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A Conversation with William C. Dudley

Speaker: William C. Dudley, President and CEO of the Federal Reserve Bank of New York, Vice Chairman of the Federal Open Market Committee
Presider: Richard E. Salomon, Managing Partner, East End Advisors
March 6, 2009
Council on Foreign Relations

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RICHARD E. SALOMON:  My name is Rick Salomon.  I'm the managing director of an investment advisory firm by the name of East End Advisors.  I'm also vice chairman of the board of the Council.

I'm here this morning to introduce Bill Dudley.  You have his bio in your materials, so I won't read it to you.  But, I would note a couple of things.  For the past six weeks or so Bill has been serving as president and CEO of the Federal Reserve Bank of New York.  It's been a tumultuous six weeks.  Bill is not a market timer -- sure.  (Laughter.)

In addition to serving as the president of the New York Fed, that position puts him as vice chairman of the Federal Open Market Committee, which is the entity that's responsible for formulating monetary policy for this country -- a very, very important job at a very, very important moment.

Before Bill joined the New York Fed, he was a partner at Goldman Sachs, and while there, along with other things, was the chief economist for Goldman Sachs.  And I will tell you, Bill, that on behalf of many people in the investment business, your work there helped us greatly.  In fact, I think if you were still there we would have all anticipated much better, and dealt much better, with the crisis that we're now confronted with.

So, while we miss you in your old job, we're very delighted that you are in your new job.  Thank you for taking the time to be with us at the Council, and welcome.

(Applause.)

WILLIAM C. DUDLEY:  Thank you very much, Richard, for those kind comments.  And thank you to the Council for having me here today.  It's a pleasure to be back here.

In the past, my fellow Reserve colleague, Governor Daniel Tarullo, gathered panels of Wall Street economists here at the Council to talk about economic issues from time to time.  When he invited me to participate it was challenging work, because Dan always asked us about our economic forecasts; and he remembered and recounted our past mistakes, and our much rarer, and more prescient, forecasts.

Before I begin, let me emphasize that my commentS reflect my own views and opinions, and do not necessarily reflect the views of the Federal Open Market Committee or the Federal Reserve System.

What has happened to the global financial system is clearly momentous.  We have seen, despite extraordinary actions by central banks and governments around the world, a severe impairment of the intermediation process between borrowers and savers.  We have seen a massive deleveraging of the non-bank financial sector; we have seen a tightening of financial market conditions even as the Federal Reserve has pushed the Federal funds rate down close to zero.  The result has been a sever loss of confidence among consumers and businesses, and a global recession.

Today I'd like to talk a bit about what went wrong; where we are today; some new initiatives that are underway; what lessons we should take from the crisis; and some steps we need to take so this doesn't happen again.

It's well recognized at this point that one important catalyst for this financial crisis was the easy credit and loose underwriting practices that fueled the boom in the U.S. housing sector.  The ability of virtually anyone to get a loan to buy a house pushed up home prices significantly faster than incomes.

To keep the boom going, underwriting standards were progressively relaxed.  But even with that support to demand, inevitably the boom proved unsustainable.  As the boom reversed and housing prices began to fall, the bad underwriting practices and the mispricing of risks became readily apparent.

When prices are rising, no one needs to default.  They always had the option of refinancing or selling the house at the now-higher price.  But, when prices are dropping, there is no easy way out.  The result has been a sharp rise in delinquencies and foreclosures as the bust has played out.

The fact that these poorly underwritten loans were used in the construction of very complex securities, collateralized debt obligations, or CDOs, with risks that were not well understood and which were grossly mispriced, made a bad situation even worse.  Investors who thought they had purchased safe, AAA-rated assets found that these assets were very vulnerable to a housing bust, and that the ratings were very unreliable predictors of the risk of loss.

The poor performance of these securities, in turn, made investors much less willing to invest in structured finance products more generally.  Secondary market liquidity evaporated, which exacerbated the difficulty in valuing the securities.  This made the market even less attractive, causing risk premium to widen further, which only worsened the valuation problems.

As this process unfolded, the result was a virtual shutdown of the securitization market for residential mortgage assets not backed by the federal government directly -- i.e., Ginnie Mae, or implicitly, by Fannie Mae or Freddie Mac.  The subprime and Alt-A mortgage markets, which relied heavily on the securitization process, dried up.

Of course, this just reinforced the downward pressure on housing prices, which, in turn, led to increased delinquencies and foreclosures.  This deterioration undermined the value of the securities further.  It was a vicious feedback loop in action.  The poor performance of highly-rated mortgage secretaries caused investors to begin to shun securitizations more generally.

The shutdown of the securitization markets led to significant pressure on bank balance sheets.  Banks could no longer securitize nonconforming mortgages, or the collateralized loan obligations associated with leveraged buy-outs, and other private equity activity that they had financed.  Moreover, bank backstop liquidity lines were triggered as SIVs and conduits could no longer issue asset-backed commercial paper.  Finally, banks took large mark-to-market losses on their trading books and had to increase their loan loss provisions.

As the crisis continued into 2008, the squeeze on banks' balance sheets intensified.  This was driven by several important developments:

First, the demise of Bear Stearns increased the pressure on the other broker-dealers to deleverage.  They did this, of course, by becoming less willing to lend funds to their counterparties, such as hedge funds, and by shrinking their trading books.

In the week leading up Bear's demise, a nasty feedback loop ensued.  Forced asset sales increased price volatility.  This led to higher haircuts by dealers on their counterparties, which led to more forced asset sales and still higher volatility.

Second, the failure of Lehman Brothers in September accelerated the pace of this deleveraging process.  Major bank intermediaries were frightened by what had happened and were unwilling to engage with one another.  Prime money market mutual funds suffered large outflows; investors fled as the news came out that the reserve fund had, quote "broken the buck," unquote, because of large losses generated by its holdings of Lehman paper.

