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The Atlanta Fed


Lockhart Discusses the Future of Credit Markets Following Recent Financial Turbulence

For immediate release: Feb. 7, 2008

Lockhart Discusses the Future of Credit Markets Following Recent Financial Turbulence

ATLANTA, Ga. — Dennis P. Lockhart, president and chief executive officer of the Federal Reserve Bank of Atlanta, today discussed his views of the future of credit markets. He addressed four questions coming out of the recent financial turmoil: Are banks going to make a comeback to regain their share of credit intermediation; is securitization dead or dying; will there be permanent shrinkage in the leveraged loan market; and will foreign investors flee U.S. credit markets?

In his remarks to the Atlanta chapter of the Association for Corporate Growth's Capital Connection Conference, Lockhart discussed the rise of off-balance-sheet special purpose vehicles, hedge funds and other entities that have taken market share from banks. While these entities' participation in providing credit has grown dramatically, Lockhart shared his view that recent financial turmoil has made it clear that banks have retained a central role in credit intermediation. For instance, he said banks created "many of the conduits that directly owned the securities. Also, they provided back-up liquidity to the conduits that served as intermediaries to the ultimate investors, and they often helped the ultimate investors finance their holdings of the securities." He also noted that when problems arose, "the markets turned to the banks to use their superior access to liquidity—both market-sourced and official—to provide funding."

To answer whether securitization was dead or dying, Lockhart said "the answer is an unambiguous no." He detailed how securitization has been around for decades, providing fee income to originators, diversification benefits to lenders and lower costs to borrowers. "The logic of securitization—done prudently—is too compelling, and the market infrastructure is advanced," he said. Still, certain weaknesses with securitization must be addressed, he said. Among those weaknesses is the lowering of loan origination standards and the perverse incentives of originators who carry minimal risk in the ultimate performance of the loan. He said he also expects securitization financing structures will become less complicated, addressing troublesome opacity issues. He added while credit ratings will continue to be important, they "are unlikely to be as singularly dominant as they have been in some markets in recent years."

In regard to whether the shrinkage of the leveraged-loan market was temporary or permanent and what the outcome might mean for private equity, Lockhart said he believes the private equity industry will continue to operate but at more modest levels of deal size, leverage and loan terms. He views the recent repricing of risk and strengthening of terms as healthy developments in the longer term. However, he also offered a cautionary note: "Leveraged lending tends to go through cycles of tighter, then looser, underwriting standards. The pressures of competition for loan origination—including competition from nonbanks and hedge funds—may play through once again."

Finally, Lockhart addressed the possibility that foreign investors might pull out of U.S. credit markets, particularly since some foreign institutional investors have suffered with recent problems. Lockhart said there has been a widespread retreat from the subprime market, and he would not be surprised if this pullback persists for some time. But after recovery, he indicated it is more likely that in the broader credit market foreign investors will be more selective and rely more on carefully vetted expert intermediaries in selecting where to invest. Overall, Lockhart does not see permanent impairment of foreign investor participation in U.S. credit markets.

A transcript of Lockhart's remarks is available on the Atlanta Fed Web site at www.frbatlanta.org.

The Federal Reserve Bank of Atlanta serves the Sixth Federal Reserve District, which encompasses Alabama, Florida, Georgia and parts of Louisiana, Mississippi and Tennessee. As part of the nation's central banking system, the Atlanta Fed participates in setting national monetary policy, supervises numerous commercial banks and provides a variety of financial services to depository institutions and the U.S. government.