Transcript of a Press Conference on the Global Financial Stability Report (GFSR) Update by Jaime Caruana, Counsellor and Director of the IMF's Monetary and Capital Markets Department, with Jan Brockmeijer, Deputy Director, and Laura Kodres and Peter Dattels, Division Chiefs in the Monetary and Capital Markets Department

July 28, 2008

With Jan Brockmeijer, Deputy Director, and Laura Kodres and Peter Dattels, Division Chiefs in the Monetary and Capital Markets Department
July 28, 2008, Washington, DC
Webcast of the press briefing

MR. MURRAY: Good day. I'm William Murray, Chief of Media Relations at the International Monetary Fund. This is the Global Financial Stability Report Update press briefing. Joining us today is Jaime Caruana, Counsellor and Director of the Monetary and Capital Markets Department; Jaime's Deputy, Jan Willem Brockmeijer, and colleagues of theirs in the Monetary and Capital Markets Department: Peter Dattels, Chief, Global Market Monitoring and Analysis Division, and Laura Kodres, Chief, Global Financial Stability Division. Jamie will have some brief opening remarks and then we'll take your questions.

MR. CARUANA: Thank you very much, Bill. Thank all of you for attending our GFSR quarterly Update. I would like to focus my remarks on our assessment of the evolution of financial risks since our Spring GFSR, and also to provide some comments on policies. But, first of all, let me introduce you to Jan Brockmeijer, who joined the department a couple of months ago. He comes from the Dutch Central Bank and has a long experience on macro prudential work at the European level. He was heading this group at the ECB.

Let me come back to the Update. Over the last several months, financial markets have made significant adjustments and policymakers have taken a considerable number of measures. Nonetheless, global financial markets remain fragile and indicators of systemic risks remain elevated. The downside risks that we have discussed previously and outlined in the April GFSR appear to be materializing, leading to a negative feedback loop between the financial system and the broader economy.

As it was discussed in the WEO Update, also the inflationary pressures complicate this kind of interaction between the real economy and the financial system. As economies slow, credit deterioration is widening and deepening and as banks deleverage and rebuild capital, lending is beginning to be squeezed, restricting household spending and clouding the outlook for the real economy. The housing market is at the center of this interaction, so stemming the decline in the U.S. housing market would remove a key component of the feedback loop as it would both help households and financial institutions recover.

At the moment however with delinquencies and foreclosures raising rapidly and house prices continuing to fall, a bottom for the housing market in the United States is not yet visible and the credit deterioration is spreading to even prime mortgage loans. Housing prices are also softening in a number of European economies, prompting concerns over future loan losses in the mortgage, construction, and commercial property sectors in those countries.

On the positive side, despite banks' write-downs now exceeding $400 billion in aggregate, banks have generally been successful in raising capital and balance sheets of the banks are adjusting. In fact, the equity raised covers upwards of three-fourths of the write-downs to date . Regarding the estimate of total mark-to-market losses that we published in our April GFSR, market prices of asset-backed securities and the ongoing delinquency experience give us little reason to change these estimates, so we have not revised the estimates on this occasion.

Coming back to the adjustment process, we think that this process of adjustment by financial institutions is necessary and must continue, even if it is expensive and difficult. Moreover, as economic growth slows, banks will face continued headwinds in maintaining earnings due to falling credit quality, declining income, high funding costs, and exposures to monoline and mortgage insurance. Consequently, as we have seen, bank share prices have fallen sharply and measures of credit default risks have also risen.

Adding to systemic concern was the uncertainty about potential losses and capital needs of the Government Sponsored Enterprises (GSEs) Freddie Mac and Fannie Mae. In light of the wide-ranging systemic consequences both in the United States and abroad that could have arisen if confidence in GSE debt had seriously come into question, the U.S. Congress passed legislation to support the agencies and to create an independent regulator. We think that the policy challenge is now to find a clear and permanent solution to the GSEs' business model and oversight while continuing to support mortgage markets.

Coming back to the interaction of the real economy and the financial markets with continuing pressures on financial institutions to deleverage, assets are being sold, lending conditions are being tightened, and their capacity to provide credit might slow further. One positive development however has been the continued resilience of the investment-grade bond issuance indicating healthy corporates still have access to needed funds. At the same time, however, the scope for monetary policy to be supportive of financial stability appears to be more constrained than before amid high and volatile commodity prices that have raised inflationary risks.

Emerging markets, as we all know, have remained resilient to the credit turmoil. However, the financial crisis and the inflation threat are starting to present a more serious test to this resilience. Some emerging markets are coming under increasing investor scrutiny, especially those with large external imbalances and inflation risks.

Inflation and the needed policy reaction represent an important challenge for emerging and developing economies. Headline inflation is running ahead of inflation targets in many countries and real policy rates have fallen into negative territory despite some nominal tightening in many cases.

