Hilsenrath on Fed and Commercial Real Estate Bubble

December 12th, 2015 7:37 am | by John Jansen |

Via the WSJ:
By Jon Hilsenrath and
David Harrison
Updated Dec. 11, 2015 8:56 p.m. ET

Federal Reserve officials participating in a “war game” exercise this year came to a disturbing conclusion: Six years after the financial crisis ended, the central bank remained ill-equipped to quell the kind of dangerous asset bubbles that destabilized the savings-and-loan industry during the late 1980s, tech stocks in the 1990s and housing in the mid-2000s.

The five officials—gathered at a conference table in Charlotte, N. C.—had to determine if hypothetical booms in commercial real estate and corporate borrowing risked collapse and damaging fallout for the broader economy.

The group was asked what to do about it. Fed officials said afterward they saw they lacked clear-cut tools or a proper road map of regulatory measures to help stem the simulated booms. They also disagreed on whether to use higher interest rates to stop bubbles, a blunt instrument affecting the entire economy.

“I walked away more sure about the discomfort I originally had,” said Esther George, president of the Federal Reserve Bank of Kansas City and a participant in the June exercise. She and others believe the Fed’s low-rate policies might have played a role in booming asset prices.

The worry has turned more concrete. Commercial real-estate prices are soaring and Fed officials face the conundrum of what, if anything, to do.

“Signs of valuation pressures are emerging in commercial real-estate markets, where prices have been rising at a solid clip and lending standards have deteriorated, although debt growth has not yet accelerated notably,” Stanley Fischer, vice chairman of the Fed, said in a speech Thursday.

Central bank officials would feel an urgency to act only if they believed the commercial real-estate market could suffer a sharp reversal that destabilizes the financial system or hurts the U.S. economy. That isn’t clear. Commercial real estate is a relatively small segment of the overall economy, and unsustainable debt hasn’t emerged as a problem.

But financial bubbles have been root causes of the past three recessions and is a consideration as the Fed nears a decision on interest rates. Officials have signaled they will raise short-term interest rates from near zero at their policy meeting next week with the economy and job market improving. For some officials, the commercial real estate boom—and other financial sector froth—could be an added incentive.

“It is certainly one of the things that I am considering,” said Eric Rosengren, president of the Boston Fed, in an interview last month.

Mr. Rosengren arranged the war-game exercise, joined by New York Fed President William Dudley, Cleveland Fed President Loretta Mester and Minneapolis Fed President Narayana Kocherlakota and Ms. George. Some of them, including Ms. George, said rates weren’t the right instrument to use against bubbles. She favored demanding banks hold more capital.

Mr. Rosengren had noticed more building cranes in Boston. It conjured memories of the New England real estate boom in the late 1980s, which led to a regional banking crisis that played a role in the U.S. recession that followed.

“Given our low interest rates, given that it is an interest-sensitive sector, it is probably worthwhile to start thinking about at what point do we become concerned that is growing too rapidly,” he said. “And if it were to reverse course at some point in the future what would be the consequences of that?”

The Fed’s low interest-rate policies have helped drive investors into such assets as commercial real estate as they search for higher returns.

“I don’t think there is an imminent threat,” Ms. Mester said in an interview last month. “But I want to keep looking at it.”

Demand for giant tower cranes leased from Morrow Equipment Co. of Salem, Ore., has grown to nearly 500 from less than 200 after the financial crisis, said Peter Juhren, the company’s vice president of operations. His best markets, he said, are New York, Miami, Seattle, San Francisco and Los Angeles.

Overall U.S. spending by businesses on new buildings is modest, at an annual pace of $456.7 billion in the third quarter, compared with more than $500 billion during the previous boom, the Commerce Department said.

But U.S. commercial real-estate prices are up 93% from a low in 2010 and 16% above the previous peak in 2007, according to Moody’s Investors Service. Among the hottest properties are apartment buildings, which have more than doubled in price since their November 2009 low and are 34% above their 2007 peak.

“In the back of your mind you’re asking yourself, ‘How far and how fast can I go?’” said Dan Lofgren, president of the Utah-based real-estate development firm called Cowboy Partners, which is building a 176-unit residential project in downtown Salt Lake City, another market dotted with building cranes.

Such rapid price increases sometimes signal trouble. Another important measure is how investors and buyers use debt. Booms fueled by heavy borrowing can backfire on investors and their lenders.

Bank commercial real-estate loan portfolios are up 10% from a year earlier to $1.76 trillion in late November, a record high, according to Fed data. Nearly two-thirds of these loans are on the books of smaller banks, Fed data show, and foreign banks hold a growing proportion. Private-equity funds and real-estate investment trusts also have jumped in the game, reaching for high-yield returns.

Despite the action in commercial real estate, debt levels across the broader financial system are still modest. Overall U.S. financial sector debt— $15.2 trillion in the second quarter—was down 16% from the third quarter of 2008. Financial sector debt has fallen to 84% of economic output from 125%, a sign the economy is less prone to a financial crisis on the scale of 2008.

“Our quantitative measures indicate a subdued level of overall vulnerability in the U.S. financial system,” Fed economists said in an August research paper that sought to assess risks of banks and markets overheating.

A boom that also surfaced in junk bonds now shows signs of fizzling. Outstanding debt in that market has grown to more than $1.2 trillion from less than $700 billion in 2007. But junk bond prices are now tumbling, while borrowing costs and defaults on this debt rise.

Not every sharp increase in asset prices ends in recession. Iowa farmland prices rose 28% between the fourth quarter of 2010 and the fourth quarter of 2011, igniting fears of a dangerous bubble. That boom has since faded.

Other countries emerged from the financial crisis with powers that made it easier for their central banks to battle bubbles using regulatory measures. The U.K.’s Bank of England, for example, has a Financial Policy Committee with the power to set minimum requirements on bank loan down payments.

Even though many Fed officials favor using regulatory powers over interest rates to stop bubbles, the U.S. was a “long way” from establishing a regulatory system that could achieve that, Mr. Dudley said in September.

U.S. regulatory powers after the 2010 Dodd-Frank overhaul law remain dispersed in Washington, Mr. Rosengren said, making them slow-moving and subject to disagreements. For instance, Fannie Mae and Freddie Mac are big players in commercial real estate debt but aren’t regulated by the Fed.

“These tools are not things you just pull off the shelf and say, ‘Now I’m going to use them,’” Ms. George said. “They tend to be things that require policy analysis, discussion with other agencies or politicians even. By the time you identify the issue you are already too late in many respects.”

—Peter Grant contributed to this article.

Write to Jon Hilsenrath at jon.hilsenrath@wsj.com and David Harrison at david.harrison@wsj.com

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