RISMEDIA, March 27, 2007-(MarketWatch)-There is no evidence that problems being experienced in the subprime mortgage sector are spilling over into other credit markets, said Timothy Geithner, the president of the New York Federal Reserve on Friday.
In typical cautious Fed fashion, Geithner said that the full implications of the meltdown in the subprime mortgage sector are not understood and the impact must still be assessed.
"As of now, though, there are few signs that the disruptions in this one sector of the credit markets will have a lasting impact on credit markets as a whole," Geithner said in a speech prepared for delivery to a conference on credit markets hosted by the Richmond Fed.
The subprime mortgage market imploded in recent months, leaving behind cash-strapped borrowers and catering the profits of lenders. Geithner's comments came a day after the Fed's director of its banking supervision and regulation division told lawmakers that traditional mortgages and the U.S. banking system are safe, so far, from spillover effects of the subprime problems.
Geithner said that the worry over subprime mortgages is similar to concerns in earlier periods of rapid change in financial markets.
"Economic theory and recent practical experience offer some reassurance against both these specific concerns and more general worries about the implications of credit market innovations for the performance of the financial system," Geithner said.
Geithner said that he did not believe that credit market innovation would make markets more volatile and the financial system more vulnerable. But he said there are some aspects of the latest wave of innovation that deserve attention.
In the past, most credit risks were in the form of loans held on bank balance sheets. Now, credit risk takes an "incredibly diverse array of different forms" and much of it is held by nonbank financial institutions.
"This does not make the system less stable, though, only different," he said.
Another worry is the complexity of the new credit instruments.
"Even the most sophisticated participants in the markets for these instruments find the risk management challenges associated with these instruments daunting," Geithner said.
A third issue is worry over the dynamics of a potential failure and the infrastructure that supports the market for over-the-counter derivatives.
"The sheer number of financial contracts that would have to be unraveled in the context of a default, the challenge that a former colleague of mine likes to refer to as 'unscrambling the eggs' could exacerbate and prolong uncertainty, and complicate the process of resolution," Geithner said.
These difficulties "help illustrate why these broad changes in financial markets may have contributed to a system where the probability of a major crisis seems likely to be lower, but the losses associated with such a crisis may be greater or harder to mitigate," Geithner said.
Facing this challenge, the Fed and other regulators "cannot turn back the clock on innovation," he said.
"The most productive focus of policy attention has to be on improving the shock absorbers in the core of the financial system, in terms of capital and liquidity relative to risk and the robustness of the infrastructure," he said.
Greg Robb is a senior reporter for MarketWatch in Washington.