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Ben Bernanke, the Federal Reserve chairman seems to
be holding his ground when it comes to short-term interest rates – at
least in the short-term. His testimony before the Congressional Joint
Economic Committee this past week offered no additional insight into how the
chairman thinks. His testimony before legislators offered no hint as to what
he would do with rates in light of some troubling economic news.
Investors have become like so many oysters of late, left to filter the
economic waters passing by in search of some morsel of insight into why the
news is good then bad and then good again.
With risks increasing on “both sides of the outlook”, Mr.
Bernanke’s open-ended belief was reiterated with the veiled suggestion
that rates could go higher or remain the same or be lower by year’s
end. Once billed as the clear speaking Fed chief, he instead left anyone
watching the Fed scratching their collective heads.
Economists believe that the mortgage meltdown in the sub-prime sector
will have a lingering effect over the growth of the economy. While the actual
effect may be more psychological than real, the threat of any slowdown by
default spreading throughout the rest of the economy is quite low. Currently,
the numbers of foreclosures have risen but recent reports suggest that only
15% of the sub-prime marketplace will be affected.
Even though that number is small, banks have begun to tighten with the
net result of fewer riskier mortgages. That may perceived as a plus for one
side of Bernanke’s economic outlook.
His focus, although is not on the mortgage market. The sub-prime
fallout has little to do with Fed policy or the regulation of short-term
interest rates. If Mr. Bernanke were concerned with the slow unfolding of
this segment of the lending market, he didn’t show it. This seemed to
worry Congress.
Instead, he came close to asking for additional regulatory power over
institutions that did not fall under his scope of banking power. Reigning in
the high-risk lenders, many of whom were financially backed by the very banks
that Mr. Bernanke currently regulates may very well have offset the problem. He
believes that the mortgage markets will self-correct and although the damage
that done was regrettable, any knee jerk reaction, namely additional
legislation might do more harm than good.
Inflation numbers still worry the Fed chief. That has brought many
investors and economists to the conclusion that rates will not be cut anytime
soon. Perhaps rates are the least of
Mr. Bernanke’s concerns.
His rather sanguine view
of the economy aside, what seems to concern the Fed chief is business. A
cursory glance at the health of businesses based on economic reports is often
deceiving and likely subject to revisions or rebounds. As one report suggests
strength, still another portrays an overall slowdown with disastrous downside
possibilities. He admits to being puzzled. This is merely a bluff.
Bernanke understands that
Congress grasps the basic business model. Keep companies strong and jobs are
created. First-time weekly jobless claims actually been falling of late,
which is generally perceived as both economically and politically good.
Closer inspection of
those reports only adds additional confusion to the economic outlook.
Businesses are hiring, yet an increase in capital spending hasn’t
followed this worker-based growth.
The extra weight of these
workers is having a negative effect on productivity. Once considered a
necessary element of growth, productivity measures have fallen below pre-1997
levels. So more than inflation is on the other side of the
“outlook”.
Historically, Mr.
Bernanke has been vocal about the relationship between inflation and
productivity/wages/growth momentum. He has pointed out that has his
predecessors seen that correlation in the ‘70’s, much of that
decades problems with inflation could have been averted. Seeking to avoid
that sort of reoccurrence on his watch, Bernanke has kept his cards close.
Yet, well within the scope
of the Fed’s regulatory jurisdiction, a growing problem has fully
matured. A new record was set during the 1st quarter of this year
in the leveraged lending market. These markets exist for business borrowing
when the usual channels require too much in the way of disclosure. If that
sounds suspiciously like the mortgage markets version of “no-doc
loans”, it is.
Under normal
circumstances, these types of loans require assets to be affixed as
collateral. Increasingly, banks have waived those requirements.
The borrowers,
often-private equity, use the money to finance leveraged buyouts. These
high-risk loans come with “covenant holidays” a grace period that
allows the borrowers to erase bad quarters from the books.
Bernanke’s banks
have written poorly secured loans to less-than-creditworthy borrowers and
then repackaged them with the lenders better credit rating affixed. Acting as
sort of middleman and in theory, spreading the risk, banks have become
sub-prime lenders. Mr. Bernanke seems to have turned a blind eye on this
outwardly benign risk.
CLO’s or collateral
loan obligations have been around for over twenty years. Banks bundle them
and sell them to investors. These financial products are sold with a
generally wink-wink understanding that purchased individually the underlying
loans would carry a low-grade credit rating. By standing behind them, at
least in reputation, the overall credit rating on these otherwise sub-par
loans improves. That improvement and a slightly higher return against
similarly rated investments, up to 2%, makes them more attractive.
These unwary investors
tend to be in the market for the AAA rated bonds. Among the unsuspecting
customers are pensions, insurance companies and the most conservative
investor of all, the ultra wealthy. Much of the underlying junk debt is involved in the current
wave of leveraged buyout, an activity that many of these investors would
normally scorn.
Is Mr. Bernanke bluffing when he tells Congress that corporate profits
should remain healthy? Possibly. If CLO’s are any indication of how his
own banking system calculates business health, Mr. Bernanke’s economy
may be on very shaky ground. Perhaps there is much more than inflation and
slowing productivity on the “other side of the outlook”.
Paul Petillo
www.BlueCollarDollar.com
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