FROM THE OFFICE OF PUBLIC AFFAIRS

My purpose today is to ask you to focus more attention and more thought – to do an even better job – promoting the transparency, depth and resilience of the interest rate volatility market. This is a challenge for all participants in the markets to price and transfer the risk of likely and unlikely outcomes for interest rates.

There is a stale debate about "whether derivatives are good or bad." There is the never-ending story in Washington about "who should regulate derivatives." I fear that these questions have diverted attention from the underlying subject matter. What is the volatility market? Is it healthy and robust? How will it and should it evolve over the coming years?

In the fourth quarter of last year, fixed-income markets experienced extraordinarily high levels of volatility. With the benefit of hindsight, this high volatility seems paradoxically to have been due, at least in part, to the resilience of our economy. Market participants came to realize, rather abruptly, that the economy was withstanding the slowdown in manufacturing, the rapid inventory adjustment, the bursting of the technology and energy bubbles, and the shock of 9-11.

At the same time, of course, the market had to adjust to the greater-than-anticipated near-term refinancing needs of the federal government, our suspension of the 30-year bond, and the exercise by millions of Americans of the options embedded in their mortgages to refinance at lower rates. While the markets adapted to this extraordinary set of events, we learned, once again, how dependent we are upon the volatility market to attenuate the transmission of shocks.

Those of us who believe, as I do, that an over-the-counter market in interest rate volatility is a vital part of our capital markets, may need to spend more time going back over the basics. To launch such a discussion, let me suggest two questions that have led me to question some of the assumptions on which my own perception of the volatility market are based.

First, do we understand the interaction of volatility risk and credit risk? And, second, looking at the structure of the volatility market, is it a "complete" market?

Credit matters and, in my opinion, it matters more now that it did a few years ago. We all can read the headlines and understand the truth of that statement, but I believe there is also more subtle, macroeconomic reason for the change. I think that the rise of credit concerns is a natural consequence of a transition from a world of volatile output and inflation expectations, which characterized the 1980s and early 1990s, to a world of more stable output and prices.

In the old environment, you made money in fixed-income markets by anticipating the rapid swings in real and nominal interest rates. The big macro-economic events were relatively more important than the particular circumstances of individual borrowers. In that environment, it was good enough for market participants to form a consensus on credit by using rough rules of thumb for spreads – both corporate and sovereign – as long as you could hang on for the ride as the underlying interest rates gyrated.

In a period of more stable output and prices, by definition, it becomes relatively less important to anticipate the changes in underlying rates and relatively more important to assess accurately the credit standing of individual borrowers. Even in the recent brief downturn and the recovery now underway, we have seen much less volatility in real output and prices than most observers expected. In this environment, we have all discovered that fixed-income markets are a little bit less about macro-economics and little bit more about micro-economics – about whether, behind the balance sheet and the corporate disclosures, the borrower has the real cash flow to meet its payment obligations in the event of either likely or unlikely outcomes.

Forgive me for this digression, but digging a little deeper, one reason output growth has been steadier and inflation more subdued and predictable is that the U.S. economy has enjoyed a remarkable step-up in growth of productivity in the past half decade. I believe that this improvement is owed in part to an intensification of the process of creative destruction. Simply put, our economy now punishes weaker performers more swiftly and rewards better performers more richly. The implications for credit risk, of course, are obvious.

The transition to this world where credit matters a-little-bit-more has been an expensive learning process for some. The habits of the 1980s and early 1990s, of tracking indexes and trading off rule-of-thumb spreads, have been hard to shed. To do so, we had all better be sure that we understand the interaction of volatility risk and credit risk. What if the periodic peaks that punctuate the volatility time line are a depiction of credit cycles or credit concerns? How should we be pricing volatility if that’s the case?

That leads me to my second question. Looking at the market’s structure, is the volatility market "complete", particularly with respect to price discovery? Now, let me confess that market structure may not be quite the right term but it does convey a "holistic" approach and my intent is to focus attention on the overall structure, dynamics and flow of the interest rate volatility market.