By late September we were in a very bad spot.  Banks weren't willing to lend to each other even at very short-term maturities.  LIBOR, the London InterBank Offered Rate, which is the rate that banks offer to lend to each other, soared even as the Federal Reserve continued to lower its federal funds rate target and injected extra reserves into the banking system.

Merrill Lynch agreed to merge with Bank of America.  The equity of the two remaining independent investment banks -- Goldman Sachs and Morgan Stanley, weakened.  Their credit default swaps spreads widened, and this began to undermine their ability to obtain funding.  In response, Goldman Sachs and Morgan Stanley jumped over the regulatory wall and became bank holding companies.

Hedge funds were forced to liquidate assets as financing terms tightened.  As a group, their performance deteriorated sharply beginning late summer.  This provoked investor redemptions, further accelerating the speed and the scope of the deleveraging cycle.

Although housing and housing finance may have been at the epicenter of the crisis, it's important, however, to recognize that the crisis goes much deeper.  In part, it was rooted in the overconfidence of investors and borrowers that paid little attention to liquidity and rollover risk, and seemed blind to the risk of a global downturn.

It was also rooted in the gaps in supervision and regulation that allowed a whole range of financial intermediaries and businesses to become more leveraged, in many cases funding long-term illiquid assets with short-term borrowing obligations.

To some extent, what has happened can be tied to changes in the nature of the business cycle and how those changes have influenced expectations.  Put simply, when business cycles become more damped, and recessions less frequent and less severe, this will cause financial market participants to take on more risk.

This will not appear to be problematic during the expansion stage, but it will make the financial system more vulnerable when the bust does occur.  Occurring with less frequency, the bust will be a bigger surprise to market participants.  They'll be less well prepared with the capital buffers and liquidity cushions needed to transverse an adverse economic environment.

The breakdown in trust across markets has been remarkable.  Essentially, it has gone like this:  "Even though I think you're a good credit, I am not going to lend to you because others may not share the same opinion."  "The problem is, if no one else thinks you are good, I may not be able to get my money back if I need it."  "Conversely, others are not willing to lend to you, even though they may think you're a good credit, because they are not convinced that I will do so."

The result is that no one lends, financial conditions tighten, and this exacerbates the downward pressure on the economy.  As economic conditions deteriorate, this undermines the financial strength of the major financial institutions, further reinforcing the downward spiral in confidence.

Another bad dynamic that exacerbated the crisis has been the reluctance of some banks to raise the additional capital they might need should the economic outlook deteriorate sharply.  Repeatedly, over the past 18 months we have heard from the GSEs, from the investment banks, from the commercial banks:  "Now is not a good time to raise capital."  This desire to postpone capital raising stems, in part, to the fact that bank executives often do not want to dilute the existing shareholders, which, of course, include themselves.

I believe that the management calculus has often gone like this:  "In good states of the world, I have enough capital.  In bad states of the world, some bad states of the world, perhaps I don't.  But, to raise enough capital to guarantee I can endure all potential bad states of the world, I will have to massively dilute my existing shareholders now."  So, the self-interested thing to do is to avoid the dilution and hope for a good state of the world.

Unfortunately, this does not always work well in practice.  Once capital preservation becomes paramount, deleveraging intensifies and counterparties grow more wary about engaging with one another.  This dynamic, in turn, makes a bad state of the world more likely.  What may be sensible for each institution individually, may collectively be a bad idea.

That is because each firm does not internalize the costs that their decision not to raise capital has on the performance of the overall financial system.  A healthy banking system is always essential, but never has that been more true right now given what has happened to securitization markets in the broad shadow banking system.

So, where are we now?  In my view, the deleveraging process is still far from complete.  Hedge fund redemptions have soared.  It would not be surprising that when we're done hedge funds assets, before leverage, will have fallen in half or more from their peak of about $2 trillion.  Of course, the Madoff scandal and other episodes of misappropriated funds have further undermined confidence, reinforcing the debt redemption pressure.

Most importantly, the pressure on the financial system has been exacerbated by the deterioration in the economic outlook following Lehman's failure.  Before last fall, the causality ran mostly from the turmoil in the financial system to the real economy.  Since then, the real economy has contracted sharply and this has reinforced the balance sheet pressure on banks and the forced deleveraging process.

So, where do we go from here?  Well, fortunately it's not all bad news.  There are a number of programs that have been enacted that already have made a difference, and several new initiatives are being enacted now that should help to support and bolster the financial system.

Those areas where the Federal Reserve and the federal government have responded en force are doing somewhat better.  Banks and dealers have plenty of access to liquidity.  The Term Auction Facility, or TAF, in which funds are auctioned off to banks; and the Term Securities Lending Facility, or TSLF, in which auctions are held to borrow securities from the Federal Reserve, have recently been undersubscribed.  That indicates that the facilities had been sufficiently sized to meet the demand for liquidity from banks and dealers.

The FDIC has also guaranteed bank and bank holding companies funding through its Temporary Guarantee Liquidity (sic) Program.  As a result, bank term funding spreads have narrowed a bit this quarter, so there has been some improvement.  However, while the Federal Reserve can provide liquidity to the banks and dealers, and the FDIC can reduce counterparty concerns by its Guarantee program, these steps cannot force banks and dealers to unlend these funds to their customers.

This is where several new initiatives may show the way forward:

First, the Federal Reserve has begun to bypass the banks and dealers -- which are balance-sheet constrained, and instead has begun to provide liquidity directly to borrowers.  One of the programs, the Commercial Paper Funding Facility, or CPFF, has been up and running since late October.

