Fed Makes Monitoring Capital Foremost Concern Amid Bubble Talk

By Craig Torres and Michael McKee

Nov. 20 (Bloomberg) -- Federal Reserve officials are stepping up scrutiny of the biggest U.S. banks to ensure the lenders can withstand a reversal of soaring global-asset prices, according to people with knowledge of the matter.

Supervisors are examining whether banks such as JPMorgan Chase & Co., Morgan Stanley and Goldman Sachs Group Inc. have enough capital for the risks they take, how much they know about the strength of their counterparties and whether risk managers have authority to influence bank practices and policies.

Lawmakers led by Senator Christopher Dodd have criticized the Fed for failing to prevent a decline in lending standards that contributed to the credit crisis.

The central bank’s monitoring takes on renewed urgency as Chairman Ben S. Bernanke’s pledge to keep the benchmark interest rate near zero for “an extended period” is helping to fuel a surge in assets. The MSCI AC World stock index is up 71 percent since hitting a recession low on March 9. Gold reached an all- time high of $1,145.50 an ounce Nov. 18.

The policy is raising the “systemic risk” of new asset bubbles, Bill Gross, who runs the world’s largest bond fund at Pacific Investment Management Co., said in a note posted on the Newport Beach, California-based company’s Web site yesterday. Finance officials in Asia say a bubble fueled by the Fed’s low rates has already arrived.

More taxpayer-funded bailouts following the rescues of insurer American International Group Inc. and Citigroup Inc., the third-largest U.S. bank by assets, would stoke public anger against the Fed as Congress debates whether to reduce its powers and independence. Andrew Stern, president of the Service Employees International Union, led a protest rally of 150 people outside of Goldman Sachs’ Washington office Nov. 16.

‘Massive’ Pressure

“The Fed staff has to be under a massive amount of pressure,” said Vincent Reinhart, a former director of the Fed’s Division of Monetary Affairs and now a resident scholar at the American Enterprise Institute in Washington. “They must have a sense of zero tolerance for failure.”

Banks might not like “leverage ratios or capital requirements, but they can be effective and protect against the really bad behavior,” he said.

Such controls are critical to economic recovery because they can help ensure that large banks aren’t hurt by swings in the capital markets. Banks are still clamping down on credit to consumers and businesses, even though gross domestic product expanded at a 3.5 percent annual pace in the third quarter after a yearlong contraction.

Falling Loans

Total loan originations in September at Bank of America Corp., the largest U.S. bank by assets, fell 6 percent to $53.6 billon from a month earlier, according to a Treasury Department report this week. The cause of the decline was “decreased demand for loans in the weak economy as companies and individuals look to reduce debt,” said Scott Silvestri, a spokesman for the Charlotte, North Carolina-based company.

New loans at Wells Fargo & Co., the nation’s fourth-biggest lender by assets, dropped 14 percent to $47.4 billion. Mary Eshet, a spokeswoman for the San Francisco bank, didn’t immediately respond to calls for comment.

Taxpayers shored up the financial system with the $700 billion Troubled Asset Relief Program. Another round of bailouts would likely stir up more congressional ire.

“My constituents, they’re not just anxious, they are mad,” Representative Michael Burgess, a Republican from Ft. Worth, Texas, told Treasury Secretary Timothy Geithner at a hearing of the Joint Economic Committee yesterday.

Capital Injections

Under the TARP’s capital-purchase program, the Treasury injected about $205 billion into more than 600 financial institutions of all sizes as of Nov. 13, according to department figures.

John Mack, chief executive officer of Morgan Stanley, said banks’ behavior justified a Fed crackdown.

“We cannot control ourselves,” he said yesterday at a panel discussion hosted by Bloomberg News and Vanity Fair at Bloomberg LP’S headquarters in New York. “You have to step in and control the Street.”

The Fed is already under pressure from Dodd, chairman of the Senate Banking Committee, who proposed legislation Nov. 10 to strip the central bank of its supervisory authority. The Connecticut Democrat’s move strikes at the core of efforts by Bernanke, 55, and Governor Daniel Tarullo, 57, to overhaul Fed supervision and increase monitoring of risks to the financial system.

Tarullo, President Barack Obama’s first appointee to the central bank, is making greater use of so-called horizontal reviews that compare several banks’ exposures and practices.

Running Scenarios

He is also drawing more on the Fed’s staff of 220 Ph.D. economists to help identify risks. The Fed is now more likely to pull in the economists to run scenarios on what would happen to bank profits if global markets plunged, especially if the central bank’s exams turn up concentrations of risk throughout the financial system.

The Fed is also studying how well banks match funding with the maturity of their assets and how the lenders’ risk managers interact with their trading and loan operations, according to the people familiar with the program.

Fed spokeswoman Barbara Hagenbaugh declined to comment.

