Bernanke on Non-Banks: Passover to a New Rule Book

Significant non-banking financial institutions like American International Group Inc. (AIG) are an integral part of the U.S. economy and so interconnected with other institutions that outright failure is not an option, Federal Reserve chairman Ben Bernanke said in a speech today. Instead, he said, such firms ought to face a strict set of regulatory requirements — and potential regulatory intervention — similar to that imposed on banks by the Federal Deposit Insurance Corp. “As a general rule, my strong preference is that any firm that cannot meet its obligations should bear the consequences of the marketplace,” Bernanke said. “But recent circumstances have been truly extraordinary.” The Fed chairman began his speech with the promise to answer four key questions about the financial crisis: How did we get here? What is the Fed doing to address the situation? Does the Fed’s aggressive response risk massive inflation down the road? Why did the Fed and the Treasury act to prevent the bankruptcy of some major financial firms? Bernanke likened the four financial questions to a practice among Jewish observers of the Passover meal, when the youngest child asks four traditional questions, the answers “to which tell the history of the Jews when they were slaves in Egypt and during their exodus to the Promised Land,” he said. It’s unclear why the Fed chairman linked major financial concerns to traditional Passover dialogues by drawing a comparison to the religious tale of enslavement and persecution at the hands of the operating government. The deliverance tale he told the Georgia-based Morehouse College students and faculty Tuesday was one of monetary policy and credit-easing efforts having led investors, lenders and taxpayers out from the oppression of default-related losses and high interest rates. Of course, the biblical ending of the Bernanke’s anecdote traditionally ends with a mass exodus from the land, with the newly nomadic Jews spending decades homeless in the desert. The recent housing boom in the US was no less characterized by wandering tendencies, with careless lending habits unchecked by regulators. this is in part due to intermediaries in the subprime market being subject to little or no federal regulation, Bernanke said. In the bursting of the bubble that followed and the panic caused by heavy losses in the secondary markets, the Fed reacted by “aggressively” lowering the federal funds rate in several short years, effectively to 0% from a recent high of 5.25%. “However, given the ongoing problems in credit markets, conventional monetary policy alone is not adequate to provide all the support that the economy needs,” Bernanke said. “The Fed has therefore taken a number of steps to help the economy by unclogging the flow of credit to households and businesses,” including short-term loans, lending initiatives to restore confidence in money market mutual funds and buying mortgage-related securities. “In doing so, we have demonstrated that the Fed’s toolkit remains potent, even though the federal funds rate is close to zero and thus cannot be reduced further.” The Fed has also, in the process, greatly increased its balance sheet (most recent data show the Fed’s consolidated balance sheet has risen to a value of $2.07 trillion as of April 8, up $1.2 trillion from April 9, 2008) and funneled considerable amounts of liquidity into the financial market. But Bernanke’s comments reiterate the Fed’s view of inflation that may “persist for a time below rates that best foster economic growth and price stability in the longer term,” according to the most recent Federal Open Market Committee (FOMC) statement. “In their latest quarterly projections of the economy, most members of the FOMC indicated that they would like to see an annual inflation rate of about 2 percent in the longer term,” Bernanke said Tuesday. “Right now, because of the weakness in economic conditions here and around the world, inflation has been running less than that, and our best forecast is that inflation will remain quite low for some time. Thus, the Fed’s proactive policy approach is not at all inconsistent with the goal of price stability in the medium term.” The Fed chairman expressed his optimism that demand will eventually recover, as consumers find more resources and inclination to purchase goods and services. Higher demand in concert with the added liquidity already fueled into the system will pose real inflationary risks “unless the FOMC acts to remove some of that liquidity and raise the federal funds rate,” Bernanke said. “We have a number of effective tools that will allow us to drain excess liquidity and begin to raise rates at the appropriate time; that said, unwinding or scaling down some of our special lending programs will almost certainly have to be part of our strategy for reducing policy stimulus once the recovery is under way.” The housing market has seen some semblance of recovery — at least in affordability –as both mortgage rates and home prices have fallen dramatically from the height of the bubble, Bernanke pointed out. “For example, two years ago, when mortgage rates were higher than 6 percent, payments on a mortgage covering 80 percent of the cost of a $215,000 home would have been more than $1,000 per month,” he said. “Today, the price of that same house may have fallen to $170,000, and, at today’s mortgage interest rates, the monthly payment would be about $700.” Despite the bit of bright news for prospective home buyers, the fact remains that their ultimate lenders — aggregaters like JP Morgan Chase & Co. (JPM) — along with giant insurers like AIG and other systemically significant financial institutions, have had to rely on government aid in recent months in the form of capital injections and targeted investments through the Troubled Asset Relief Program. Many of these firms have come under criticism for accepting taxpayer money from the government and paying out millions of dollars in what are viewed by the public and media alike as unnecessary programs, like AIG’s recent retention bonus flop. The Fed and Treasury Department have increasingly been called out on their oversight of these institutions and, in some cases, their decision to bail out these firms in the first place. In the case of AIG, according to Bernanke’s comments, failure would simply not have been an option. Complex financial firms like AIG “tend to be highly interconnected with other firms and markets,” posing not only a risk to their own shareholders but to other intitutions abroad as well as “the entire global financial system,” according to Bernanke. “At best, the consequences of AIG’s failure would have been a significant intensification of an already severe financial crisis and a further worsening of economic conditions,” he said. “Conceivably, its failure could have triggered a 1930s-style global financial and economic meltdown, with catastrophic implications for production, incomes, and jobs.” AIG’s significance may have necessitated intervention, but it also calls attention to the need for “a new set of procedures for dealing with a complex, systemically important financial institution on the brink of failure,” according to Bernanke’s comments. The investor fear in recent months has been a nationalization — or at least partial nationalization — of the U.S. banking system and federal regulation that reaches deeply into the roots of even the private sector. The Fed chairman did not say the regulators’ new rule book on non-banks would mean such severe federal control, but his comments supported the view of some sort of intervention as necessary. New non-bank-related procedures “would allow federal regulators to unwind a failing company in ways that minimize disruptions in financial markets,” Bernanke said. “An effective regime would also provide the authorities greater latitude to negotiate with creditors and to modify contracts entered into by the company, including contracts that set bonuses and other compensation for management.” Only time will tell exactly how much control such a regime would exert over the U.S. banking system and private sector. Read his speech. Write to Diana Golobay at [email protected]. Disclosure: The author held no relevant investment positions when this story was published. Indirect holdings may exist via mutual fund investments. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.