Under the terms of the CPFF, the Federal Reserve offered to purchase A1/P1-rated commercial paper at 84 days maturities from issuers.  Although A1/P1-rated paper is the highest quality stuff, it makes up almost all of the commercial paper market.  The only catch is that the CPFF will only buy at rates that are quite high compared to the rates that one would expect in the market during normal times.  The Fed has to charge a high rate in up-front fees to provide some equity in the fund to offset potential credit losses.

The CPFF has worked extremely well in restoring market function in the commercial paper market.  Initially, there was a surge of issuance into the facility, commercial paper rates in the market were high and the issuers wanted to extend the maturity of their obligations.  But, since that time, purchases have slowed sharply.  Following the introduction of the CPFF, commercial paper rates in the marketplace dropped below the rates charged by the CPFF.

As a result, issuance into the program has collapsed because many issuers can now raise funds more cheaply in the private market.  About half of the maturing paper in the CPFF has not been rolled over.  As a result, the amount of CPFF holdings, which peaked at around $350 billion in mid-January, has fallen by over $100 billion to below $250 billion.  To date, at least, the CPFF has worked this plan, and has been very successful in rehabilitating the private commercial paper market.

Second, the Term Asset-backed Securities Lending -- Loan Facility, or TALF, will provide balance sheet capacity directly to investors beyond the banking and dealer community.  This program is designed to restart the securitization markets.

The TALF is being rolled out in two stages:

In the first stage, which I'll call TALF Version 1.0, the Federal Reserve will provide non-recourse loans to investors against AAA-rated consumer asset-backed securities collateral.  Primary dealers will serve as the contact point with these investors to make it easier for the Federal Reserve to interface with potentially hundreds of investors.  The AAA-rated securities eligible as collateral for this non-recourse lending program are used to fund a wide variety of consumer and business loans, including student, credit card, auto and small business administration loans.

The market for these securities has dried up because the traditional investors in these securities -- SIVs, bank-related conduits and security lenders have either disappeared or are balance sheet constrained.  This has reduced the availability of credit for consumers and has led to higher borrowing costs which the TALF is determined to address.

The first subscriptions for financing under TALF Version 1.0 will occur on March 17th.  The first batch of new securitizations will be funded on March 25th.  TALF Version 2.0 will follow.  This will broaden the TALF into new asset classes, such as commercial mortgage-backed securities.  Development of this phase is still in its early days but it's anticipated that the size and scope of the TALF will expand sharply in the months ahead.

So, how will the TALF restart securitization activity and provide balance sheet capacity to the private sector?  By providing leverage in three-year term, non-recourse financing to investors, the TALF should increase the demand for AAA-rated securitizations.  Yields of LIBOR plus 400 basis points may not be sufficiently attractive on an unleveraged basis, but at 10 times leverage the returns become very attractive.

The non-recourse nature of the loans is also important.  If the price of the securities falls considerably, the investor just loses the amount equal to the size of the haircut.  For example, if the haircut was 10 percent, and the value of the security was $100, the most the investor could lose would be $10.  Thus, the facility eliminates much of the downside risks that would arise from a deep recession, or the fire sale of assets that could cause prices to drop sharply temporarily.

This is a very exciting program because it provides balance sheet capital -- capacity to risk capital that currently cannot get leverage.  It goes beyond the current programs.  Just as important, once it's up and running it can be scaled up, and out, in many different dimensions.  In principle, it could be applied to other distressed asset classes; it could be moved down the credit spectrum to lower-rated tranches; and it could be used to fund older vintage assets.

Two other important initiatives are also (entrained ?) that deserve note.  Last week the Treasury and the major banking supervisors announced the details of a capital stress assessment process for all bank holding companies with assets in excess of $100 billion.  This process is designed to ensure that the banking system has sufficient, high-quality capital to be able to absorb the losses that would likely to be generated by an economic scenario considerably worse than generally expected.

The stress assessment assumes an adverse economic environment.  For example, under this scenario the unemployment rate is anticipated to average more than 10 percent in 2010, which is considerably higher than the consensus economic forecast.

The stress assessment will unfold in three steps:

First, each bank holding company will be asked to evaluate the credit losses that are likely to occur under the adverse economic environment.  These losses would then be evaluated relative to the banking holding company's ability to absorb those losses.

Second, if this analysis indicated that the bank -- (inaudible) -- was likely to fall short of "well-capitalized" in the stress environment, the bank holding company would be able to obtain additional capital via mandatory convertible preferred stock purchased by the Treasury.

Third, if the stress scenario were actually to occur, generating losses that depleted common equity capital below what is deemed adequate, then the mandatory convertible preferred would be available to be converted into common equity.  The government's mandatory convertible preferred investment is, in some sense, contingent capital that is available to be converted into common equity only as needed.

I believe this program is very important if we are to break the adverse dynamic that I outlined earlier.  As I mentioned earlier, many bank holding companies don't have an incentive to raise sufficient capital to ensure that they can handle a very bad outcome.  That is because such capital-raising would severely dilute existing shareholders.

This implies that, left to their own devices, banks might end up being undercapitalized in a stress environment.  The risk of this outcome makes these banks, and their counterparties, very cautious in terms of their behavior.  This cautiousness, (in turn ?), which is rational for each bank and counterparty individually, is bad for the system, because it constrains the supply of credit and results in tighter financial conditions.  This, in turn, makes the bad economic outcome more likely.

The stress assessment regime that is being implemented should help to break this dynamic.  Banking institutions will end up with sufficient capital to withstand even an adverse environment.  This should reassure banks and investors that the banking system will remain resilient. With more capital in place, more lending should take place.  This, in turn, should reduce the likelihood that the bad economic scenario will, in fact, be realized.  The result:  A virtuous, rather than vicious, circle.

