Fed’s Sack Says Financial System Needs Leverage

March 27 (Bloomberg) -- Brian Sack, head of the markets group at the New York Fed, said the financial system can’t operate well without leverage and signaled that he supports the return of a “properly” structured securitization market.

“Securitization is a powerful vehicle that should play an important role in the intermediation of credit in the economy,” Sack said in a speech delivered by video conference from New York to an audience in Sydney. “We should also understand that a reduction in leverage to near zero in the financial system is not desirable.”

Sack’s comments come as U.S. lawmakers revamp regulation to prevent a recurrence of the financial crisis, which began with the collapse of the U.S. subprime-lending market in 2007 and led to about $1.76 trillion in losses and writedowns by banks and other financial institutions worldwide. Fed Governor Kevin Warsh, speaking yesterday in New York, said the securitization market will ultimately come back.

“To be sure, the expansion of securitized credit was much too extensive and its subsequent collapse was terribly disruptive, contributing significantly to the damage to the economy,” said Sack, 39, a former Fed economist and section head who returned to the central bank system last year.

“Those developments do not mean that securitized credit, if structured properly, should not return in size,” he said during the speech at the ACI 2010 World Congress. Derivatives are also “integral” to the functioning of financial markets, allowing risks to be redistributed, Sack said.

‘Operate Efficiently’

“The financial system cannot operate efficiently without leverage,” he said.

“Of course, much of the turmoil we witnessed across financial markets was due to the build-up of excessive leverage in the system, and we cannot miss the chance to learn from this painful lesson,” Sack said. Even so, the focus now should be in part “on how to make the use of leverage less pro-cyclical.”

Since December 2008, the Federal Open Market Committee has held the federal funds rate target for overnight loans between banks in a range of zero to 0.25 percent. Policy makers have also created unprecedented emergency programs to revive credit.

The FOMC in its public comments has “retained its flexibility” to extend the programs, Sack said in response to an audience question.

“It has not clarified under what conditions it would do so and presumably those conditions would depend on the behavior of long-term interest rates and on economic conditions more broadly,” he said. “I don’t think anything has been taken off the table.”