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Bernanke on Subprime: Watch What I Do, Not What I Say
April 3, 2007

Bernanke on Subprime: Watch What I Do, Not What I Say

The event on subprime lending put on last week by the DC Chapter of PRMIA and the American Enterprise Institute drew almost 200 people. Many thanks to all who participated. The general tone of the discussion was bearish regarding the outlook for the housing market and the impact of a deflating real estate bubble on the US economy.

In our comments, we focused on how extraordinarily low the credit default experience has been for different types of banks: commercial lenders, mortgage lenders and subprime lenders. We predicted that the default experience of most US banks would rise sharply in the next 12-18 months and possibly test the peaks of the 1991 period. We noted in particular that the extremely-low default rates of the larger mortgage and commercial lenders may be red flags for future credit quality.

Click here to read our presentation at the PRMIA/AEI event, "Mortgage Credit and Subprime Lending: Implications of a Deflating Bubble"

One highlight of the program was Nouriel Roubini of NYU, who continued to sound a warning about sharply lower economic activity as a result of a generalized the slowdown in housing sales, construction and related sectors. Nouriel's been dead on target about the negative trends in the mortgage sector and caught a good bit of "early bird" scorn and ridicule from Sell and Buy Siders, who did not want to see the party end.

But now Roubini is clearly enjoying being right. He gave a very concise, point-by-point rebuttal of Fed chief Ben Bernanke's "everything is alright view." In fact, he did so just hours after Chairman Bernanke told the Congress that the festering asset quality problems so apparent in the subprime mortgage lending sector would not spread to other types of lending and securitization.

The image of Bernanke reassuring members of Congress that the subprime virus won't spread reminds us of a bad science fiction movie, something like Resident Evil where authorities initially deny that a problem is escalating out of control, but then the secret virus kills everyone on earth. While it may be difficult to confuse Chairman Bernanke with zombie slayer Milla Jovovich, there is no mistaking the rising tide of regulatory signals and very real activity coming from Washington to head off systemic problems in the banking sector.

For over a year, we have been getting reports from former auditors and federal bank regulators about quiet appeals emanating from Washington asking them to come out of retirement. Why lure a retired bank examiner with 25 years bank audit experience back into service? To consult for small and medium size institutions facing internal controls problems. One case involved a community bank newly involved in C&I; lending. Another involves a regional bank with a case of toxic derivatives poisoning. But all of these triage samples involved one common malady: financial innovation.

More recently, subscribers to www.fbo.gov have witnessed a flurry of proposals to enhance the flow of data and other resources available to federal bank examiners. In at least one case in 2007, a request for proposal came out of the Treasury that was intentionally structured to attract former regulators in a consulting capacity to act as advisors to their former colleagues. The new regulatory advisories regarding exotic mortgages, etc., fall into this category as well.

Last week, we even heard reports from several quarters that the RFP for the proposed modernization of the Shared National Credits survey is likely to be released before June. Now some three years since regulators published a proposal for public comment in the Federal Register to standardize and expand the data collected from regulated institutions, Shared National Credit or "SNC" is expected to be expanded to cover securitized loans, derivatives and counterparty risk reporting.

As we wrote in GARP Risk Review in December, moving forward with the SNC proposal has been delayed for years because of the monumental disaster regarding the implementation of Basel II, an ongoing train wreck that more than one senior financial regulator has ridiculed publicly, this even as the deadline for comments passed last week. How departing Governor Susan Schmid Bies, who is responsible for shaping the final Basel II proposal, can wax eloquent in the financial media about her accomplishments at the Fed is beyond us.

The good news is that events in the credit markets are, as we predicted some months ago, pushing theoretical musings about capital adequacy a la Basel II into the background. With credit conditions softening and the markets clearly jittery about liquidity problems regarding whole loans and collateralized debt obligations or CDOs, small surprise that the SNC program has suddenly risen from the dead. Indeed, if the proposed rule implementing SNC is published later this year, a rising tide of concern regarding the safety and soundness of banks may help to make the new reporting regime even tougher than anticipated.

One measure of the level of anxiety surrounding the rapid completion of the SNC project is the apparent decision not to employ eXtensible Business Reporting Language or XBRL in the first implementation of the new reporting regime. Sources close to the matter say that the decision was made to exclude XBRL in the SNC data gathering design in order to ensure that the project is completed "on time" once the government selects a vendor to perform the task.

With members of both major political parties in the Congress talking openly about lenders offering forbearance to subprime borrowers, those of us who've already seen this movie wonder how far Washington will go in socializing the losses from the mortgage market debacle. If the magnitude of the crisis is severe enough to challenge the bank loan default rates of the early 1990s, it is possible that the Congress will be tempted to legislate forbearance, perhaps forcing the GSEs to purchase the delinquent paper from private banks and investors.

The growing hum of activity in Washington surrounding the provision of enhanced bank supervisory resources and risk reporting generally should gradually make clear that everything is not really alright in the banking sector. Between now and when the markets generally understand this fact, Fed Chairman Ben Bernanke needs to write a new, somewhat more compelling series of responses for that next set of questions about the burgeoning crisis in US asset quality.

Questions? Comments? [email protected]

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