The point of the stress assessment is not to pick winners or losers, but instead to ensure that the banking system and all the major banks have sufficient capital to withstand a very adverse environment.  Following the conclusion of the stress assessment process, the government is committed to supplying whatever amount of capital is needed to ensure that all the major banks will remain viable.

The second major initiative that deserves mention is the PPIF, or Public-Private Investment Fund.  This facility, which would be underpinned by TARP capital and private capital, would purchase illiquid legacy assets.  Although the terms and conditions of the PPIF have not yet been announced, this facility should help put a floor under the prices of lower quality assets and provide a means for banks to shed such assets from their balance sheets.

Despite all these efforts, I don't want to give you the impression that all will be well soon.  That seems unlikely.  It will take time for the deleveraging process to come to an end and, as the recent employment data have underscored, the economy still has considerable momentum to the downside.  But, the Federal Reserve is prepared to do whatever it takes, within the bounds of its legal authority, to keep markets working and credit available and affordable.

So, finally, what are the lessons to be learned from this crisis?  What do we need to do to fix the system in order to make our system more robust and our economy less vulnerable?  Let me offer a short list of seven areas that we might focus on, recognizing that this list is by no means complete or exhaustive.

Number one.  We need more transparency and homogeneity in securities.  The difficulty in valuing opaque and heterogeneous securities has led to greater illiquidity, price volatility and market risk, bigger haircuts, and more forced deleveraging.  Opacity has also led to an undue reliance on credit ratings.

Number two.  We need central counterparties, or CCPs, for over-the-counter derivatives in order to reduce settlement risk.  To do this properly, we'll have to work with international supervisors, regulators and governments to achieve global solutions in this area.  On this score, a lot of progress has been made in the credit default swaps -- (inaudible) --, with several new CCPs likely to be up and running in months, if not weeks.  But, we can do more in this area.

Number three.  We need an accounting and disclosure regime that allows investors to meaningfully ascertain the risks they are taking.  For example, the same assets are often carried on different bank books, at different prices.  If you can't trust the valuation marks on the assets, how robust can we expect confidence to be in the ability of the financial system to withstand stormy weather?

Number four.  We need a resolution mechanism for bank holding companies and non-bank financial institutions.  Legislation is needed here.  Judging from the actions of the past year, there are, indeed, institutions that are, quote, "too big to fail," unquote, at least under certain circumstances.  So let's set up a resolution framework that is robust and transparent so everyone understands the "rules of the road" and likely outcomes beforehand.  An ad hoc approach increases uncertainty and reduces policymaker credibility.

Number five, if large, systemically important institutions are indeed too big to fail, then there needs to be an explicit quid pro quo for this; otherwise, this implicit support will create moral hazard and discriminate against smaller institutions.  In particular, important institutions cannot be allowed to stay outside in the sun during good times but allowed to go inside the regulatory net when it's raining outside.

Number six, we need a more robust capital regime for banks.  Measures of regulatory capital lag far behind real-time, market-based measures of capital and risk.  Moreover, the capital regime is pro-cyclical.  Banks are constrained in the amount of reserves they can build in good times as a buffer against cyclical downturns.  Finally, banks balk at cutting dividends to conserve capital are replenishing the capital they sorely need in the middle of crisis.  These incentives reinforce the downward pressure on the financial system during times of stress.

And number seven, we need a more effective regulatory system.  We need a systemic risk authority that has both the responsibility and the powers to look across the entire financial system, both depository institutions and the capital markets.  Our regulatory regime is incredibly balkanized which makes coordination difficult.  And it means that important information can fall between the cracks.  It also leads to less accountability for supervisory shortcomings and failures,  which is another area where we have to do better.

This list is just a hint of the agenda that lies ahead.  We need to put our financial system into the repair shop for intensive reconstruction.  We need to do this in order to rebuild confidence and to ensure that we do not repeat the type of financial boom and bust that has characterized this cycle.

I thank you very much for your kind attention.  I'm going to take questions, but I would restrict the questions to no questions on individual companies.  Thank you.

(Applause.)

SALOMON:  Thank you, Bill, for what was a very interesting diagnosis and prescription of our current circumstance.

I should have said at the outset for the eighth time you've heard it during this conference, turn off the cell phones.  This session, as opposed to a number of the others that you've participated in, is on the record.  So be aware of that in terms of both Bill's comments so far and these questions.

What we're going to do, I'm going to ask Bill a couple of questions and have a little bit of a dialogue, and then we'll open the floor up to questions from you all.

Bill, as you know, this is the Council on Foreign Relations.  We are very concerned about the geoeconomic dimension of the crisis.  And one of the concerns that we have is protectionism.  We've seen protectionism in the non-progress with respect to Doha where actually nothing is getting done, and certainly that is protectionist.  We have had a flurry of buy-American activity which is certainly protectionist.  And that sentiment or tendency has been seen in other places around the world.

What I'm concerned about as a third type of protectionism is really financial protectionism.  And my question is this.  As the government gets more involved in the major financial institutions in this country, will there not be a lot of political pressure to constrict lending to domestic entities, this in a country which depends on capital flows to finance and enormous current account deficit?  But it does seem to me probable that political pressure will be significant.

DUDLEY:  I think it's fair to say that that is a risk, that political pressure does put constraints that says we can only benefit domestic institutions.  Obviously, you know, national treatment is the right approach so that foreign institutions that do business here would ideally be treated the same as U.S. institutions, and the same would be true internationally.  So we certainly have to resist those pressures.  I think they are real.  And you know, I think we've learned the lessons of protectionism in the past.  Beggar-thy-neighbor policies don't work.  So I think, you know, it's a real issue, it's a real danger.  The Fed is aware of it.  We're going to articulate our views very firmly in the direction of not being protectionist.

