The Fed goes sniff­ing for bub­bles

The cen­tral bank sends a warn­ing to reck­less lenders “They’re erring on the side of stim­u­lus”

Bloomberg Businessweek (Asia) - - Contents - −Christopher Con­don and Jeanna Smi­alek

The Dec. 18 mes­sage from the Fed­eral Re­serve and two other gov­ern­ment agen­cies seemed in­nocu­ous enough. Posted on the Fed’s web­site, it “re­minded” fi­nan­cial in­sti­tu­tions about “ex­ist­ing reg­u­la­tory guidance on pru­dent risk man­age­ment prac­tices for com­mer­cial real es­tate lend­ing.”

That joint state­ment from the Fed, the Fed­eral De­posit In­sur­ance Corp., and the Of­fice of the Comptroller of the Cur­rency (OCC), how­ever, was an im­por­tant warn­ing to banks across the U.S.: The com­mer­cial property mar­ket is heat­ing up in cities from Bos­ton to Dal­las to Seat­tle. As a re­sult, fed­eral reg­u­la­tors are on high alert for slack lend­ing stan­dards and un­healthy con­cen­tra­tions of loans in the in­dus­try.

Broad­cast­ing timely re­minders of risk is one of many reg­u­la­tory ap­proaches that fall un­der what’s called macro­pru­den­tial pol­icy. If the Fed uses it cor­rectly, it can steer lenders away from dan­ger zones with­out re­sort­ing to in­ter­est rate hikes. Tra­di­tional “pru­den­tial” reg­u­la­tion en­sures the safety of in­di­vid­ual banks. But types of loans that are safe when made by a sin­gle bank be­come dan­ger­ous when thou­sands of banks make them at the same time. That’s where macro­pru­den­tial su­per­vi­sion is sup­posed to kick in.

The suc­cess­ful ap­pli­ca­tion of macro­pru­den­tial pol­icy could win lat­i­tude for Fed doves, who are in­clined to move grad­u­ally on ad­di­tional in­ter­est rate in­creases in the wake of the cen­tral bank’s first hike in al­most a decade, on Dec. 16. Con­tain­ing po­ten­tial bub­bles might keep of­fi­cials from hav­ing to raise rates quickly. That in turn would give the econ­omy time to build enough mo­men­tum to drive up in­fla­tion to­ward the Fed’s 2 per­cent tar­get.

Haunted by the col­lapse of the sub­prime mort­gage mar­ket, yet keen to keep mon­e­tary pol­icy loose to boost growth and in­fla­tion, Fed of­fi­cials are ap­ply­ing reg­u­la­tory pres­sures ear­lier, more pre­cisely, and more ag­gres­sively to stamp out nascent bub­bles. “They’re erring on the side of stim­u­lus, so there’s al­ways a risk to fi­nan­cial sta­bil­ity,” says An­gel Ubide, a se­nior fel­low at the Peter­son In­sti­tute for In­ter­na­tional Eco­nomics in Wash­ing­ton. So it makes sense to bal­ance dovish mon­e­tary pol­icy with ag­gres­sive reg­u­la­tion. “The Fed is clearly more sen­si­tive than they were in the past,” says Mark Ma­son, chief ex­ec­u­tive of­fi­cer at HomeStreet Bank, a Seat­tle-based re­gional lender. “They were re­ac­tive last time, and they need to be pre­emp­tive.”

In a war-game-like ex­er­cise in June that in­cluded staff from Wash­ing­ton and re­gional Fed banks, or­ga­niz­ers at the Bos­ton Fed pre­sented a fi­nan­cial cri­sis sce­nario and asked of­fi­cials how they might best re­spond us­ing macro­pru­den­tial tools. Par­tic­i­pants pre­ferred to ad­dress prob­lem ar­eas first with su­per­vi­sory guidance and “moral sua­sion,” much as the Fed did on Dec. 18. Man­dat­ing big­ger cap­i­tal buf­fers and higher liq­uid­ity re­quire­ments were also pro­posed in the ex­er­cise.

