Fed's worry on optimism

Doug Henwood dhenwood at panix.com
Sun Jul 5 08:34:51 PDT 1998

The Federal Reserve's letter to banks warning about loose credit standards - described in all the press accounts as "unusual" - is available in an obscure corner of their web site at <http://www.bog.frb.fed.us:80/boarddocs/SRLETTERS/1998/SR9818.HTM>. It makes interesting reading in these giddy times.

A few excerpts:

<quote> Since there is no indication that these competitive pressures to ease terms are subsiding, supervisory experience strongly suggests that this is a critical time for banks to maintain their lending discipline, and indeed to continue to enhance their controls and practices where they can. [that sentence in italics] In particular, institutions should not rely unduly on the benign experiences of the past several years in assessing the underlying risks of current and future borrowers. [...] The attached supervisory staff report notes that formal projections of a borrower's future performance were present in only 20 to 30 percent of the loan approval documents reviewed, and that formal analysis of alternative or "downside" scenarios was even less common. [...] After several years of favorable economic conditions, banks should guard against complacency and, in particular, the temptation to base expectations of a borrower's future financial performance almost exclusively on that borrower's recent performance. [...] Many recent reports about the degree of easing prominently cite significant decreases in loan spreads, and the findings of the Loan Quality Assessment Project are consistent with these reports....[B]anks should incorporate into the pricing decision the appropriate risk of loss on the loans being considered. [...] Several of the institutions reviewed as part of the Loan Quality Assessment Project had experienced rapid growth in exposure to real estate investment trusts over the past year, with the growth in each case amounting to hundreds of millions of dollars. These loans are typically large, syndicated, and unsecured. Although bankers and others have emphasized that REITs currently have strong equity positions and a ready ability to raise funds in public financial markets, loans to REITs remain fundamentally a form of real estate exposure. Therefore, lenders should consider the ability of REIT borrowers to maintain their financial strength and liquidity in the event of a widespread downturn in commercial property markets. Acquisitions of new properties by REITs have been cited as an important force in escalating commercial property values, which in turn tends to increase the net worth of the REITs themselves.

To this point, there appear to be no substantial safety and soundness issues with regard to loans currently being extended to REITs. Nonetheless, they have become an important concentration of credit risk at some banking organizations. In this setting, examiners should remain informed about developments in a banking organization's loans to REITs and, in particular, should note the degree to which its REIT loans are contributing to a material concentration of credit risk within the loan portfolio. <endquote>

The letter, from Richard Spillenkothen, director of banking supervision, goes on to remind bankers that they should have formal credit guidelines (incudling projections of risk in an economic downturn), written loan approval documents, review of lending decisions by senior managers, and good information systems about borrowers. You'd think that these were pretty basic banking practices, but apparently they've been forgotten.

In her column in today's New York Times, Gretchen Morgenson writes:


Singling out REITs, [banking analyst Charles] Peabody said, may be a concession to Fed members worried that rocketing real estate prices are one of the wealth effects of an overheated stock market. He thinks a schism may be developing inside the Fed.

In May's Open Market Committee meeting, William Poole, president of the St. Louis Fed, and Jerry Jordan, president of the Cleveland bank, dissented from the decision to leave interest rates unchanged. Arguing for a tighter monetary policy, Jordan cited asset price inflation as a main concern.

Peabody finds this intriguing, because schisms within the Fed are unusual. There was a similar divergence on policy between regional Fed banks and their Washington counterparts in 1928. The regional members wanted to raise rates, Washington did not.

The split made headlines in March 1929, giving a jolt to stock prices. They recovered, but what happened later that year is, as they say, history. <endquote>

Last week, the Bundesbank worried that European stock markets are dangerously overheated, too. Interesting.


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