The President''s Working Group (PWG) – chaired by Treasury and consisting of the Federal Reserve, the SEC, and the CFTC -- is leading a comprehensive review into the policy implications resulting from current challenges in the credit markets. A number of these issues are directly tied to the mortgage markets; others affect the capital markets more broadly. Given the global nature of our financial markets, I will also work with the G7 and through the Financial Stability Forum to address several of these issues.

One area the PWG has already addressed is hedge funds. Back in February, the PWG produced forward-leaning guidance for the industry and its participants including regulated financial institutions which serve as prime brokers and counterparties to hedge funds. Our principles and guidelines serve as a foundation to enhance vigilance and market discipline, strengthen investor protection and guard against systemic risk. While a small number of hedge funds were forced to wind down in recent months, there were no systemic events associated with their closure, and hedge funds have not proven to be a significant problem.

The real irony is that the material problems arising in recent months were in regulated institutions in certain markets. Many regulated institutions, both in the U.S. and elsewhere, appear not to have fully appreciated all of the risks associated with the securitized assets on their balance sheets or the many risks associated with commitments to provide liquidity to off-balance sheet vehicles, such as conduits and structured investment vehicles.

Deteriorating subprime mortgage performance over the last several months led investors to question their assumptions about the credit quality and value of many assets. In July, as default rates surpassed their models'' projections, ratings agencies downgraded billions of dollars worth of subprime mortgage backed securities.

The statement by ratings agencies that they were unable to accurately characterize the default probabilities of subprime mortgages created broader uncertainties in financial markets. Not surprisingly, investors reacted by reassessing and repricing risk across all market segments that relied heavily on the use of ratings, particularly in complex, structured credit products. Predictably, given the interconnectedness of our capital markets, the influence of this development was global.

The reassessment of risk has played out more rapidly in some markets than in others. In certain asset classes, risk has been reassessed and repriced fairly quickly as investors gained confidence in their fundamental assessments. In such markets, liquidity has returned and markets are operating normally. Good examples would include world equity markets, sovereign debt markets, and investment grade corporate debt.

On the other hand, some sectors that are characterized by more complex securities or that rely more heavily on securitization and ratings -- such as the jumbo mortgage market, the leveraged loan market, and the asset backed commercial paper market -- are still operating under some stress with impaired liquidity. Conditions are better than they were a few weeks ago, and we continue to see improvements, but it will take longer for these sectors to fully recover.

Market–based efforts and initiatives are emerging to address some of the current challenges in the capital markets. I am pleased that yesterday a group of commercial banks announced their intent to establish a master conduit to help improve liquidity in the asset-backed commercial paper marketplace. The market participants and investors who may voluntarily participate in this enhanced facility recognize the benefit of such a structure. The leading financial institutions as well as investors realize the importance of improved liquidity in the high quality, asset backed commercial paper sector – a sector of the market with great importance for securitized assets such as mortgages, as well as for the broader capital markets.

This is promising. Just as in the mortgage market, we need to work on parallel tracks, addressing current concerns as well as addressing policy issues to avoid repeating the recent market turmoil.

Treasury and the President''s Working Group are conducting a comprehensive review of such issues, including two areas that have a direct relationship to the events in the mortgage markets.

First, it is clear that we must examine the role of credit rating agencies including transparency and potential conflicts of interest. We must also assess if regulations and supervisory policies are encouraging an over-reliance on ratings by financial institutions and investors.

Second, we must continue to address financial institution risk management and related regulatory issues. In particular, we must ensure that they adequately take into account the risks posed by protracted periods of market illiquidity or the risks posed by a reduced ability to securitize and sell loans, including leveraged syndicated loans and mortgages.

Our bank regulators must evaluate regulatory capital requirements applicable to bank exposures to off-balance sheet vehicles. Transparency is important here, so we will also review the accounting rules that are applicable to off-balance sheet vehicles.

We will examine other areas that are indirectly related to the mortgage market which nevertheless impact our capital markets, ranging from enhancing the management of counterparty credit risks, to market infrastructure issues, to issues surrounding reporting and risk disclosure, to evaluating the important role of investors and, finally, how our long-standing regulatory structure and tools respond to today''s continuously evolving financial system.

Conclusion

Innovation is the hallmark of our capital markets and it brings with it significant benefits to individual investors and our overall economy. However, innovation often outpaces regulation. That is not surprising, and we would not want it the other way around. If it were, we would have less competitive and efficient markets, which would ultimately stifle economic growth. It would mean fewer jobs and lower wages.

However, when problems arise, we need to shine a light on them and move to address them in a balanced way. Today it is clear that we need to do just that. We have a lot of work to do. We need to ensure yesterday''s excesses are not repeated tomorrow.

As the mortgage and credit markets continue to adjust, all of us – policymakers and market participants -- will no doubt learn new lessons. Through a dedicated effort by all parties, we will work to strike the right balance, protect consumers and make mortgage capital widely available to Americans ready to be homeowners.


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