Where Fed Fears Asset Bubbles
Janet L. Yellen, the Federal Reserve chairwoman, told Congress that an ailing job market and stagnant wages justify keeping interest rates low.
Publish Date July 24, 2014. Photo by Doug Mills/The New York Times.
Has Janet Yellen jumped the shark already?
That appears to be the case after Ms. Yellen, the Federal Reserve chairwoman, testified before Congress last week that in the face of insatiable demand from investors for higher yields — because of the Fed’s continuing zero interest-rate policies — the Fed would use nothing more than its supervisory authority over the big Wall Street banks to try to rein in excessive risk-taking.
What Ms. Yellen should be using to stop the mispricing of risk in the market for financial assets is her unique ability to raise interest rates. But she seems determined not to do that.
“There are mixed signals concerning the economy,” she said on July 15. “We need to be careful to make sure that the economy is on a solid trajectory before we consider raising interest rates.”
She also said that even though the Fed would soon wind down its so-called quantitative easing program, which has swelled its balance sheet to nearly $4.4 trillion from about $800 billion, she is determined to keep interest rates at their historically low levels until the economy improves, employment picks up further and inflation shows signs of revival.
“A high degree of monetary policy accommodation remains appropriate,” Ms. Yellen said. “Although the economy continues to improve, the recovery is not yet complete.”
Interest rates, of course, reflect the price of money. Like any price, the one for money should reflect the supply and demand for it in the marketplace. But since the start of the quantitative easing program in 2009, the Fed has artificially stimulated the demand for debt securities, causing their prices to soar and long-term interest rates to fall. Both short- and long-term interest rates are now at historically low levels. Ms. Yellen says she intends to keep them that way, with the idea being that if money is cheap, people and corporations will want more of it and use it to buy things, build things and hire more people.
Among the unintended consequences of the Fed’s relentless cheap money policies is that people who have money, and don’t need to borrow it, like savers and investors, receive very little reward for simply keeping that money in a bank. At the moment, the interest rate banks pay savers is about 0.08 percent, pretty close to zero. That drives crazy anyone on a fixed income or anyone who makes a living making money from money. So savers and investors are in a desperate search for yield — the so-called yield hunger games — through investments that, while risky, at least offer a higher return than a savings account or a Treasury security.
One of the areas that investors’ hunger for yield shows up in is the market for leveraged loans, which Wall Street banks issue for clients like buyout firms that then use the money to buy companies with as much debt and as little equity as they can. According to Bloomberg, so far in 2014, banks have issued about $227 billion of leveraged loans, which have a higher interest rate than regular corporate loans (more risk, more reward), and are on track to surpass the record $358.3 billion issuance of such loans last year. In the mad rush to issue these loans to meet investor demand, the banks have again lowered their underwriting standards, allowing these loans to be issued without the typical covenants — like a debt to cash-flow ratio — that can serve as an early warning signal to investors that a loan may not be paid back. To get the yield they want, investors seem to be willing to overlook the underwriting flaws. The Wall Street banks, meanwhile, eager to earn more and more fees, are only too happy to underwrite these loans, flaws and all, and then sell them to the hungry investors.
To its credit, the Fed has at least noticed that risk is again being mispriced. In 2013, the Fed urged the big banks to improve their underwriting standards in the issuance of leveraged loans. But, in her testimony last week, Ms. Yellen said that instead of an improvement, the Fed has actually seen a “marked deterioration” of those standards and that more than half of the leveraged loans issued in 2014 do not have the protective covenants. She said that to try to remedy this continuing failure to price risk properly the Fed was engaged in “strong supervisory follow-up,” which is Fed-speak, I suppose, for warning the big banks to improve their underwriting standards, or else.
Or else what? The Wall Street banks aren’t going to change their behavior simply because their “prudential” regulator tells them to do so.
“Regulators talk about using tools and other supervisory measures to rein in the banks,” Beth MacLean, an executive at Pimco, the mammoth bond-fund manager, told Bloomberg. “But ultimately there is still supply and demand, and there is ample demand. There is not much they can do, and that is evident in that terms haven’t really changed since the guidelines came out.”
The banks underwrite these loans without covenants because their big fee-paying private equity clients — like the Blackstone Group, KKR and the Carlyle Group — like them and the yield-hungry investors snap them up at a moment’s notice. Everyone is getting the risk they want. The last time people spoke openly about everyone being happy with the risks they were taking, you may remember, was in 2007 in the heyday of the synthetic collateralized debt obligation.
We always assume that people like Alan Greenspan, Ben Bernanke and Ms. Yellen, with their fancy degrees and pedigrees, are really smart and know what they are doing when they set monetary policy. I am not so sure anymore. Believing that a little more supervisory oversight will change banks’ behavior doesn’t seem very savvy. Nor does a continuing policy of manipulating the price of money.
What does seem smart to me are the comments of the billionaire hedge fund investor Stanley Druckenmiller, who last week used his time at the Delivering Alpha Conference to again denounce the Fed’s easy-money policies.
“Given the complexity of our financial system, if policy strongly encourages investors to move out the risk curve, market participants invariably tend to find a way to step around regulators,” he said. “The odds are very high that the consequences of Fed policy will be more disruptive down the road than the Fed anticipates.”