SALOMON:  Let me ask you a question about the Fed balance sheet and balance sheet expansion.  As you look back over the last six months for sure, maybe even a bit longer, the growth in assets of the Fed's balance sheet has been enormous, and the quality of those additions is, at least, open to question.  In a way, the Fed's balance sheet looks a little bit like the investment bank balance sheets, which were responsible for this problem in the first place.  Haven't gotten there yet, and I hope won't.  But the Fed is in a position of having to supply the agency market, the asset-backed market, a public-private partnership and to be a buyer of last resort for Treasuries.  That is a big agenda.  Are there limitations to the capacity to expand the Fed balance sheet?  And at what point does this become a concern such that the other potential buyers of Treasuries will only buy at much higher interest rates?

DUDLEY:  I don't think there's any sort of magical number where the balance sheet passes a certain threshold and becomes too large.  I think the way we're thinking about our balance sheet is we're trying to gauge in programs that help supply credit to the private sector, slow down the rate of de-leveraging process.  And these programs, their use depends, in part, on what's happening in terms of market conditions.  When market conditions are particularly adverse, the demand for our programs is probably going to increase and our balance sheet it going to expand.  When the market conditions improve, programs will tend to diminish in size and the balance sheet will tend to contract.

What's interesting about it is our balance sheet has actually contracted quite a bit over the last month and a half.  The CPFF has fallen in size, as I mentioned in my remarks, from about 350 billion (dollars) to below 250 billion (dollars).  Why has it declined?  Because we charge penalty rates for commercial paper relative to the rates that we would expect to see in the market in normal times.  And so when the market function improves, our facilities become less attractive and the usage of our facilities shrinks automatically.

Most of our programs are of that sort.  So if you look at our balance and look at where the growth in our balance sheet's been, most of it's been in programs like the CPFF, like TALF, like the foreign exchange swap programs, all programs that are very elastic where the balance sheet should contract pretty automatically once market conditions normalize.

SALOMON:  Good.  You mentioned in your comments the public-private partnership.  And we were talking last night about some of the initiatives that are under way and the problem with confidence, the psychology of the market environment and investors, generally.  It does seem to me that some of the things that have been initiated by the Fed and the Treasury have initiated little sparks of confidence.  The TALF has been very well-received.  I think people see real potential there for a sizable program to get the asset-backed market moving again.  And that's been very encouraging to see.  I think also the response to the mortgage restructuring program has been a good one.

But I think all eyes are on this public-private partnership.  I think people are anxious to get the details in many respects, in terms of the size of the program, whether we are going to be using mark-to-market accounting, whether you can use discounted cash flow accounting in terms of how this is all going to work.  The anticipation is great and time is short on this, is my impression.

I think there's a lot of anxiety that could be eased greatly if this program is put in place in a substantial way.  I think it makes less difference which accounting approach is used than the fact that the program get launched soon.  And if you launch it with a number of different competitive programs, so if you put 10 different funds in business at buying these assets, it seems to me that the price discovery can work pretty effectively because they're going to be competing with each other.  And in my view, it's more important to get that launched than exactly how you launch it.  So I'd be interested if you can tell us any more about that program.

DUDLEY:  Well, that program is under development.  The Treasury has said that they're moving forward with PPIF.  The details have not been announced yet.  It's obviously very important for the reasons that you've stated.  It will put a floor under asset prices.  It will allow banks to remove some of the more liquid, less attractive assets from their balance sheet, which I think is important because that will reduce the tail risk exposure of the banks to adverse economic outcomes.

You can deal with bank's problems in two ways.  You can give them more capital or you can protect them against bad outcomes by removing bad assets.  And so you can think of the program as having two parts to it.  One part is to put in more capital, two is also to have a mechanism to allow them to offload bad assets.  So the PPIF is very important in that regard.

SALOMON:  Okay, thank you.  We've got a very complicated agenda, and I think some of the initiatives that have been taking place really are very constructive and hopefully begin to restore confidence.

Let me turn to the audience for some questions.  Henny.  So please, introduce yourself and keep your questions short.

QUESTIONER:  Henny Sender, the Financial Times.  Bill, in your remarks you talked about the reluctance of the banks to raise capital in a timely manner for fear of dilution.  Can you comment on the pros and cons of debt-equity swaps for banks, particularly given the fact that a lot of the holders of the debt would presumably have already written down that debt a lot already?  Thank you.

DUDLEY:  I think that, you know, obviously, the Federal Reserve does not have a policy about how banks conduct their individual business.  You know, my view is that the federal government has made it pretty clear that they're providing a tremendous amount of support to the banking system, to the viability of the large banks.  They're determined to put as much capital in as needed and keep the large banking organizations viable.  So it's not clear, given that, why debt-equity swaps need to be on the table at all, frankly.

QUESTIONER:  (Off mike) -- encouragement?

DUDLEY:  As I said, we don't manage individual bank's business.  But you know, to the extent that the government is determined to put enough capital in the banks to ensure their viability, we've seen that that would seem to allow it.  If I were a bank manager, that would seem to me to rule out going down that path at this time.

SALOMON:  Sir.

QUESTIONER:  John Beatty from UBS.  One of the proposals in your speech is to increase disclosure of the underlying assumptions related to the risk of financial products.  However, given the fact that the mathematical models traditionally rely primarily on default probabilities going back only five or 10 years and did not effectively take into account unusual events, is an increase in disclosure of itself going to make much difference?  Or do we also need to fundamentally rethink the mathematical model in the first place?

DUDLEY:  I think it's fair to say that the amount of history you have should affect your view on how robust the model is.  You know, the models that track corporate debt markets have gone through many ups and downs in the economy and have proven to be quite robust.  The models for structured finance and CDOs in particular, you know, there never really was a truly deep-stress environment, and so the models, you know, should have been viewed with more skepticism.

