Bloomberg Businessweek (Europe)
The Fed goes sniffing for bubbles
The central bank sends a warning to reckless lenders “They’re erring on the side of stimulus”
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.