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U.S. NEWS

Updated February 7, 2013, 8:44 p.m. ET

Fed's Stein Sees Risks for Credit Markets

By VICTORIA MCGRANE And JON HILSENRATH

ST. LOUISA Federal Reserve official pointed to signs of overheating in some corners of the credit markets and raised uncomfortable questions for the central bank about how to address the trend if it continues. Federal Reserve Board Governor Jeremy Stein said there isn't an imminent threat to the wider financial system, but highlighted several marketsincluding junk bonds, mortgage real-estate investment trusts and commercial banks' securities holdingsas areas where potentially troubling developments are emerging, possibly as a result of the Fed's easy-money policies. Mr. Stein spoke Thursday at a symposium at the Federal Reserve Bank of St. Louis. Mr. Stein's comments are significant because they are among the strongest from a Fed official about risks developing in bond markets in the presence of low interest rates and because he raises the prospect that the Fed might, down the road, need to use tighter credit policies to deal with it. Junk-bond issuance, for example, set a record in 2012. Mortgage REITs, investment vehicles that buy mortgagebacked securities, also are growing rapidly. The Fed has pushed short-term interest rates to near zero and promised to keep them there, in addition to launching

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bond-buying programs in a bid to ease the cost of credit and spur spending and investment. Mr. Stein's comments indicate that attention at the Fed is turning to the effect of these policies on credit markets. Tougher regulation is widely viewed within the central bank as the Fed's first line of defense against a bubble. But Mr. Stein hinted, without taking a firm position, that if overheating in these markets builds, then the Fed might need to tighten credit in response. "Despite much recent progress, supervisory and regulatory tools remain imperfect in their ability to promptly address many sorts of financial stability concerns," he said. Right now, the Fed is more focused on keeping credit easy to bring down unemployment. Mr. Stein noted that supervisory and regulatory tools might not be the best way to contain risk-taking behavior sometimes associated with low interest rates. For instance, risk-taking often happens in corners of the financial system that regulators can't study very well and don't have full authority to regulate, he said, noting "Monetary policy gets in all the cracks." Mr. Stein's comments are the latest indication of worry among Fed officials that their easy-money policies could be causing markets to overshoot. Such concerns could be a factor as they consider how long to continue bond-buying programs. Fed officials failed to appreciate the building risks in the financial system that eventually led to the 2008 crisis. Fed Chairman Ben Bernanke has restructured the Fed's bank supervision division in response, and created the Office of Financial Stability Policy and Research to lead the central bank's efforts to spot such threats. Mr. Stein said he sees "fairly significant" evidence of investors taking on more risk in corporate credit markets, pointing to data such as the record-high volume of so-called junk bonds, those issued by low-rated borrowers. Meanwhile, the mortgage REIT sectorin which lightly regulated firms buy mortgage-backed securities backed by government agencies and finance their purchases mostly with short-term loanshas more than doubled in two years to $398 billion in 2012 from $152 billion in 2010. Commercial banks, meanwhile, are investing in more and more longer-term securities, he said, seeking to generate income in the low-interest-rate environment. Holding more long-term securities makes banks vulnerable to volatility

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when interest rates rise. Wellington J. Denahan, chairman and chief executive of Annaly Capital Management, the nation's largest mortgage REIT, said through a spokesman that the sector isn't overheating. "Overall growth in the mortgage REIT sector has been driven by successful capital raising in the public equity markets," Ms. Denahan said, which has left these firms well capitalized. The sector's capital as a percentage of assets, at 14.3%, "compares favorably to the overall banking system's ratio of 9.3%," she said. Mr. Stein said while the individual examples he highlighted on their own wouldn't necessarily create a systemwide crisis, they could hint at broader problems that policy makers can't see. "We should be humble about our ability to see the whole picture, and should interpret those clues that we do see accordingly," he said. Asked if the 2008 financial crisis would have unfolded differently if the Fed had tightened credit during the preceding boom, Mr. Stein said there is no strong evidence that the housing bubble would have turned out differently if the Fed had raised interest rates. A version of this article appeared February 8, 2013, on page A2 in the U.S. edition of The Wall Street Journal, with the headline: Fed's Stein Sees Risks For Credit Markets.

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