The credit crisis is not over: the anatomy of a financial unravelling.

• Author: Malmgren, Harald B.

On September 18, 2007, the Federal Reserve reduced both its federal funds rate and discount rate by an unexpected fifty basis points. On the surface, the Fed got what it wanted: some temporary stability. However, the market adjustment has not been orderly--and the consequent unwinding of exposures is far from complete. On September 20, Fed Chairman Ben Bernanke told the U.S. Congress that the subprime meltdown had "triggered uncertainty about structured products more generally and reverberated in broader financial markets ... The turbulence originated in concerns about subprime mortgages, but the resulting global financial losses have far exceeded the most pessimistic estimates of the credit losses on these loans ... These wider losses ... reflect a significant increase in investor uncertainty centered on the difficulty of evaluating the risks for a wide range of structured securities products, which can be opaque or have complex payoffs."

Recognizing that the problems are global, in September U.S. Treasury Secretary Hank Paulson encouraged the G7 finance ministers to initiate a major review of the functioning of world financial markets. He also announced that a Presidential working group, led by him, but including the Chairman of the Federal Reserve and other top regulators, would begin a review of the basic principles on which the financial system operates.

The G7 finance ministers requested the Financial Stability Forum to examine four specific issues: (1) market and credit risk practices, including treatment of complex credit products and conduits; (2) accounting and valuation procedures for financial derivative instruments; (3) basic supervisory oversight principles for regulated financial entities, especially given exposures to off-balance sheet, contingent claims; and (4) the role of credit rating agencies in evaluating structured finance products. The multilateral FSF is made up of a huge assemblage of central bankers, finance ministry officials, regulators, and financial experts from many countries. It would be surprising if such a large group would be able to find consensus about what the problems really are and what to do about them--at least in the next year. Similarly, the U.S. Presidential working group will find it difficult to reconcile the diversity of opinions among regulators with differing jurisdictional responsibilities, and among Treasury officials and those of the U.S. central bank and its regional offshoots.

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It should be recognized that these international and domestic inquiries face two historic challenges: First, the regulatory and supervisory framework which had been developed over the last...