So I think, you know, investors should ask, what's your proof over how long a time period?  What sort of stress assumptions have you put your models under?  What correlation assumptions are embedded in your CDO models?

So I would say that, you know, investors shouldn't just say, well, gee, it's AAA rated.  The credit rating agency is confident that they have the right model.  I don't think that's sufficient.  You know, the buyer should be beware.  There's not a lot of history, then there should be a greater skepticism until that history bears out that the models in fact are robust.

QUESTIONER:  Corky Mariscot (ph) from The Royalton Group.  Yields on 10-year U.S. Treasuries and 30-year U.S. Treasuries have been rising steadily over the last two months.  They're up about 100 basis points from the beginning of the year.  And that, of course, is the typical crowding out, potential it may offset some of the benefits of the fiscal stimulus program, it may offset some of the benefits of the other programs on the side.  At what point do you begin to really worry about these rising yields?  And what are the pros and cons as you see them of starting to buy more aggressively long-dated U.S. Treasuries?

DUDLEY:  In terms of the Federal Reserve's willingness or unwillingness to buy long-dated Treasuries, you look at the minutes to the last -- (inaudible) -- meeting, it was very clear that the key issue is, will those purchases of long-term Treasuries ease private-sector credit conditions?  So buying long-term Treasuries just for the sake of buying long-term Treasuries is not what the Fed is interested in.  The Fed is interested in only buying long-term Treasuries to the effect that that eases private-sector market conditions.  And I think the issue there is whether you can be more powerful buying Treasuries easing credit market conditions or you can be more powerful using other methods, for example when buying agency debt or mortgage-backed securities or engaging in other liquidity facilities.

At this juncture, judging from the Fed's actions, I think you can reach a logical conclusion that at this point in time the Fed has judged buying long-term Treasuries is not the most efficient means of easing financial market conditions.

QUESTIONER:  Thank you very much, Bill.  That was a great presentation.  Can you see any circumstances under which pushback from Congress would limit your ability to use your balance sheet to address this crisis going forward?

DUDLEY:  I think the goals of Congress and the goals of the Fed here are very much aligned, getting the economy going, getting credit flowing to U.S. households and businesses.  So I don't really see much scope for conflict on this score.  The Federal Reserve can only lend on a secure basis.  The Fed has to be secured to its satisfaction.  As long as we do that and do it in a way that, you know, is consistent with our goals of, you know, trying to obtain full employment and price stability, I don't really see why Congress would have any quarrel with our actions.  So I don't really see any reason for conflict.

SALOMON:  Jacob.

QUESTIONER:  Thank you.  Jacob Franken.  I thought that this statement of yours has been extremely important and well done.  You outline an agenda at the end of it, including more transparency, accounting disclosure regimes, resolution framework, (prosecuality ?) systemically important institutions and the like.  Given the globalization that we have, it seems that it is essential that other countries adopt very similar agenda because if they do not we will be exposed to all the regulatory arbitrage and the distortions that come with it.  Is this part of your agenda to bring them onboard?  And if they are going to be reluctant, are you going to have to have a little bit of a different road map to the implementation of this particular agenda which I think is an excellent one?

DUDLEY:  I think the premise of your question is very much correct, Jacob, that, you know, you can't do this in isolation and be effective.  On Saturday, I'm flying to Basal.  I'm going to be talking to my international and central banking colleagues.  And that is very, very much part and parcel of building a consensus in terms of how to address these problems.  Obviously, different people in different places have different ideas of how much weight to put on number one versus number seven.  But I think everyone agrees that something substantial has to be done.  And so I think, you know, that's what we're working for to try to achieve the closest consensus as possible to limit the risk of the regulatory arbitrage that you point out.

I also think that when we're doing regulatory reform, we have to be really thinking also about the brand that we're creating.  You know, if you do regulatory reform the right way, you're not just imposing cost on firms, you can also be putting on them a Good Housekeeping seal of approval which can make people want to be under your regulatory safety net.  So I think when we judge regulation, it shouldn't all be just about putting on costs, it should also be about concurring benefits.  And so I think we do that, that also reduces the risk of the regulatory arbitrage a little bit.

QUESTIONER:  Thank you.  Maren Jano (ph), Columbia University.  You spoke about a resolution mechanism for bank holding companies.  Is there still consideration of the bad bank concept?  Or has that moved into the PPIF -- (inaudible)?

DUDLEY:  The question is, is there still consideration of bad bank framework, or has that moved into the PPIF consideration?

Well, I think you're right with your question that the PPIF and good bank-bad bank are sort of kissing cousins.  And I think that, you know, the PPIF is sort of leading the race at this juncture.  But you know, I don't think we, you know, would rule out categorically a good bank-bad bank formulation for individual firms should they want to go in that direction.  You know, there have been other good bank-bad bank formulations in the U.S. in the past and, you know, they can work quite successfully.  So I wouldn't want to rule it out by any means.

QUESTIONER:  Gene Solomon (sp) from -- (inaudible).  In your opening remarks, you recognize that the momentum of the economy in this financial crisis is still to the downside.  And you just said a moment ago that you would expect at those times the size of the Fed balance sheet to expand.  But then you immediately pointed out that it's actually been contracting.  Does that suggest that the Federal Reserve is either sort of moving too slow or needs additional programs sooner rather than later?

