Bernanke normally adopts a measured tone and, as befits someone whose words can move markets, takes great care not to dwell too heavily on bad news. So it was suprising to see him issue a fairly pointed statement on risks to the banking system.
His remarks on the perils of private equity loans, when taken in combination with a speech made by New York Fed president Timothy Geithner, the most candid Fed spokesman, make clear that the Fed is worried. And it should be. One LBO borrower, Steve Rattner of the Quadrangle Group, has already warned of lax lending and a coming debt crisis. The numbers themselves, as reported in the Wall Street Journal, tell of a frenzied market:
LBO loan volume hit $121 billion last year, compared with $31 billion in 1998, the peak of the previous cycle, according to Standard & Poor’s Leveraged Commentary & Data. Volume this year has reached $88 billion, more than double the year-earlier period. Meanwhile, interest-rate spreads have fallen to their lowest levels ever, and loan restrictions have been loosened.
In the old days, this public message would have been accompanied by private jawboning, but that strategy appears to have fallen out of favor in the Greenspan era. It’s a pity, because that approach was used effectively in Australia by then Reserve Bank Chairman Ian MacFarlane to take the air out of its housing bubble. Despite the mounting evidence that lenders are entering the danger zone, the Fed appears to be taking no other measures. The Office of the Comptroller of the Currency is merely studying the situation (which the Journal depicts as a more aggressive step):
As yet, there is no sign regulators plan formal guidance such as they issued on commercial bank lending last year. However, the Office of the Comptroller of the Currency, which regulates nationally chartered banks, has launched a special study of leveraged lending, or loans to heavily indebted companies, including private-equity buyouts, “to look specifically at what changes in underwriting practices we’re seeing,” said Kathy Dick, deputy comptroller. She said she expects results by August.
A Bloomberg story on the same speech placed more emphasis on the economic implications of the Fed warning, which extended to real estate markets:
Bernanke, speaking at a conference in Chicago today, said curbs on subprime lending “are expected to be a source of some restraint on home purchases and residential investment in coming quarters.” And he said the Fed is “beginning to look at” what he called “the risks that are associated with working with private-equity firms.”
The Fed chief’s comments suggest the central bank has raised its guard against a second credit bubble emerging in the form of leveraged buyouts at a time when the U.S. economy is dealing with the mortgage bust. Lawmakers and consumer advocates have blamed the Fed and other regulators for lax enforcement while lenders wrote a record $2.8 trillion in mortgages from 2004 to 2006.
We’ve seen this movie before. In the late 1980s, banks fell all over themselves to lend to ever larger and ever dodgier LBOs, seduced by big up-front fees that they could book as profits, rather than amortize them. And predictably, it ended badly as many of the deals went bust. Many banks fell below their capital requirements as a result of the writedowns, which meant they had to curtail new lending, and some banks, most notably Citibank, were in danger of failing. Greenspan salvaged the industry by engineering a very steep yield curve (remember that banks in the old days borrowed short and lent long), which was a massive subsidy.
While Bernanke and his colleagues clearly see the parallels to the 1980s LBO crisis, they can tell themselves that this time is different because the banks are much better capitalized and more diversified. While that is true, we have an unprecedented profligacy of lending across virtually all debt markets. Residential mortgages, thanks to the subprime debacle, may be the only one that now has risk adequately priced in.
Remember the lesson of Long Term Capital Management: in a crisis, all correlations are one. Translation: all assets reprice together. There is a collective flight to quality. In debt land, that means that riskier credits would drop significantly in price across all markets. And banks are now required to mark their assets to market. Can the Fed be sure their banks are adequately capitalized in that scenario, particularly as they load on more LBO debt?