We should recognize that the volatility market, while increasingly important, is quite young. While the major instruments we rely upon have been around for 20 years or so, the market as we now know it is really only about 10 years old, and is continuing to develop.

The bond market, of course, has been around for a long time. But we should recognize that the interest rate volatility market has become a major market in its own right and, at least at present, it is not at times clear, as between the bond market and the volatility market, which is the tail and which is the dog – or even whether that’s the right metaphor for their relationship.

In looking at the overall structure of the volatility market, we need to address some important questions: Where is the demand for volatility coming from? Are the correct players pricing, trading, and eventually owning volatility? Is there a healthy price discovery process?

These questions are inter-related and I am not going to try to answer them definitively both because I do not have the answers and because I think that their resolution should be driven by you in the private sector. But I will identify some issues associated with just one of these questions - whether we are getting good price signals.

Two major players hold positions that require the rest of the market systematically to be short volatility. One is the federal government, and the other is the American homeowner, through the mortgage market.

The federal government absorbs volatility from the economy through its tax and expenditure policies. One way of thinking about this is to view the Treasury as holding a short volatility position. In effect, we pass this along to the markets, without the benefit of explicit pricing, through changes in our cash balances in the banking system and changes in our debt issuance.

We think that for a borrower of our size and long-term focus, our commitment to financing entirely through regular and predictable auctions of straight debt is more cost-effective, and more effectively promotes efficient capital markets, than attempting to arbitrage across different interest rate markets or retaining or separately pricing and transfering the variance in our refinancing needs.

We do not think we can better judge where and how to transfer the volatility in our refinancing needs between markets and across time – other than by trying our best to spread all of our financing needs across a curve of liquid instruments.

As a consequence, we pay for the uncertainty associated with our borrowing needs, the old fashioned way, in the yield on our debt. You all trade this volatility among yourselves very efficiently and that, undoubtedly, has an impact on the yields in our auctions. But we do not help provide a primary market for volatility. We leave price discovery entirely to the secondary market.

The American homeowner, through the mortgage market, is in a roughly similar position: a potential source of market volatility but not helping in the explicit pricing of that volatility. The normal thirty-year mortgage allows homeowners to refinance if interest rates move lower. This option is not explicitly priced but paid for implicitly in the mortgage interest payments. Homeowners could choose to forgo this option, and presumably pay lower interest rates, but apparently are quite content not to.

In the rational desire to put a ceiling on our most important monthly cash flows, we take out fixed-rate mortgages and pay for the option to refinance if rates move lower. While the price homeowners pay for the option can be extracted, it is not explicit or separately priced.

Do we have a healthy price discovery process? We do have an extraordinarily efficient secondary market for volatility. But we don’t have much of a primary market, do we?

Neither the homeowner nor the federal government is aiding in price discovery. Some corporate borrowers and some other sovereign borrowers engage in explicit pricing and sale of volatility risk. But they take their prices from the secondary markets that you trade, not the other way around. So, the price discovery process is certainly not ailing but the more I think about it, the more the market seems to me to be incomplete.

Do we have the right set of players, the right flow of volatility, and do we have enough capital? Again, I do not know but I doubt that the market structure we have now for this relatively young market is the one that we are likely to have 10 or 20 years from now.

I have only scratched the surface of the questions that I think we need to ask ourselves about the structure and the dynamics of the volatility market. But given the extreme events of last year, and of the preceding years, it seems to me that we all have been a little slow to question some of the assumptions on which our current understanding of the volatility market are based.

Going forward, we need to know whether there are sufficient investors, in aggregate, willing to commit the capital needed to bear the risk of holding the short-volatility position. We need to better understand all of the different ways that volatility risk and credit risk can interact. We need to work hard to promote an efficient volatility market place, one in which there are a sufficient number of sufficiently strong market participants to withstand the periodic shocks.

I do not have the answers to these questions, nor do I think it is the role of the federal government to provide the answers. But we all had better be working on them.

To begin this process, you need to focus more of your attention on the structure and the dynamics of the volatility market to be sure that it has the transparency, depth and resilience that are commensurate with the risks that you trade and hold.