Fed Split Over How Long To Keep Cash
Spigot Open
By JON HILSENRATH and VICTORIA MCGRANE
WSJ's Global Economics Editor David Wessel and Chief Economics Correspondent Jon
Hilsenrath discuss the Federal Reserve's newest concern: The danger that its easy money
policies may fuel another financial crisis.
Federal Reserve officials, uneasy with potential risks springing from the central bank's
low-interest-rate policies, are split over an early retreat from the experimental programs
created to revive the U.S. economy.
Minutes released Wednesday from the Fed's January policy meeting show officials
concerned that the current easy-money policies could lead to excessive risk-taking and
instability in financial markets. The Fed is buying $85 billion in mortgage and U.S.
Treasury securities a month to drive down long-term rates and has promised to keep
short-term rates near zero until unemployment improves.
The program hasn't fueled inflation, as many feared, and many officials are inclined to
stay the course. But some said the Fed might have to taper its controversial bond buying
before the job market fully recovers, according to the January minutes. The Fed has
previously allowed bond buying programs to end in this recovery and then restarted them.
It will review the programs at its next meeting, March 19-20, setting the stage for another
high-stakes debate.
Behind the Fed's growing unease is a deep change at the central bank since the 2008
financial crisis. Many economists used to regard financial crises as problems of
developing economies, and they saw asset bubbles as problems best dealt with after they
burst.
Now, Fed Chairman Ben Bernanke said in an appearance at the University of Michigan
last month, the Fed "needs to think about financial stability and monetary, economic
stability as being in some sense the two key pillars of what the central bank tries to do."
Of late, the view in financial markets has been unsettling: Banks and investors are
holding riskier debt. Companies are issuing record amounts of junk bonds. And exotic
corners of mortgage securities and corporate loan markets are growing.
Fed officials aren't convinced these recent signs point to any immediate danger to the
U.S. financial system. But they are debating whether Fed programs could lead to future
financial turbulences and whether the programs will be more difficult to unwind later, as
they grow.
The Fed has said that short-term rates would stay low until unemployment falls to 6.5%,
from its current level of 7.9%, as long as inflation remains low, and that the bond-buying
programs would continue until substantial job market improvements. But officials have
always hedged these forecasts, saying they could change with any emerging threats to the
financial system.
The same low interest rates intended to trigger spending, investment, growth and hiring
are also spurring a race by investors to find higher returns that, by nature, carry higher
risks.
"We have a hyper-robust bond market right now," Dallas Fed President Richard Fisher, a
former investment manager, said in an interview. These robust markets are part of the
Fed's policy intent, he said, but the credit market jump has put him on guard for a new
destabilizing credit boom. "You don't sit on a hot stove twice."
Jeremy Stein, a Federal Reserve governor, likened the Fed's challenge to that of a ship's
crew, which must distinguish chunks of ice from dangerous, deep-rooted icebergs. A lot
happens in markets beneath the surface, beyond the notice of regulators, he said in a
recent speech: "We should be humble about our ability to see the whole picture, and
should interpret those clues that we do see accordingly."
Identifying financial threats is harder than spotting such problems as inflation or
unemployment, which have uniform measures. Until recently, the long-running complaint
among economists critical of the Fed's low-rate policy was the danger of high inflation,
which has settled below the Fed's 2% target.
Mr. Stein, a finance specialist on leave from Harvard University's economics department,
expressed worry over the growth in junk bonds and corporate loan markets this month
and acknowledged the Fed's conundrum: Its low-interest-rate policies to help the U.S.
economy might also contribute to destabilizing booms.
The danger is that low rates prompt some individuals and institutions to take on too much
debt or too many risky assets. In worst-case scenarios, such market behaviors can topple
banks and financial institutions that are heavily exposed.
Eric Rosengren, president of the Federal Reserve Bank of Boston, said in an interview
that it wasn't the central bank's job to halt every episode of financial excess.
Individual financial institutions regularly fail without bringing down the economy, and
financial bubbles don't always wreck financial systems. When the tech bubble burst in
2000, for example, the U.S. experienced a relatively brief and shallow recession. It didn't
lead to the same cascade of market collapses and a deep downturn as in 2008.
Instead, Mr. Rosengren said, the Fed needed to zero in on fixing market problems that
threaten widespread damage. In 2008, banks and other financial institutions took on too
much debt. They lost their balance in the market chaos and dumped their holdings in fire
sales that spread financial panic. Mr. Rosengren is calling for changes in rules for money
market mutual funds to make them less prone to such investor runs.
As an academic, Mr. Bernanke studied the role of unstable banks and the Fed in the Great
Depression, part of his long-running interest in understanding financial crises. When he
became Fed chairman in 2006, he directed his staff to look for threats to financial
stability.
The directive led to much debate about the subprime mortgage boom and corporate
credit. But the Fed failed to uncover related weaknesses in the financial system. One
missed sign was the exposure of big banks to a $1.2 trillion market called asset-backed
commercial paper, which was heavily invested in troubled mortgage debt. When
investors fled this market in 2007, banks were stuck with ballooning portfolios of
troubled mortgage securities that had fewer and fewer buyers, contributing to the
financial crisis.
After the crisis, Mr. Bernanke stepped up the effort. In November 2010, he created the
Office of Financial Stability Policy and Research, staffed with about two dozen of the
central bank's top economists. Their job: keep better watch over weak links in the
financial system, and make sure Fed bank regulators spent more time comparing notes
with Fed researchers.
