Repair and recovery of the U.S. mortgage markets will be a gradual process that demands both market and regulatory discipline, Federal Reserve Governor Randall Kroszner said today. From the beginning of the process with consumers, the end of it with investors in mortgage-backed securities, he said two principles -- clarity and simplicity -- will be key. "Greater transparency and less complexity in credit instruments will help to promote broader scrutiny of credit risk," Kroszner said in prepared remarks to the Conference of State Bank Supervisors meeting in Amelia Island, Florida. The root of the current credit crisis was the layering and compounding of unrecognized and poorly managed risks at all levels of the mortgage market. Beginning in 2005, underwriting at the consumer level deteriorated in the originate-to-distribute model, in which mortgages are sold on in packages to investors. "Originators made loans that layered multiple sources of credit risk," Kroszner said. The risks included low documentation of borrower incomes, high combined loan-to-value ratios and non-traditional payment schedules that sometimes deferred both principal and interest. However, Kroszner expects the originate-to-distribute model, now in disgrace, to revive, "but, I hope in a much stronger form." That would mean consistent underwriting standards and credit packages for investors that are less complex and easier to evaluate. One step up from the consumer level, ratings agencies failed to understand or at least to make clear that investment-grade ratings on some mortgage-backed securities, particularly collateralized debt obligations (CDOs) backed by subprime or alt-A mortgage securities, carried greater risk than traditional investments with the same ratings. In the final step, many institutional investors, relying on those ratings, failed to recognize the risks accumulating across their firms with such investments, including the structured investment vehicles (SIVs) off their balance sheets. They failed to recognize the liquidity risk, as opposed to the default risk, and the potential "cliff effect" in which they were "vulnerable to extremely large losses in those rare events of widespread financial stress," Kroszner said. Across the board, regulators and financial firms are now working on the repair of those deficiencies with emphasis on simpler, more transparent securities and better risk management practices. That will take time.