Fed Council Warned of Credit Risk, Asset Price Bubble
A Federal Reserve (TREFTOTL) panel of bankers warned policy makers in February that record stimulus was pushing financial institutions to take on more credit risk and creating a “bubble” in the price of U.S. farmland.
“The margin pressures that the low-rate environment has put on financial institutions, coupled with dramatically increased compliance and other infrastructure costs, have caused many to seek higher returns by accepting greater interest-rate or credit risk,” the bankers said on Feb. 8, following a Federal Open Market Committee meeting on Jan. 29-30.
The minutes of the meeting by the Federal Advisory Council trace how the 12 bankers’ views evolved from opposition to the Fed’s announcement of new bond buying in September to support for Fed efforts in February to boost an economic expansion beset by a “drag” from fiscal tightening.
Bloomberg News obtained the minutes in a Freedom of Information Act request. The council includes Joseph Hooley, chairman and chief executive officer of State Street Corp. (STT) in Boston; James Gorman, chairman and CEO of Morgan Stanley in New York; Kelly King, chairman and CEO of BB&T Corp. in Winston-Salem, North Carolina; and D. Bryan Jordan, chairman and CEO of First Horizon National Corp. (FHN) in Memphis, according to the Fed’s website.
Policy makers are debating how long to press on with unprecedented easing, including plans to keep buying $85 billion in bonds each month. The central bank has held the main interest rate at zero since December 2008 and pumped up its total assets to $3.32 trillion to spur growth and combat 7.5 percent unemployment.
The panel of bankers in February supported continued Fed easing even while flagging its risks.
“Believing the economy to be improving but still vulnerable, and recognizing the high quality of the Federal Reserve’s information-gathering and analytical resources,” the panel “continues to support the FOMC’s current accommodative monetary policy,” the council said in its quarterly meeting.
The yield on the U.S. 10-year Treasury note climbed yesterday two basis points, or 0.02 percentage point, to 1.78 percent in New York, according to Bloomberg Bond Trader prices.
The Fed’s advisory council in February saw “exceptional strength” in the balance sheets of both borrowers and financial institutions, leaving room for “considerable potential for credit expansion as headwinds subside,” according to the minutes.
The declining interest-rate spreads in some consumer finance categories “suggest that monetary actions are being transmitted more directly to the economy,” the minutes said.
Still, several bankers warned Fed officials in February that “uncertainty over health-care costs, tax policy, and the mounting U.S. debt” were among the reasons commercial and industrial loan growth remained “tepid” and credit lines were “chronically undrawn,” according to the minutes.
The panel also said in February that farmland valuations posed an asset-price bubble caused by unusually low interest rates, echoing concerns expressed by Kansas City Fed President Esther George.
“Agricultural land prices are veering further from what makes sense,” according to minutes of the council’s Feb. 8 gathering. “Members believe the run-up in agriculture land prices is a bubble resulting from persistently low interest rates.”
The Fed pledged to hold the benchmark interest rate at zero until the unemployment rate falls to 6.5 percent, as long as inflation expectations don’t exceed 2.5 percent. The U.S. central bank has also engaged in three rounds of bond purchases, known as quantitative easing.
Data compiled by the regional Fed banks have documented a rapid run-up in farmland prices, particularly across the Midwest’s Corn Belt. The Kansas City Fed said irrigated cropland in its district rose 30 percent during 2012, while the Chicago Fed reported a 16 percent increase.
The panel of bankers is appointed by regional Fed banks and dates to the founding of the central bank in 1913. Bloomberg obtained minutes from the quarterly meetings from May 2011 until February.
At a meeting in February 2012, the council said “growth in student-loan debt, to nearly $1 trillion, now exceeds credit-card outstandings and has parallels to the housing crisis.”
Student lending shares features of the housing crisis including “significant growth of subsidized lending in pursuit of a social good,” in this case higher education instead of expanded home ownership, the council said.
The advisory council opposed continued Fed accommodation on Sept. 14, a day after the conclusion of the FOMC’s two-day meeting Sept. 12-13. The Fed after that gathering announced a third round of bond buying with purchases of $40 billion per month of mortgage-backed securities.
“Further accommodation is not warranted,” the bankers said, according to the minutes.
The advisory council warned of distorted bond prices resulting from the Fed’s purchases, limited impact on the economy, and “uncertain effects” from an eventual unwinding of the balance sheet, including “risks to price and financial stability.”
As early as Dec. 2, 2011, the bankers warned that financial institutions were relaxing underwriting standards while facing limited loan opportunities.
“The combination of a sluggish economy and muted credit demand, very low interest rates, abundant bank capital and liquidity, reduced fee income and dramatically increased regulatory and compliance costs is causing some aggressive banks to lead a broader relaxation of risk/reward tolerances,” the council said.
“Aggressive pricing and looser underwriting, including extended terms and weaker transaction structures, are likely to persist and even get worse,” the bankers said in December 2011. “These accumulating risks, including interest rate risk mismatches, will ultimately result in higher loan losses.”
President Woodrow Wilson, who signed the Federal Reserve Act into law in 1913, pushed for the creation of a politically-appointed oversight board in Washington to monitor the 12 reserve banks. He set up the advisory council to ensure the Fed Board in Washington was informed of banking and business conditions nationwide. Council members typically serve for three years.
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