This Turmoil Shall Pass

Families unexpectedly losing their homes, businesses unable to get much-needed loans, banks reporting major losses and other stories of financial gloom and doom dominate today's headlines. Is the frenzied swirl of facts, figures and sound bites really as chaotic and threatening as it sounds?

The short answer is that we are in the midst of a phenomenon painfully familiar to Americans. From the gold rush to the Internet bubble, cycles of innovation, excess, adaptation and recovery to a point of even greater prosperity have defined America's economic progress. In the present situation, we are seeing the rough edges of the same recent financial innovation that has brought enormous benefits to many investors, businesses and consumers. But these net benefits are of little consolation to the Americans whose lives are being seriously disrupted by the current financial-market turmoil. In response, policymakers in the United States and around the world are taking aggressive and targeted actions to stabilize financial markets, reduce the impact of markets on the U.S. economy and protect against the same mistakes' being repeated.

We don't know exactly how, or when, this turmoil will end. But like other periods of market instability, it will end. Though we face difficult times, we are taking steps to ensure that the flexibility, resilience and strength of U.S. capital markets will eventually prevail. In the meantime, as we act to minimize the impact on the overall economy, we must avoid overreacting with regulations or policy responses that stifle innovation or distort the natural self-correcting forces of markets. As we work through this experience, we will learn, adapt and emerge stronger.

How did we come to this point? An abnormally long period of benign economic conditions marked by low interest rates, low inflation and less volatile asset markets led many to ignore the "risk" half of the risk-reward equation at the heart of financial markets. Investors around the world, who in preceding years had enjoyed above-historical returns on most types of investments, continued reaching for ever-higher gains. The financial-services industry created a variety of complicated new products to meet this demand. Regulators and investors alike showed a growing complacency toward risk. These factors blended into a dangerous cocktail of underlying conditions ripe for instability.

This imbalance between risk and reward was perhaps most evident in the U.S. housing market, where lenders significantly loosened credit standards—particularly for a new generation of adjustable-rate mortgages with low teaser rates, interest-only features and low or no down payments. Yet aggressive financial innovation went well beyond mortgages. Banks and brokers created an alphabet soup of products with simple names like CDOs, CLOs and SIVs, which were in fact complex and opaque investment products and structures. They relied on bundling assets, particularly mortgages, to better distribute the investment risk, and the greater use of leverage or borrowing to generate higher returns. Credit-rating agencies responsible for assessing and rating these assets, as well as investors who purchased them, failed to question the chances of these underlying investments' going bad.

Last summer these new vulnerabilities in our financial system became clear. Looser credit standards in the housing market, combined with an end to rapid home-price appreciation, led to a significant rise in delinquent mortgages. This in turn contributed to immediate and unexpected losses for investors and a reconsideration of the risk-reward relationship—first in housing, and soon after, across all asset classes. The shaken investor confidence in housing assets had a domino effect throughout world markets, ratcheting up demand for cash and liquidity, and curtailing the pace of the new lending and investment necessary for strong growth to continue.