We think that it is important to recognize the complexity in dealing with this inflationary pressure especially set against the slowing global economy and the need also to respond on different fronts. But we also think that it is important to ensure that the benefits achieved over years of good macroeconomic policies are not put at risk. If inflationary expectations become entrenched, not only might sharper tightening of monetary policy conditions be necessary, but financial markets and flows may also be sensitive to situations in which policies are perceived to be behind the curve.

Let me conclude with some comments on policies in mature markets. Until now the extraordinary steps taken by central banks to extend the range of collateral, the maturity, and number of counterparties have succeeded in capping systemic risks. However, in the context of the deleveraging process and uncertainty about asset valuations, credit risks remain elevated indicating that further rising of capital may be needed in a number of financial institutions. In this phase of the crisis, the nature of the resolution strategies and the extent of government support have come into sharper focus. Financial market disruptions will still need to be dealt with on a case-by-case basis and there is no iron-clad rulebook as to how to handle such instances in today's more global environment. Prompt and transparent government responses however will go a long way to relieving the uncertainties.

Finally, on the medium- and long-term policies and reforms that are needed as set forth by the IMFC and the Financial Stability Forum, progress has been made and continues to be made by the relevant institutions and fora. I thank you very much for your attention, and we will be happy to take your questions now.

QUESTIONER: I just wanted one quick point of clarification. The loss that you were talking about that you haven't adjusted is the $1 trillion one. The question I had is: You said that there would need to be a permanent solution to the regulation of Fannie and Freddie. Do you have any idea what kind of form you would recommend that takes, and what was inadequate about the previous regulatory framework?

MR. CARUANA: Yes, the figure that I was referring to in terms of losses was the calculation that we presented in our April GFSR of nearly $1 trillion in losses. We think that this figure is probably right and we have not changed it. I will ask Pete if he wants to add a little bit on what are the different elements because the total figure has not changed. Some of the items may have changed a little bit, but basically we think these figures continue to be appropriate.

In terms of the GSEs, these institutions and the risks that they were presenting to the economy have been discussed for a long time, so we hope that this will be a good opportunity to address these fragilities that were present in the institutions. And again, this has been discussed for a long time. The access of these institutions to the funding markets in favorable conditions has allowed them to grow rapidly. The fact that there was a perceived implicit guarantee by markets has reduced the capacity of the markets to provide market discipline for these institutions. I think there are a number of elements that are important that have to be revised. The capital base of the institutions is lower than in other institutions, such as banks. So, the analysis of the capital that these institutions will require should include a review of their business model, the oversight structure and regulatory framework. I think these are very important elements that will need to be discussed. Certainly, the fact that now there will be an independent regulator with more capacity will be a key element to move forward in these reforms. Perhaps, Pete, I don't know if you want to add a little bit on the losses.

MR. DATTELS: In terms of the losses, you may recall that about $720 billion of the $945 billion in losses was based on mark-to-market valuations of securities and since we did the report there has been some further deterioration in residential mortgage-related securities, which would act to increase the number, but that has been offset by some improvement in commercial mortgage-backed securities. So, overall in terms of the mark-to-market portion, those numbers remain, the $720 billion is broadly unchanged.

We'll be taking a look at the loan categories more closely in the upcoming GFSR, and in particular we'll be examining the default cycles related to the loan categories. And in that context of course much will depend on the depth of the housing market correction, which is not yet over. So we'll take a look at the various scenarios and revisit the numbers at that time. But at this point, as Jaime said, the number looks fine.

MR. MURRAY: Thanks, Pete. The full GFSR will be released in early October for planning purposes. Are there any other questions from here in the room?

QUESTIONER: I guess the perception is that most of the turmoil or the problems in the financial sector have been focused on institutions in the United States, investment banks and the big banks, while Europe, maybe it's just a perception, seems to have been less affected. Is it the fact that European banks don't have to disclose as much? Is it accounting? What can you say about that?

MR. CARUANA: I think Jan will take this question.

MR. BROCKMEIJER: First of all you have to realize that the center of the crisis did occur here in the United States and that the U.S. housing market of course is the central force of events. So from that perspective one would expect the impact to be most heavily felt in the United States in the first instance.

With regard to Europe, I think the European banks have disclosed their 2007 figures and that gives a pretty clear view of the state of affairs. It is indeed so that their disclosures are less rapid than here in the United States, so information on 2008 is more patchy, it's less clear to make categorical judgment on that. But, certainly, as the crisis is unfolding and becoming broader and affecting more categories, the impact will be felt more elsewhere and also in Europe, I'm sure.

MR. MURRAY: I have a question from the Media Briefing Center from Reuters. It's regarding your opening remarks, Jaime. It asks: Can you explain what you mean when you say that "a bottom to the housing market is not visible, however recent developments in affordability may provide support for house prices to stabilize"?

