institutions safer and to constrain excessive risk-taking, and we need a regulatory framework that gives the Federal Reserve and other agencies the ability to address risks to the financial system as a whole.

Critically, so that we will never again face the unpalatable choice between bailouts and a disorderly bankruptcy that threatens to bring down our financial system, we must bring an end to the belief that some financial institutions are too big to fail. To do that, we urgently need a new resolution regime for large, complex, and interconnected financial firms, similar to that already established for banks. To end too-big-to-fail, the new regime should permit regulators to close a failing firm and impose losses on shareholders and creditors; indeed, I would argue that no financial instrument counted as regulatory capital should be allowed to receive any protection from losses. At the same time, regulators must have the tools necessary to minimize the associated disruption to the financial system and the broader economy.

The Federal Reserve strongly supports ongoing congressional efforts to reform our financial regulatory framework, but we are not waiting for new legislation to make improvements...

To make our supervision more effective and better able to identify risks to the financial system as a whole, we are also making fundamental changes to our daily operations...

As we've been working to make our supervision more effective, we have also been taking care to ensure we do not inadvertently impede sound lending. Businesses need access to credit to maintain or expand their payrolls and make productive investments. Banks need to continue to lend to creditworthy borrowers to earn a profit and remain strong. If bankers become overly conservative in response to past lending-if examiners force such-will hurt bankers' own long-term interests and the economy in general. For this reason, we have joined with the other federal banking agencies to issue a series of policy statements to examiners: on the importance of bank lending to creditworthy borrowers, on small business lending, and on commercial real estate loan restructuring. We have followed up this formal guidance with training for examiners and outreach to the banking industry. Our message is a simple one: Institutions should strive to meet the needs of creditworthy borrowers, and the supervisory agencies should do all they can to help, not hinder, those efforts. We also must support sensible efforts to work with troubled borrowers to bring them back into good standing...

In these and other areas, we at the Federal Reserve will continue to improve how we regulate and supervise financial firms while continuing to do all in our power to identify and mitigate risks that may endanger the financial system as a whole.

Economic Challenges

Notwithstanding the progress that I've noted, critical challenges-both near term and longer term-remain. We have yet to see evidence of a sustained recovery in the housing market. Mortgage delinquencies for both subprime and prime loans continue to rise as do foreclosures. The commercial real estate sector remains troubled, which is a concern for communities and for banks holding commercial real estate loans.

Some of the toughest problems are in the job market. The unemployment rate has edged off its recent peak, but at 9.7 percent, it is still close to its highest level since the early 1980s. Although layoffs have eased in recent months, hiring remains very weak. More than 40 percent of the unemployed have been out of work six months or longer, nearly double the share of a year ago. I am particularly concerned about that statistic, because long spells of unemployment erode skills and lower the longer-term income and employment prospects of these workers.

That said, my best guess is that economic growth, supported by the Federal Reserve's stimulative monetary policy, will be sufficient to slowly reduce the unemployment rate over the coming year. If economic conditions improve, as I expect, we should see increased optimism among consumers and greater willingness on the part of banks to lend, which in turn should aid the recovery. Meanwhile, for the near term, inflation appears to be well controlled. Productivity improvements have helped firms control costs, and little pricing power is evident. Inflation expectations, as measured in the financial markets or in surveys, appear stable.