Fed Effort to Stoke Growth May Be Undermined by ‘Tight’ Credit

By Scott Lanman

Sept. 22 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke’s efforts to stoke a U.S. economic recovery may be undermined by the central bank’s other goal of restoring the banking system to health.

The Federal Open Market Committee, at the conclusion tomorrow of a two-day meeting, will probably maintain its assessment that “tight” bank credit is impeding growth. Lending contracted for five straight weeks through Sept. 9, a drop that in part reflects Fed orders to banks to raise more capital and toughen lending standards, analysts say.

A failure to restore the flow of bank credit carries the risk that the economic recovery will be slower than the Fed anticipates, or even that the U.S. lapses into another recession, economists say. That would make it more likely the Fed will keep its main interest rate close to zero for a longer period.

“They would be absolutely delighted if banks went out and raised a lot more private capital and then began to lend more,” said former Fed Governor Lyle Gramley, now senior economic adviser with New York-based Soleil Securities Corp. “Until that happens, the Fed has to continue to try to encourage economic growth through easy money.”

The FOMC, composed of Bernanke, Fed governors and regional Fed-bank presidents, is expected to release a statement at about 2:15 p.m. New York time. Economists surveyed by Bloomberg News unanimously forecast the Fed will leave its benchmark interest rate unchanged.

The central bank may also decide to extend the end date of its $1.45 trillion program to buy housing debt, now set to expire at the end of the year, and to gradually reduce the size of the purchases.

Lending Contracts

Banks have become more careful about lending. A Fed report released last week shows banks had $6.85 trillion of loans and leases outstanding to businesses and households as of Sept. 9, down for a fifth straight week and below the record $7.32 trillion in October 2008. Real estate loans, the biggest portion, stood at $3.79 trillion, up $7.5 billion from the prior week while down from a peak of $3.9 trillion.

The Fed’s second-quarter survey of senior loan officers, released Aug. 17, showed U.S. banks tightened standards on all types of loans and said they expect to maintain strict criteria on lending until at least the second half of 2010.

“While it is important for economic recovery that lenders provide credit to worthy households and businesses, they also must maintain enough capital to withstand losses -- even if economic conditions turn out to be worse than anticipated,” San Francisco Fed President Janet Yellen said in a Sept. 14 speech.

‘Far From Healthy’

“The financial system is still far from healthy and tight credit is likely to put a damper on growth for some time to come,” Yellen continued.

Fed-led stress tests of the 19 biggest U.S. banks earlier this year were designed to ensure that the firms had enough capital to withstand a more severe economic downturn. The tests found that the banks need to raise $75 billion to withstand potential losses.

Separately, regional and some smaller U.S. banks may need $12 billion to $14 billion in additional capital to cope with troubled loans still on their books, the Congressional Oversight Panel said in August.

Banks have a Nov. 9 deadline from the Fed to raise the amount of capital determined by the stress tests. Bernanke said in June that the 10 firms that required capital had raised or announced actions to generate $48 billion of new common equity. The firms included Bank of America Corp., Wells Fargo & Co. and GMAC LLC.

Mortgage Rules

The Fed has taken other steps to make sure banks avoid riskier loans. In July 2008, it tightened mortgage rules by requiring lenders to determine a borrower’s ability to repay and barring other practices that led to the collapse of the housing market.

Minimum regulatory-capital requirements may change as officials in the U.S. and abroad craft new financial rules. Consumers are less credit-worthy as the job market deteriorates and after a record loss of wealth from plunging share prices and real estate values.

Rising unemployment will slow the pace of the recovery, Bernanke said on Sept. 15.

“Even though from a technical perspective the recession is very likely over at this point, it’s still going to feel like a very weak economy for some time,” Bernanke said in response to a question after a speech in Washington. Fed officials in June predicted that GDP will expand 2.1 percent to 3.3 percent next year after shrinking 1.5 percent to 1 percent this year, according to the central tendency of their forecasts.

Banks have plenty of reasons to hold back on lending, analysts say.

Behind on Payments

Americans fell behind on their mortgage payments at a record pace in the second quarter, with delinquencies rising to 9.24 percent, according to an August report by the Mortgage Bankers Association.

“Consumers aren’t necessarily that creditworthy a proposition right now,” said John Ryding, chief economist and founder of RDQ Economics LLC in New York.

Falling values of commercial real estate are also a problem for banks, with an “uncertain degree of losses” to come, said Ryding, a former Fed researcher.

“Banks are all trying to ratchet back their credit exposure,” said Eric Hovde, chief executive officer of Hovde Capital Advisors LLC, who manages about $1 billion with a concentration in financial and real-estate related companies and is chairman of Sunwest Bank in Tustin, California.

Bigger Down Payments

For instance, JPMorgan Chase & Co. now requires mortgage borrowers to make bigger down payments than before the crisis, and it has stopped allowing so-called stated-income loans that don’t require documentation of earnings, said Tom Kelly, a spokesman.

Neal Soss, chief economist at Credit Suisse in New York, predicts the lending lull will end within a few months after businesses finish depleting inventories and financial firms better determine how much in capital governments will require them to have.

“Bank lending is going to pick up all by itself as banks go looking for ways to add more juice to their earnings profile,” said Soss, who used to work as an aide to former Fed Chairman Paul Volcker. Soss said he forecasts 3.5 percent economic growth in 2010, on the high end of analyst projections.

The 24-company KBW Bank Index rallied 69 percent from March 31 through yesterday as concern faded that lenders might not survive the economic slump.

‘Creditworthy’ Borrowers

Even as banks hold back, Fed policy makers have been trying to encourage borrowing to stoke an economic recovery. The Fed and other U.S. regulators told banks in November to maintain lending to “creditworthy” borrowers while warning against paying dividends that would cut funds available for loans.

In March, the Fed started an emergency program, the Term Asset-Backed Securities Loan Facility, to restart the loan- securitization markets that help form the so-called “shadow banking” system. That has helped generate investor demand for debt tied to auto and credit-card loans, unfreezing part of the credit markets.

“The question for the Fed, which is a very difficult question, is: what is the appropriate level of bank lending?” said Joseph Mason, a Louisiana State University banking professor and former economist at the Office of the Comptroller of the Currency. “It’s not bubble lending, it’s some subset of that. That is where the art of central banking lies.”

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net.