The Federal Reserve sees the latest financial market turmoil as driven by two factors: a wave of rating downgrades of housing-related credits and increased fear over economic fundamentals. Above all is the outlook for the housing market.
Underlying this is the "information problem" that has plagued markets since the credit crisis began at the end of July. No one knows how large losses will be or how they will be distributed among financial entities.
Since mid-October the value of supposedly safe AAA-rated tranches of collateralised debt obligations with mortgage exposure has fallen sharply, driven by rating downgrades, worsening conditions in housing and further increases in mortgage delinquency rates.
Some renewed weakness in the markets was not surprising to policymakers, who were bemused by how bullish investors were in early October. But the extent of declines in higher-rated CDOs disappointed. Some officials hoped the market had already discounted the looming downgrades and further housing weakness.
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