"You're not trying to predict the weather. It is more about building sea walls," Nellie
Liang, a Fed economist who runs the group, said in an interview. "The idea is if
something really bad happens, you're ready."
The group, which produces four internal surveillance reports a year, is now at the center
of some of the Fed's biggest decisions. Ms. Liang, who holds a Ph.D. in economics from
the University of Maryland, spent most of her 27-year career at the Fed examining
markets, rising through the ranks with a demanding yet down-to-earth style, according to
people who worked with her.
Every two weeks, Ms. Liang's group briefs Mr. Bernanke and two of his top
lieutenants—Fed vice chairwoman Janet Yellen and governor Daniel Tarullo—on
potentially weak links in the financial system, according to people familiar with the
matter.
Several times a year, the group briefs the Federal Open Market Committee, the group of
Fed governors and regional Fed bank presidents that makes decisions on interest rates
and bond buying. It also plays a central role in designing stress tests, which examine the
ability of big banks to withstand economic shocks.
Most of the private sector has paid down substantial amounts of debt from the 2000s,
which makes another credit crash look unlikely at the moment. Total borrowing by
financial institutions, at $13.8 trillion in September, was down 19% from its peak in
2008, according to Fed statistics. Consumer borrowing, a big driver of the last boom, is
down 7% from its 2008 peak.
"It is hard for me to draw the conclusion that we're facing an imminent problem," said
Lewis Alexander, chief economist at Nomura Securities and an adviser at the U.S.
Treasury from 2009 to 2011. "Most of the private sector has become extremely risk
averse."
Others see potential trouble ahead. Esther George, president of the Kansas City Fed and a
former bank supervisor, said the Fed's bond-buying programs could cause "economic and
financial imbalances," meaning the kinds of excess in markets that led to the 2008 crisis.
Sandra Pianalto, president of the Cleveland Fed, said this month the Fed might need to
scale back its bond-buying programs "to minimize some of these risks" of financial
turbulence.
But, as is often the case at the Fed, there is no consensus. Mr. Rosengren doesn't want to
use the blunt instrument of interest rates to address market threats. "Aggressive monetary
policy is appropriate," he said, because the damage to the economy caused by high
unemployment outweighs the risks of financial instability.
Fed officials are watching several potential dangers, including junk bonds. Last year,
companies issued $274 billion worth of junk bonds, up 55% from a year earlier and more
than double the levels seen before the financial crisis, according to Dealogic. Yields on
low-rated junk bonds have fallen to under 6% as investors push up their prices. One risk
is for borrowers who take on too much debt; another is for investors should the value of
junk bonds collapse.
In another market, corporate borrowers are facing looser restrictions from lenders on new
loans. Covenant-lite corporate loans—borrower-friendly business loans that don't require
firms to meet traditional performance standards—are up. In 2012, banks underwrote $58
billion worth of such loans, according to Dealogic. That compares with $36.5 billion in
2011 and $8.5 billion in 2010.
Credit ratings firms are taking notice. When Netflix Inc., the video rental firm, issued
$400 million worth of new debt late last month, Standard & Poor's lowered its outlook
for the debt, noting the firm's increased debt. Moody's Investors Service downgraded JG
Wentworth, a financial services firm, after it took out a $425 million covenant-lite loan in
February and used most of the proceeds to pay shareholders a special dividend. Moody's
noted the firm's debt would triple.
David Miller, the chief executive of JG Wentworth, said the added debt was manageable
because the firm generates lots of cash and interest rates are low. He added S&P didn't
downgrade the firm's debt. A Netflix spokesperson declined to comment.
Mortgage real-estate investment trusts are growing briskly, too, and that has caught the
attention of regulators. These largely unregulated financial firms use short-term loans to
buy mortgage-backed securities. One worry among regulators is that their short-term
funding could dry up quickly if the firms face challenges, forcing the sale of assets at a
loss. Other regulators, including the Financial Stability Oversight Council, a group of
regulators run by the U.S. Treasury, have been looking at the business model of these
firms, according to several people familiar with the matter.
The industry has bigger capital cushions than most banks and is disciplined because it
doesn't rely on a government safety net, said Wellington Denahan, the chief executive of
Annaly Capital Management Inc., the sector's largest company by assets.
Fed officials have also taken notice that some banks are taking more risks, as they
venture away from such safe but low-yield investments as Treasurys in the search for
higher returns.
Gerald Lipkin, chief executive of Valley National Bancorp of Wayne, N.J., which has
$16 billion in assets, sees problems looming for banks. His customers want to lock in
low-rate, long-term loans, and he worries that too many low-rate loans will squeeze
profits if interest rates go up.
"I think this could be a major problem for financial institutions that do it," he said. He
said he was resisting that temptation, but added, "it's getting very, very difficult not to do
it," because of the Fed's low-rate policies.
Write to Jon Hilsenrath at jon.hilsenrath@wsj.com and Victoria McGrane at
victoria.mcgrane@wsj.com
Corrections & Amplifications
Wellington Denahan is the chief executive of Annaly Capital Management Inc. An earlier
version of this article misspelled her name as Denihan.
A version of this article appeared February 21, 2013, on page A1 in the U.S. edition of
The Wall Street Journal, with the headline: Fed Split Over How Long To Keep Cash
Spigot Open.