The Fed Gets a Bubble Cop

Watch out, Wall Street. The Federal Reserve, a primary banking regulator, is trying harder to spot speculative excesses.

In a speech on Thursday, governor Jeremy C. Stein, who joined the Fed last year, focused on parts of the financial markets that show signs of overheating. He went into considerable detail, citing metrics that appear designed to spot bubbles. Specifically, Mr. Stein raised a red flag about junk bonds and mortgage-backed securities, and how investors are financing their purchases of such assets.

Wall Street has often been a facilitator of bubbles, and in their formation, financiers find plenty of seemingly sound justifications for strongly rising asset prices.

Of course, the Fed is against rampant speculation weakening the banks and distorting the wider economy. But central bank officials say they don’t want to take tough action like raising interest rates to stamp out speculation in specific asset classes, because such a response may unnecessarily cool large sectors o the real economy that aren’t frothy.

Testifying before the Financial Crisis Inquiry Commission in 2010, Fed Chairman Ben Bernanke explained why, in the middle of the last decade, the central bank didn’t raise interest rates to stifle what appeared to be an overheating housing market. “Monetary policy is a blunt tool,” he said. “Raising the general level of interest rates to manage a single asset price would undoubtedly have had large side effects on other assets and sectors of the economy.”

But that stance carries a big risk: What if the Fed fails to spot when localized speculation has tipped into something much more dangerous

Mr. Stein’s speech shows that the Fed wants to get better at making that distinction.

First, he says, after many months of ultra-low interest rates, there are signs of frothiness. He sees it especially in junk bonds and securities backed with mortgages.

Mr. Stein takes things a step further, though. He addresses those parts of the ma! rket infrastructure that could magnify the pain caused by a potential sell-off in such bonds. In particular, he focused on the link between short-term borrowing and bond purchases. Financial firms take out short-term loans and use that money to buy longer-term, higher-yielding assets.

But in jittery times, short-term loans stop becoming available. Investors then have to sell the longer-term assets financed with the short-term debt. On a broad scale, this can cause vicious declines in longer-term assets, and paralysis across the system if the selling turns into a panic. The Fed, therefore, has to make sure that investors aren’t using too much of this short-term debt.

Mr. Stein notes, approvingly, that Wall Street firms are using less short-term borrowing to finance their vast inventories of bonds. But he also recognizes that disorderly selling of bonds could come from another source, like exchange-traded funds. “If investors in these vehicles seek to withdraw at the first sign of trouble, the this demandable equity will have the same fire-sale-generating properties as short-term debt,” he said.

Mr. Stein singles out a sector that has recently grown a lot â€" the investment funds that buy government-backed mortgages. They use repo loans to finance their investments. As of the fall, these real-estate investment trusts, or REITs, had nearly $400 billion of assets, up from around $150 billion at the end of 2010, Mr. Stein said. If repo costs go up and the mortgage bonds fall in price, the funds could suffer.

However, industry analysts who cover such trusts aren’t worried. Even after their growth, the trusts represent only a small portion of the overall market for mortgage-backed bonds, says Bill Carcache, analyst at Nomura. He also says the trusts don’t use an excessive amount of borrowed money. “Leverage levels are very comfortable,” he said.

Mr. Stein then turned his gaze on commercial banks’ mortgage-bond holdings. The longer a bond’s maturity, or the amoun! t of time! investors have to wait to be fully paid off, the more sensitive it is to movements in interest rates. The Fed governor notes that the maturity of banks’ mortgage bonds is near historical highs. He warns, “The added interest rate exposure may itself be a meaningful source of risk for the banking sector and should be monitored carefully-especially since existing capital regulation does not explicitly address interest rate risk.”

But for all the forensics, Mr. Stein didn’t say whether there was frothiness in United States Treasuries. With its enormous bond buying programs, designed to whip up economic growth, the Fed has driven down the price of government bonds.

Critics say this is creating a bubble in Treasuries, which has to be serious because they make up such a large asset class. Skeptics add that all the big central banks are buying large amounts of government debt, encouraging unstable levels of government borrowing. This could harm the wider economy in the same was as excessive motgage debt did, they say.

One critic is Kevin Duffy, a portfolio manager at Bearing Asset Management, a hedge fund. In response to Mr. Stein’s speech, he asks, “Where is the mention of debt buildups at the government level that the central banks are enabling”