The close attention to banks’ capital adequacy started in July when the Fed began applying some of the lessons it learned from stress tests conducted in May. Those tests showed how the 19 largest lenders would fare in a slower recovery with higher- than-forecast unemployment. Ten companies including Bank of America, Wells Fargo and Citigroup needed additional capital.

Abrupt Turns

Assuring that institutions are strong enough to weather an abrupt turn in asset prices “is critical,” said Deborah Bailey, deputy director of supervision at the Fed’s Board of Governors until June, when she joined Deloitte & Touche LLP in New York as a director. “The Fed is committed to try and get it right.”

The central bank has been Morgan Stanley’s primary regulator since September 2008, when it became a bank-holding company to gain access to Fed funding after Lehman Brothers Holdings Inc. collapsed.

“We have probably 15 to 20 Fed regulators in our building 24 hours a day,” Mack said. “They test our models. They question everything we do. I’ve never been regulated like that before. It’s a different environment. Someone said to me, ‘What do you think of it?’ I love it.”

Some officials in Asia are questioning whether regulation alone is enough, suggesting the Fed’s record-low federal funds rate -- the central bank’s interest-rate target for overnight loans between banks -- is pushing asset prices in their region too high. Liu Mingkang, chairman of the China Banking Regulatory Commission, warned Nov. 15 of “new, real and insurmountable risks to the recovery of the global economy.”

‘Financial Turmoil’

Continuing the zero-rate policy may lead emerging economies “to overheat and experience financial turmoil,” Bank of Japan Governor Masaaki Shirakawa said in Tokyo Nov. 16. The MSCI Asia Pacific index is up 66 percent since the March 9 low, and Asian countries from Singapore to South Korea are trying to rein in surging property prices.

The U.S. shouldn’t adjust monetary policy to account for rising Asian assets, Federal Reserve Bank of St. Louis President James Bullard said Nov. 18. “If there are problems in real- estate markets in Asia, it is not very practical to say you should raise interest rates in the U.S.,” he said.

U.S. investors are concerned, too. They would have to be “joking or smoking -- something” to think the Fed would raise rates with 15 million people out of work, Gross wrote in his note. Pimco had $940.4 billion in assets under management as of Sept. 30, according to its Web site.

Safe Investments

Nevertheless, yields on safe investments such as three- month Treasury bills -- which hit .005 yesterday -- are so low, money managers are increasing the risks they take, and “the legitimate question of the day is, ‘Is a zero-percent funds rate creating the next financial bubble, and if so, will the Fed and other central banks raise rates proactively, even in the face of double-digit unemployment?’” Gross said.

Central bankers are “carefully evaluating” the situation, Bernanke told the Economic Club of New York Nov. 16. “It’s not obvious to me, in any case, that there’s any large misalignments currently in the U.S. financial system.”

He said the “best approach here, if at all possible, is to use supervisory and regulatory methods to restrain undue risk- taking and to make sure the system is resilient in case an asset-price bubble bursts in the future.”

The Standard & Poor’s 500 Index is trading at its highest valuation in seven years after climbing 62 percent from a 12- year low in March. The index is valued at almost 22 times the reported operating profits of its companies, more than twice its price-earnings ratio on March 6.

Internet Bubble

The current ratio is still well below the 30.68 P/E reached the week of March 24, 2000, near the end of the Internet bubble. And as corporate earnings continue to rise, the estimated S&P P/E ratio based on analysts’ forecasts for future earnings falls to 17.35.

Profits at Wall Street banks surged in the third quarter as they risked more of their own capital. Goldman Sachs, which converted to a bank-holding company to get Fed backing during the crisis, said Oct. 15 that profit more than tripled to $3.19 billion from a year earlier on trading gains and investments with the firm’s own money.

Morgan Stanley reported profit of $757 million on Oct. 21, its first in a year, as trading revenue rose to the highest level in 12 months. Earnings for JPMorgan Chase, the second- biggest U.S. bank by assets, were $3.59 billion, the highest since the 2007 collapse of the subprime-mortgage market, as investment-banking revenue helped it overcome losses on consumer loans.

Too Reliant

Fed officials are watching to see if financial companies may become too reliant on short-term funding the longer rates remain at record lows, according to the people familiar with the process. The central bank won’t raise its benchmark until August 2010, according to the median estimate of 45 economists surveyed by Bloomberg.

Former Fed Chairman Alan Greenspan telegraphed increases in his 2004-2005 tightening cycle with a phrase in the Fed statement that said “policy accommodation can be removed at a pace that is likely to be measured.” When asked if investors should be prepared for the possibility of more-abrupt action this time, Charles Plosser, president of the Philadelphia Fed said yes.

“There are states of the world and conditions that could arise where we may have to raise rates a lot faster than the last cycle,” he said in an interview. “I am not saying that will be the case. I am just saying we just have to make the markets understand that we will do that if it is required.”

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.netMichael McKee in New York at mmckee@bloomberg.net