DUDLEY:  I think that the size of the balance sheet is really driven by a number of things -- what's happening in the economy but also what's happening in the actual markets in which the Federal Reserve is intervening.  So what's happened since the beginning of the year is that the spread between LIBOR and the federal funds rate has come down, and that's made a lot of the Fed facilities which were addressed at providing liquidity to banks both here and abroad less attractive.  And so that's reduced the demand for our facilities.  We should feel good about that because that reduction in demand for our facilities is because market function has improved over that time period.  So I don't think you should mechanically translate, you know, our balance sheet size to the size of the economy.  I think it's a lot more complex than that.  It depends upon where we're intervening, what's happening in that marketplace.  That's going to affect the demand for our balance sheet in those market segments.

SALOMON:  Yes.  Why don't you get a mike there.

QUESTIONER:  Kevin Harrington, Clarium.  On that point, you can look at the swap lines and say that maybe there's less liquidity demand.  But on the other hand, the basis swaps in the markets indicate that there's even more funding pressure for dollars than was true even in late November last year.  So why is there that contradiction between the market's signal that there's an extreme dollar-funding pressure and what we're seeing on the swap line contraction?

DUDLEY:  I don't have a really good explanation for why that basis has widened out recently.  Obviously, the use of the swap facilities, you know, in theory could be constrained by, you know, availability of collateral, but DCB has a pretty broad definition of eligible collateral.  So I don't think that collateral is the binding constraint.  So I don't really have a good answer for you.

SALOMON:  Yes, on this side.

QUESTIONER:  My name is Fred Broda, Oxford Analytica.  My question relates to regulation.  You referred to the balkanization of regulation in our country.  My question is, is the Fed going and are you going to do anything in the reform of that to get a greater role?  And what possibilities do you see with regard to Congress going along?

DUDLEY:  Well, I think, obviously, as you note in your question, this is a decision for Congress to make, not the Federal Reserve to make.  I think what we can do at the Federal Reserve to be helpful is to articulate in what ways the regulatory structure could be made better.  And then it's up to Congress to decide who is going to do what to implement that vision.  So I'm much more focused right now on what do we need to fix as opposed to who's going to do what.  I will leave that to Congress to decide.

I can't hear the question about regulation without referencing a comment I heard Tim Geithner make at a meeting of the Peterson Institute for International Economics in Washington.  And Tim was asked what it was like -- this was just after Bear Stearns had collapsed and was found a home for and before Lehman had collapsed.  And people were asking him how that weekend was.  Tim said it was a brutal weekend, the pressures were enormous, very high stress, and it was complicated by the fact that all of the investment bank and commercial bank CEOs in the room kept saying to him, listen, we know we didn't do as good a job at self-regulation as we should have, but we hope from all this we do not get more regulation.  We will do a far better job of self-regulation, trust me.

Tim heard this several times and commented to me, self-regulation is to regulation as self-importance is to importance.  (Laughter.)  Which I thought put it pretty well.

QUESTIONER:  Lester Wegler (ph), Citi Smith Barney.  Do you believe that -- thank you for addressing us today.  Do you believe that there is a role of Fannie and Freddie in restarting the securitization business?  And if there is, is a more explicit government guarantee required?  Thank you.

DUDLEY:  Fannie and Freddie are already actively involved in the securitization business.  And you know, what their long-term disposition is going to be, that's going to be up to the administration and Congress to decide.  And I think, you know, the market is looking for that resolution.  And I think, you know, once that resolution is provided, I think that will be, you know, very helpful in sort of figuring out the evolution of the securitization markets.  But that's not a Federal Reserve decision for sure.  That's the Congress and the administration to work out.

SALOMON:  Yes, ma'am.

QUESTIONER:  Hi.  Barbara Matthews with BCM International Regulatory Analytics.  Thank you for that excellent presentation.  I'm going to ask a question about central clearing for the CDS market and the regulatory issues there.  It looks like we may be heading toward two different clearing centers.  And there's been quite a debate in the press with Europe about who gets to regulate this.  You've talked about a global solution.  I'm wondering if you could unpack that a little, describe perhaps the state of play but also what you think is important going forward for the oversight of the central counterparty.

DUDLEY:  This is a fairly technical question about central counterparties.  What's going on is Europeans, at least some Europeans, would like to have a CCP in Europe.  And they're providing some push behind that by discussing the idea that entities located in Europe might have to use the CCP in Europe.  You know, I think our position is very clear.  We have no problem with a CCP being located anywhere, but it should be located there based on market competing and figuring out the best CCP model.  It shouldn't be determined by the location of the users.

The second thing I would say on that point, it's much better from a risk perspective if we end up with one CCP located somewhere rather than a CCP located in the U.S. and another CCP located in Europe.  And so we're going to, you know, make our views known, and hopefully we can can an open competition for the best CCP model.  And I think, you know, that it would be best if we could end up with one CCP, frankly.

SALOMON:  Yes, in the back.

QUESTIONER:  James Tunkey, Professional Risk Managers International Association.  How do you propose to eliminate or reduce regulatory arbitrage?  (Laughter.)

DUDLEY:  I'm going to take out my magic wand and wave it.  (Laughs.)  How do I propose to reduce regulatory arbitrage?  Well, coming back to Jacob's question, one thing we can do is try to work very closely with our foreign counterparties to provide less room, you know, less difference between our regime and the regimes abroad.

Number two, as I mentioned in my earlier answer, we can also increase the value of the brand of staying put in the U.S., you know, like being a primary dealer.  Primary dealers have costs but they also have benefits.  People decide if they want to be primary dealers weighing those costs and benefits.  And I think we can do that more broadly in terms of how we propose a robust regulatory system.  If we have a system where just the burdens are really, really high and if those burdens are unrealistically high, then, of course, we're going to encourage other entities to set their burdens lower, and we're going to encourage people to migrate out, away from our system.  So we certainly have to be very cognizant of that as we set the appropriate level of oversight and burden.  So it's not easy.

SALOMON:  Pete.