MR. CARUANA: It says exactly that--it is difficult to find at this very moment the bottom, that some indicators continue go south in the sense that the prices continue to go down. There has been some mixed data in terms of sales of new houses, which was a little bit better than expected but not in existing houses. So the indicators still are not clearly pointing to a bottom, but the fact that prices have gone down are facilitating to some extent, the affordability ratios. Lower prices mean affordability for households is better than it used to be, and that is one of the elements that at some point of time could lend some support in the financial markets to stabilize this housing market. And as Jan was saying, we consider that this market is still at the center of this turmoil and some of the valuations that we have been talking about still depend on where this housing market finds its bottom. So we continue to pay attention to this market.

QUESTIONER: I have two questions. First, I would like to know if you see widespread loan deterioration in the U.S. as the main risk for the global markets right now. Then, regarding the increased risk in emerging markets, you referred to Asia as the main focus. I wonder if you could talk about Latin America and how bad or how the risk is increasing in the region. Thank you.

MR. CARUANA: The main risk that we are seeing is this interaction that we were describing of the financial markets and the cycle. We tend to think that a good part of the adjustment coming from the subprime was already happening or had already happened, if you take into account just the subprime. But now it is the cycle that was influencing financial markets. And it is a loop because financial markets then have less capacity to provide credit to the economy and this is the cycle that we were considering. So it is more the macro risks that now are playing a role in financial markets and then the feedback into the markets. One of the features of this slowing in the economy affecting markets is that now the assets are not only concentrated on the subprime, are more widely affected. In fact, the economy is more widely affected in terms of asset classes and it is more widely affected also in terms of regions, it is more widely affected the terms of various financial markets. That's the first part of the question.

On emerging markets, what we are seeing is that they have been very resilient for good reasons. They have had good policies and the fundamentals there have been improving. On the one hand, though, there has been tighter financial conditions for a period of time, a significant period of time. For a number of months we have seen this crisis developing and financial markets have been tightening financial conditions. That's a little bit of a tougher environment for emerging markets, and now it is the inflationary pressures that they are suffering from. Many of the emerging and developing markets are growing healthily and the inflationary pressures are more acute in these markets, and therefore we were addressing the issue that it is very important that the benefits that they have been acheived over years because of good policies is maintained, and that their reaction to these inflationary pressures and to this new situation and trade-off of growth and inflation is properly addressed. This is important not only because if they don't do it promptly, they will have to do it later and perhaps more intensely, but also because financial markets are going to discriminate among those countries that do not take the measures properly.

There is a differentiation. It depends on different countries. But I would say that in Latin America some of the major countries have been taking some of these monetary policy measures, they have been raising rates, but still they will have to be vigilant to the inflationary risks.

MS. KODRES: I'd like to note that in our upcoming GFSR we will be looking more closely with spillovers to emerging markets focusing primarily on equity markets. And the issue there is to look to see whether the domestic improvements that have been taking place over the last decade or so in terms of better infrastructure and more institutional investors in domestic markets, such as pension funds and mutual funds, have stabilized equity markets in some of these countries versus the external factors, such as liquidity arising from mature markets and the risk appetite of mature market investors. So we will be taking a very close look at the relative influence of these different factors in our upcoming GFSR--so stay tuned.

QUESTIONER: Mr. Caruana, any recipe or any suggestion for the central banks facing this crisis, the European Central Bank and the Fed?

MR. CARUANA: I think the difference between the trade-offs and economic situations that are facing mature markets, such as the ones you mentioned, and the emerging markets is that mature economies are facing some clear slowdown in the future. What we expect is that this slowdown in the future will facilitate the decision taking of these institutions in terms of less pressure on inflation. However, in both cases I think it is very important that central banks continue to be vigilant to the inflationary pressures in these mature economies.

MR. MURRAY: There's a question coming in the Media briefing Center. It's about the Spanish housing sector, but I'll generalize it to make it trends in European housing: The deterioration in the housing sector in Spain and elsewhere in Europe is large and fast. Are you concerned, and what could be the impact of this deterioration in the housing sector on the euro zone?

MR. CARUANA: There are a number of countries where we have started to see some softening or falling in prices of housing. The impact is twofold. On the one hand, the impact on the economy depends on each country, so I would not like to generalize because countries are different. But it will have an impact on the economy and it will have also an impact on the financial system that will have to face all the loans. It will depend on each case and it will depend on how rapid has been credit growth and what is the situation of the financial markets. I have been asked this question many times in relation to Spain and I always say that, yes, the first impact in the Spanish case will be in the economy and it will be an important adjustment coming from the housing and construction sectors, and banks will face difficulties and headwinds coming from this slowing of prices. However, I tend to think that the financial system in Spain is able to cope with that and is properly capitalized in a general sense, in a broad sense.

MR. MURRAY: I think that is it for questions. I appreciate you coming. Again, 11:00 a.m. Washington time, 1500 GMT embargo expiration. If you have any follow-up questions before the embargo expires, send an email to and we'll follow-up for you to get clarification.

Again I'd like to thank everybody for joining us today.


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