Be­fore the 2007-08 fi­nan­cial cri­sis, the Fed un­der for­mer Chair­man Alan Greenspan took a more hands-off ap­proach to reg­u­la­tion. Greenspan be­lieved lenders would limit risk out of self-in­ter­est. In 2008, how­ever, he ad­mit­ted “shocked dis­be­lief” over the fail­ure of that ap­proach af­ter the sub­prime mort­gage mar­ket col­lapsed. Nor was Greenspan a fan of de­flat­ing bub­bles by rais­ing rates, pre­fer­ring in­stead to let them burst and ad­dress the dam­age by cut­ting rates, a strat­egy that worked well with the dot-com bust of the early 2000s but dis­as­trously a few years later, when huge in­vest­ment banks reached the brink of bank­ruptcy.

It’s pos­si­ble the Fed is set­ting it­self up for fail­ure. Bub­bles are hard to iden­tify un­til they burst, and mea­sures meant to head them off of­ten are in­ef­fec­tive or come too late. The U.S. reg­u­la­tory land­scape is frag­mented among a num­ber of agen­cies that may need to co­op­er­ate quickly to be ef­fec­tive. “In the­ory, macro­pru­den­tial pol­icy is a very good thing,” says David Laf­ferty, chief mar­ket strate­gist at Natixis Global As­set Man­age­ment. But he adds that “it’s very hard to im­ple­ment and get it right, other than sim­ply be­ing re­ac­tionary to what hap­pened in the last cri­sis.” Fed Vice Chair­man Stan­ley Fis­cher, who heads the bank’s com­mit­tee on fi­nan­cial sta­bil­ity, aired his own reser­va­tions in a June speech. “It is not clear that there are suf­fi­ciently strong macro­pru­den­tial tools to deal with all fi­nan­cial in­sta­bil­ity prob­lems, and it would make sense not to rule out the use of the in­ter­est rate for this pur­pose,” he said.

It’s too early to tell whether the Dec. 18 state­ment will be enough to cur­tail the trends that worry the Fed. From 2011 to 2015, loans for mul­ti­fam­ily devel­op­ments from banks in­creased 45 per­cent and made up 17 per­cent of all com­mer­cial real es­tate loans held by fi­nan­cial in­sti­tu­tions, ac­cord­ing to the state­ment. As prices for mul­ti­fam­ily prop­er­ties rose, cap­i­tal­iza­tion rates— the ex­pected re­turn on real es­tate com­pared with its mar­ket value—fell to record lows, the reg­u­la­tors noted. Separately, Bos­ton Fed Pres­i­dent Eric Rosen­gren in a Nov. 9 speech cast doubt on the sus­tain­abil­ity of prices in com­mer­cial real es­tate, “which have grown quite rapidly, de­spite only mod­est growth in real GDP over the re­cov­ery.”

Fed of­fi­cials might be look­ing for the same type of im­pact that the cen­tral bank made in the mar­ket for lever­aged loans. Such loans are ex­tended to al­ready heav­ily in­debted com­pa­nies. In March 2013 the Fed, the FDIC, and the OCC re­sponded to a then-rapid in­crease in lever­aged fi­nance. They up­dated guidance and eval­u­ated lenders’ risk man­age­ment, un­der­writ­ing, and val­u­a­tion stan­dards. This scru­tiny was fol­lowed by a slump in the mar­ket for loans to be­low-in­vest­ment-grade com­pa­nies as banks shunned deals that didn’t meet the Fed’s guide­lines.

“The reg­u­la­tory en­vi­ron­ment postcri­sis has been a lot bet­ter geared to­ward get­ting ahead of a lot of the in­sta­bil­ity,” says Gen­nadiy Gold­berg, U.S. strate­gist at TD Se­cu­ri­ties. Still, he adds, the Fed is keep­ing its in­ter­est rate ham­mer at the ready.

The bot­tom line Doves in­side the Fed are hop­ing a va­ri­ety of reg­u­la­tory moves will de­flate bub­bles be­fore they burst.

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