QUESTIONER:  A few months ago, the Institute for International Economics did some forecasts on foreign debt levels under a variety of scenarios.  And even before our current huge deficit projections, the amount was pretty sobering scenarios.  Now, given the huge increase in debt that we are now talking about, given foreign capital countries needing stimuli in their own countries, does this raise or not your concern about various hard-landing scenarios?

DUDLEY:  I think, you know, at the current time frankly there is probably going to be plenty of appetite for our debt, both here and abroad because what we have is an environment where people are trying to flee risk into less-risky assets.  I think the issue of a hard landing also, I think, is reduced by the fact that the U.S. markets are liquid, deep.  And they're also reduced by the fact that if not U.S., where?  It's not as if the U.S. is performing very badly and other alternative regions are performing extraordinarily well.  You know, this is a global recession, and so I think also the ability to migrate from one region to another, you know, quickly, I don't think there's going to be much appetite for that.

I think the more interesting period, in terms of, you know, risk is going to be really as we actually generate an economic recovery and trying to figure out the timing of when the right time is to actually start to tighten up on financial market conditions, history has shown that this is not easy to do, both in Japan in the 1990s or in the United States in the Great Depression.  In 1937, there was a premature tightening that pushed the economy right back down into recession.  So I think that's going to be really, really difficult because if you don't get that timing right, you know, that's when I would be worried that you could have a loss of confidence in the policy regime.  And that's when I would be more worried about the risk of, you know, a hard landing.

SALOMON:  I perhaps don't need to elaborate, but that last question was from Pete Peterson who for many years served as the chairman of this organization.  And he along with Les Gelb and Richard and others, I think, really deserves the plaudits for making this organization as strong and successful as it is.

So Pete, thank you for that.  (Applause.)  A very handsome portrait here.

Other questions?  Yes.

QUESTIONER:  I echo my thanks for your talk.  I'm Julia Coronado with Barclays Capital.  When the TALF details were released, there was an intriguing paragraph at the end that the Fed and the Treasury would seek legislative measures to help the Fed manage its balance sheet going forward.  Now, my own interpretation of that was that someday the Fed would like the ability to perhaps issue its own debt so that it could sterilize some of the balance sheet expansion once you determine that that's appropriate because not all of these facilities will be as flexible, the TALF in particular, as a three-year term.  So is that the right interpretation?  Or are you at liberty to say just as yet?

DUDLEY:  Well, I think that, you know, right now, the balance sheet on the asset side, we have all these assets that we've accumulated, and on the liability side we have a lot of excess reserves in the banking system.  And one could imagine a future point in time where the facilities hadn't shrunk sufficiently to eliminate the excess reserves, where we might actually want to tighten monetary policy.

Now, we think we have the tools in place today to accomplish that exit without any difficulty because we can pay interest in excess reserves, which we are doing.  And by raising the interest rate on excess reserves, we think we can raise the federal funds rate -- (inaudible).  So we don't think that there's a huge problem, but it's always nice to have a belt and suspenders.  And the suspenders in this case would be to have another independent mechanism to drain the excess reserves from the banking system should we want to have that ability to do so.

And there's really two ways we could do this.  One is we could have the Treasury issue bills and take the proceeds and put it on our balance sheet.  The problem with that, if course, is that if those bills are subject to the debt-limit ceiling then the Treasury might be constrained in their ability to do so in the size that we would like.  If those were exempted from the debt-limit ceiling, then we would not have that problem, and the Treasury could do, presumably could accomplish whatever the Fed needed to have accomplished in terms of the size of those transactions.

And the second approach would be to give the Federal Reserve its own authority to issue Fed bills presumably of very short maturity so the Federal Reserve could conduct it on its own.  But I think as long as the Fed has confidence that it will happen when the Fed wants it to happen, both of those courses are, you know, feasible.

I think the second course of Fed bills, you might argue, has a slight optical advantage because it really has more separation from the Treasury where the Fed is conducting its policy, it's issuing its bills, it's draining its banks reserves so it's not relying on the Treasury in any way.  So I think the second way may have a bit of an optical advantage.

But at the end of the day, this is the idea of just having another tool so that if it turns out you found out, which we don't think we will find out, but if you found out that draining the excess reserves was advisable because maybe it would give you a little bit better control over the federal funds rate, it would be nice to be able to have that ability to do so.

SALOMON:  Last question.

QUESTIONER:  Thank you.  Peter Gleysteen, CIFC.  The liquidity initiatives to date have primarily focused on real estate and the consumer.  But U.S. employers, corporations, mainly non-public ones, don't seem to have much focus yet, but yet the credit crunch is, of course, further destabilizing our economy.  Are there going to be incremental focus by the government to help U.S. corporations who, of course, provide employment and ultimately sustain real estate values?  Thank you.

DUDLEY:  Well, the TALF actually does address corporate America to a degree because it's going to be available to Small Business Administration loans.  Whether the Federal Reserve would go broader than that to larger corporations, we are doing that through the CPFF, commercial paper funding facilities, providing quite a bit of funding to corporate America.  That's one of, you know, the biggest borrowers.  You know, it's non-financial companies, financial companies and asset-backed commercial paper issuers.  So the CPFF is actually doing exactly what you've requested.

Now, could the Federal Reserve come up with additional programs that address the corporate sector?  Yes, it's possible.  We'd have to determine that the market is not functioning well and that we had an instrument that we could develop that would address the market's dysfunction in a way that would ease financial market conditions.  So I wouldn't rule it out categorically but, you know, we are already doing quite a bit for the public sector, frankly.

SALOMON:  Good.  I think that uses up our time.  I think I'm sure you will all share my appreciation for Bill for being with us this morning.  It was a very, very busy time in his life.  And also our gratitude that we have such a competent official dealing with these very complicated matters.

(Applause.)

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