Courtesy of woodleywonderworks, flickr.com

The views expressed below are those solely of the interviewee and do not, in any way, represent the views of the Federal Reserve Bank of Boston or the Federal Reserve System.

What will be the role of derivatives and complex financial instruments in the future? Looking at the current financial crisis, how is that going to change?

In my own personal view, derivatives and financial instruments will have a place in the financial system for the foreseeable future. It is very unlikely that we will have a tremendous revision in the way we think of financial architecture along those lines. But I also think that it is important to distinguish two types of derivatives: ones that are fairly straightforward, transparent, and simple to understand versus those derivatives that are complex and that inhibit transparency. In the future, firms are going to be a lot more reticent to sign derivative contracts that are very complex. But I don’t think we’re going to see a wholesale abandonment of financial derivatives by any stretch of the imagination.

One point that I’ve tried to make clear in the work that I’m doing now is that people often confuse complex financial derivatives with securitization in general. For example, a lot of people think that the typical mortgage-backed security – which is a pool of individual mortgages collected into a single security – often had very complex features in them. Sometimes the security was complex, but there were a lot of smart people at financial institutions who could understand what was going on in that security.

Where you really got into trouble was when you created securities out of securities out of securities. You often didn’t quite understand the correlation properties of everything you were putting into a particular “collateralized debt obligation’’ (CDO) or CDO-squared. People included debt instruments that they thought were uncorrelated, but these instruments turned out to be much more closely correlated than they originally thought. So, for example, when the housing market began to suffer, you saw a lot of pieces of individual CDOs or CDO-squared go bad, all at the same time. This was not what people expected.

So, summing up, regulators and financial firms are going to rethink a lot of things they have done over the past decade or so. Everybody agrees with that. But I think that derivatives in general have a place in the financial system, though the derivatives we see in the future may be less complex.

If there is a need for a reform in global financial architecture, how best do we go about achieving it?

When you talk about reform of the current financial system, you can talk about many different things. You can talk about how transparent banks or other institutions are. You can talk about the complexity of the contracts or the instruments that they sign. You can talk about reforms of the way that people in the United States purchase homes, or the types of people who are able to get mortgage loans. There is going to be a lot of reform; however I think it is hard to say how that reform is going to take place. The overarching principle of reform should be, for lack of a better analogy, not to throw the baby out with the bath water—not to go so far that we inhibit a lot of trades from occurring that seek to spread risk in an optimal way, or that allow people with damaged credit to purchase a home.

One thing that is of particular concern to me is whether we are going to blame the entire crisis on subprime mortgages. While there were a lot of problems with subprime mortgages, I personally believe there is a place for the subprime market in the US mortgage industry. Subprime mortgages are often quite useful for people. However, we need to understand how sensitive subprime mortgages are to declines in house prices, and we need to structure and price subprime mortgages in an appropriate way.

Shifting to a global focus, for the economic crisis in general, are there reforms that need to happen, what kind of international cooperation is needed, and what would be the best forum for that?

The international atmosphere is an important aspect of this crisis. We’ve known for years that there have been imbalances in the international economy. A few years ago, the Boston Fed sponsored a conference on global imbalances, where we analyzed what it meant for the United States to run large current account deficits while countries like China were running large surpluses. The major question at this conference was how those imbalances were going to be unwound. Conference participants were overwhelmingly concerned that the United States would find itself in a position that other debtor countries have faced in the past. Specifically, these countries found that the willingness of international investors to hold assets denominated in the domestic currency—dollars in our case—suddenly stopped. The subsequent capital outflow or sudden stop was the garden-variety thing that most people were worried about then.

That’s not the way this particular crisis has played out. If anything, as uncertainty in the global economy has increased, international investment has not flowed away from the United States. Rather, dollar-denominated assets have been perceived as less risky and have therefore become relatively more attractive, so the dollar has been boosted by a “flight to quality.” But that doesn’t mean that the imbalances haven’t had somewhat of an effect. Specifically, the level of consumption in the United States has really declined precipitously in the last several months. It is almost as if consumption in the United States, which was high and contributed to our current account deficits, suddenly reversed – that there was a dramatic U-turn in the path of U.S. consumption. This was an underlying concern in previous years—the idea that US consumption levels were unsustainable and they would have to fall dramatically. Previously, I think people worried that consumption would have to fall because foreigners were going to be less willing to subsidize imports, so there was going to consumption declines of the type seen in countries that have gone through previous crises. But now you are seeing consumption declining because the pillars that have previously underpinned American consumption have been compromised: the labor market has declined; home prices have declined; uncertainty has gone up.