I appreciate the opportunity to comment on these three papers. They illuminate the sources and effects of the current financial market turmoil, and I learned a considerable amount from reading them and thinking about their implications. Instead of providing detailed comments on each paper, I would like to draw out the relationships among them and, in the process, comment a little on the papers and their implications. To foreshadow: I will be highlighting the role of leverage—in the household sector and in financial intermediaries—as a critical factor in understanding the buildup of excesses and their unwinding.

At the beginning of the chain of causation is the housing cycle in the United States. Karl Case points out the difference between this housing cycle and others over past decades and asks why the difference developed. One culprit he identifies is changes in the financial system that affected the way that mortgage credit is made available to borrowers. A key element of these changes, and one that accounts for a good part of the subsequent effects on the financial system and the economy, is the rise in leverage in housing finance. For several years mortgage indebtedness rose substantially relative to the value of owner-occupied housing. The willingness of lenders to tolerate—or, in some cases, encourage—huge increases in loan-to-value ratios added to the demand for housing, especially by people who normally might not have had the savings to enter the market, and contributed to the rise in home prices.

One reason for the loosening of standards was the expectation that home prices would continue to rise—and even more certainly that they [End Page 262] could not fall in all regions at the same time, supporting diversification through securitization. Rising prices would enable lenders to recoup their funds even if the borrower was unable to service the loan, mostly because the borrower would be able to obtain extra cash through refinancing. Expectations of home price appreciation facilitated and interacted with the increasing complexity of mortgage securities, including multiple securitizations of the same loan, which made it virtually impossible for ultimate lenders to monitor the creditworthiness of borrowers—a task they, in effect, had outsourced to credit rating agencies. The absence of investor caution and due diligence was especially noticeable for the highest-rated tranches of securitized debt.

Elevated leverage in housing markets has meant that as prices have fallen, lenders have had to absorb an unusually high proportion of the losses. As Case points out, foreclosures by lenders have added to the downward pressure on those prices. Conceptually, such price declines moving down the demand curve for housing services could accelerate and cushion the adjustment in activity necessitated by previous overbuilding.

The heavy involvement of financial intermediaries in amplifying the housing boom and the subsequent economic effects of the bust brings me to the paper by Stephen Morris and Hyun Song Shin, which raises a host of important issues related to the systemic aspects of financial intermediation and the lessons from the recent turmoil. As they emphasize, one of the important lessons has been the greater-than-expected vulnerability of secured financing when intermediaries are engaged in maturity, credit, and liquidity transformation. Recall that the turmoil first came onto the balance sheets of the banks through the collapse of the asset-backed commercial paper market in the fall of 2007, before it affected the funding of investment banks through the triparty repurchase agreement market. The new vulnerability results importantly from the extension of secured short-term financing to increasingly illiquid and riskier long-term assets. As the liquidity and creditworthiness of those assets—especially related to mortgage-backed securities—were called into question, lenders became more concerned about the possibility that they might end up owning the underlying assets, and they raised haircuts or simply refused to roll over loans.

Clearly, as Morris and Shin point out, what we have learned about various risks implies the need for intermediaries to build greater liquidity and capital buffers in good times, as well as to improve their abilities to manage their risks. And those larger buffers would help to offset the moral hazard...