Financial Update First Quarter 2008)

Atlanta Fed President Discusses Credit Market Instability

Dennis LockhartAtlanta Fed President and Chief Executive Officer Dennis P. Lockhart delivered a pair of speeches this month in which he discussed recent turmoil in the nation's credit markets.

Lockhart placed recent events in a global context, explaining that the U.S. economy and credit markets continue to deal with persistent global imbalances—trade imbalances, savings and investment imbalances, fiscal imbalances, and foreign-owned dollar surpluses.

Pondering the future of banks
In Feb. 7 remarks to the Atlanta chapter of the Association for Corporate Growth, Lockhart addressed four questions stemming from recent financial turmoil: Are banks going 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?

Text of Feb. 7 speech
Text of Feb. 8 speech
Dennis Lockhart biography

On the first question, Lockhart said that despite the rise of off-balance-sheet special purpose vehicles, hedge funds, and other nonbank entities, recent financial turbulence has made it clear that banks have retained a central role in channeling credit to borrowers. As to whether securitization was dead or dying, Lockhart said "the answer is an unambiguous no," but he said participants in the securitization process must address certain issues including lowering of standards and, in some cases, fraudulent behavior by originators.

In addressing the shrinkage of the leveraged-loan market, Lockhart said he believes the private equity industry will continue to operate but at more modest levels of deal size, leverage, and loan terms. Finally, Lockhart said that while foreign investors might become more selective, they will not retreat from American credit markets.

Global imbalances a major influence
In fact, in a Feb. 8 speech Lockhart emphasized the significant role of global financial imbalances, particularly foreign dollar surpluses, in the domestic economy and credit markets.

The effect of those imbalances is that large, mature countries like the United States can be net debtors to the rest of the world for long periods of time. This development can be a creative force: The movement of capital from net saving countries causes financial market innovation as bankers try to design vehicles that appeal to investors, including foreign investors, Lockhart said.

Certain countries have amassed surpluses of dollars from selling large quantities of goods and commodities, such as oil, to the United States, Lockhart noted. In the 1970s and 1980s, many of those dollars were channeled through banks to uncertain emerging-market debt. More recently, that money helped finance risky U.S. household debt, again with banks in the middle, Lockhart said.

"At this point conclusions about cause and effect are more speculation than science,"he said of the role of global imbalances in U.S. markets. "But I am persuaded that the liquidity conditions created by foreign-owned dollar surpluses trying to find an investment home in this country contributed to markets' recent unstable conditions."

Lockhart stressed that the United States "should not become identified with investment protectionism,"nor should the nation impose excessive regulation that would undermine innovation and competition.

"If global imbalances are unlikely to disappear for some time, and we must live with them, then market practitioners and financial authorities must improve their ability to monitor global investment flows and recognize incipient problems,"he said.

February 27, 2008