The bulls are running on Wall Street, but the chief of America’s central bank worries that the market remains dangerously fragile. Federal Reserve Chairman Ben Bernanke explained why on Friday, May 10, in a speech in Chicago at the Fed’s branch there.
Here are five things that nag at Bernanke, in his own words.
1. Times may be too good. There is an “apparent tendency for financial market participants to take greater risks when macro conditions are relatively stable. Indeed, it may be that prolonged economic stability is a double-edged sword.” Stability “could … reduce the incentives for market participants to take reasonable precautions.”
2. Securities lending remains problematic. The financial crisis revealed that borrowing by securities broker-dealers “is potentially quite fragile.” In the crisis, “Borrowers unable to meet margin calls and finance their asset holdings were forced to sell, driving down asset prices further and setting off a cycle of deleveraging and further asset liquidation.”
3. Money market funds are still vulnerable. “The risk is increased by the fact that the Treasury no longer has the power to guarantee investors’ holdings in money funds, an authority that was critical for stopping the 2008 run.”
4. A default in the repo market would be no fun. This is kind of like point No. 2, except that here, Bernanke is focusing on so-called triparty repo. Repo lending is short-term lending that’s secured with collateral such as bonds. Triparty repo is where a big bank—usually JPMorgan Chase (JPM) or Bank of New York Mellon (BK)—stands between the borrower and lender, clearing the transaction. “More work is needed to better prepare investors and other market participants to deal with the potential consequences of a default by a large participant in the repo market.”
5. The rising tide hasn’t lifted all boats. “Gains in household net worth have been concentrated among wealthier households, while many households in the middle or lower parts of the distribution have experienced declines in wealth since the crisis. Moreover, many homeowners remain ‘underwater,’ with their homes worth less than the principal balances on their mortgages. Thus, more detailed information clarifies that many households remain more financially fragile than might be inferred from the aggregate statistics alone.”