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Financial Markets: Settling but Cautious

Credit markets have settled a great deal since late summer, when it became starkly apparent that subprime mortgages were much riskier than had been previously thought. The value of a broad array of assets fell dramatically, as market participants reassessed the price they were willing to pay for risky assets more generally. Rates paid on credit default swaps - indicators of the market's appetite for risk - jumped sharply in August but have declined substantially in recent weeks, suggesting that markets have become more comfortable with taking on some risk.

Credit Default Swaps

Many of the subprime mortgages had been repackaged into new asset-backed securities called collateralized debt obligations (CDOs). The CDOs are essentially sliced into claims - called tranches - that are structured in such a way so as to have different levels of risk. Some of the "safer" tranches were financed through the issuance of asset-backed commercial paper. Unfortunately, even the safest slices of mortgage debt proved to be much riskier than originally thought. Spreads on commercial paper over safe Treasury issues of comparable maturities also jumped in August, as purchasers of commercial paper became reluctant to buy new paper as the old paper matured. Although the spreads may have declined, lenders remain cautious, and spreads have retraced some of their recent declines.

Commercial Paper Spread

It is widely accepted that although credit markets have settled relative to last summer, the economy is far from being out of the woods. The problem is that no one really knows what the appropriate value of assets is now or how deep the subprime mess extends into financial market institutions and beyond. Over the last two weeks, for example, several major financial firms surprised market participants by writing down the value of mortgage-backed assets by a much greater amount than had been anticipated. Market participants are dubious about whether the write-downs are sufficient.

Asset write-downs are charged against earnings. Thus, profits in the financial sector have taken quite a hit. The recent decline in the Financial Stock Price Index reflects the charge to profits. Moreover, it appears as though the market anticipated some of the tough sledding faced by financial institutions. While the broad S&P 500 Index has increased around 6 percent year-to-date, the Financial Stock Price Index has fallen - beginning its descent in the spring.

S&P 500

The big question facing policymakers is whether the effects of the subprime mess will spill over to the economy more generally. To the extent that the S&P is forward-looking, the absence of further declines in the broad composite stock index since August suggests that the worst may be behind us. Notwithstanding the recent increase in stock market volatility, the gains in equity prices overall suggest that the nonfinancial sector remains robust.

CBOE Market Volatility Index

Moreover, analysts predict that the operating profits of S&P 500 firms will grow at healthy rates over the next year or so. Operating earnings do not take into account special write-downs like those made by financial firms, so they tend to be higher than reported earnings.

S&P 500

Projections of operating earnings per share are "bottom-up" aggregates, meaning that they are share-weighted averages of analysts' predictions of individual firm earnings. As-reported earnings projections, on the other hand, are top-down predictions made by equity strategists. The divergence between the two estimates clearly indicates that the strategists anticipate further write-downs next year although "as reported" earnings are still projected to grow for the broad index. These projections suggest that the effects of financial turmoil are not spreading beyond the financial sector.

Policymakers are keenly aware that the financial market turmoil could be prolonged and are monitoring financial conditions carefully. If it appears as though financial conditions are worsening and beginning to clearly undermine the economic expansion, central banks can use monetary policy to offset the macroeconomic risk. However, as Federal Reserve Board Governor Frederick Mishkin said on Monday, central banks are "powerless" when it comes to "valuation risk."

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