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Do-nothing Fed is dangerously disengaged
When it comes to bubbles, Alan Greenspan and his crew are strangely passive. As problems multiply in the financial sector, their lethargy threatens all of us.
By Jim Jubak
Talk is cheap, Mr. Greenspan.
But when it comes to bubbles and potential bubbles, that's all we get from the U.S. Federal Reserve. Greenspan and company can sure talk the talk. But walk the walk? Forget about it.
And I think that's going to get us -- and Alan Greenspan's successor as Federal Reserve chairman, come January -- in trouble. Again. In 2006, I'd estimate.
Remember the run-up to the popping of the technology stock bubble in March 2000. As easy money, which the Federal Reserve itself provided, drove up stock prices, we got lectures on irrational exuberance. Bad things were bound to happen to investors who forgot about risk, Greenspan warned. (As the bubble continued to inflate, the Federal Reserve chairman changed his tune: Higher productivity justified some portion of these "irrationally" higher stock prices.)
When it came to action, though, the Federal Reserve punted. The central bank ignored all calls -- some from the Wall Street establishment itself -- for higher margin requirements that would have forced investors to borrow less and put up more of their own cash to buy stocks. Would that have helped deflate the bubble more gradually? It might have. But we'll never know.
Now, belatedly, the Federal Reserve has decided to warn us that housing prices are getting worryingly high in some markets. Some local housing markets might even be experiencing, dare we say it, a bubble. Some consumers are adding variable-rate mortgage debt without a thought of risk. The Federal Reserve would be much obliged, thank you very much, if all you irresponsible borrowers and real-estate flippers -- you know who you are -- would stop.
Related news and commentary on MSN Money
All reserve, no resolve
But is the Federal Reserve doing anything about the causes of this potential bubble? Not that I can see. When it comes to U.S. banks, the part of the financial system where the Federal Reserve has real, honest-to-goodness clout, Greenspan and his colleagues are curiously passive. And that's truly dangerous. Because the real problems in the financial system, the ones that could blow up at individual institutions and then cascade to affect the entire financial market, are on bank balance sheets.
And the Federal Reserve -- like other bank regulators -- seems content to let the problem build.
Homeowners and home buyers may indeed be taking on too much debt. Too much of that debt may carry a variable rate that could explode on real-estate borrowers if interest rates rise. Too much of it has undoubtedly been extended to home buyers and home borrowers who can't afford the interest payments that kick in after some initial period of no or below-market interest.
But it's easy to understand why borrowers would be tempted to borrow more than they should. Who hasn't felt the allure of a bigger house? Or of that slightly extravagant vacation? Or of borrowing a few hundred now -- and oh, maybe next month, too -- to get through an end-of-the-month rough patch? Lecturing consumers on the need to borrow less, as the Federal Reserve has done, when money is so cheap thanks to its own policies, is like standing in front of an open bar and telling your party guests not to drink more of the free liquor than is good for them.
It's great if you like to hear yourself talk and want to be able to say "I told you so" to your hung-over friends. But, please, let's not kid ourselves that it's an effective way to change behavior.
A regulator forgets to regulate
And besides, the Federal Reserve has an alternative for attacking this bubble: The central bank can go after the banks that are making these loans. For every underqualified investor taking out a loan that is likely to go south, there's a bank making that loan and a banker stretching the rules of sound lending. And the Federal Reserve could do a lot about this deterioration of lending standards if it wanted to.
Let's take a look at the Federal Reserve's snapshot of the U.S. banking sector at the end of 2004. On the surface, the banking sector was in good shape. Loans grew by 3.5%, about $170 billion, in the fourth quarter, with the fastest growth in commercial real estate, home equity and credit card loans.
But that's only on the surface. Take a slightly deeper look and you'll see some unsettling trends. For example, despite that huge $170 billion increase in loans in the fourth quarter, banks saw their uncommitted capital rise. And despite that increase in loans, net income fell in the quarter.
Not by much. Just a 1.4% decline from the third quarter of 2004. But significant, especially given the increase in loans outstanding for the quarter.
Why did banks make more loans and yet show less profit?
First, because net interest income fell as the yield curve got flatter: Banks make their profit on the spread between long-term interest rates -- what they charge borrowers who take out mortgages, for example -- and short-term rates -- what they pay to raise money in the capital markets and what they pay in interest on savings accounts and other short-term instruments. The Fed's hikes in short-term interest rates have collapsed that spread so that, as of Sept. 6, there was just a 0.6 percentage point difference between the yield on a 10-year Treasury note, the benchmark for many mortgages, and the 3-month Treasury bill, the benchmark for the cost of short-term money.
Second, because banking is a competitive industry just like automobiles and steel, banks with lots and lots of money to lend cut the prices of their loans in order to put more of their cash to work. The Federal Reserve first flooded the banks with cheap capital. Then, as the Fed started to tighten, foreign investors made up the difference and more. (Foreign investors have poured money into the U.S. bond markets, a big reason the yield on the U.S. 10-year note has moved constantly lower.)
Finding a spare $1.3 billion
The Federal Reserve's 2004 data shows that profits at U.S. banks would have been even worse at the end of the year except that 1) banks earned more non-interest income from trading and from servicing mortgages, and 2) they reduced their reserves for loan losses. That second item takes a bit of explaining. In the arcane world of bank accounting, when a bank decides that it only needs to reserve $200 million for losses from future bad loans instead of $300 million, the $100 million difference goes straight to the bottom line, where it is added to earnings.
So for example, KeyCorp (KEY, news, msgs) released $28 million from its loan-loss reserve in the second quarter of 2005. That added 4 cents a share to the bank's earnings of 70 cents a share for the quarter. That's just a recent example of a trend that's been at work for a while. In the fourth quarter of 2004, for example, banks reduced their allowance for loan losses by a total of $1.3 billion, according to the Federal Reserve's own numbers.
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