Fed chief edgy over subprime bust, flood of buyouts

Federal Reserve Chairman Ben Bernanke issued a double-barreled warning on the U.S. economy, saying the housing market will continue to struggle and the Fed sees "significant risks" in the leveraged-buyout boom.

Bernanke, speaking at a conference Thursday in Chicago, said curbs on subprime lending "are expected to be a source of some restraint on home purchases and residential investment in coming quarters."

And he said the Fed is "beginning to look at" what he called "the risks that are associated with working with private-equity firms."

The comments suggest the central bank has raised its guard against a second credit bubble emerging in the form of leveraged buyouts at a time when the economy is dealing with the mortgage bust.

Lawmakers and consumer advocates have blamed the Fed and other regulators for lax enforcement while lenders wrote a record $2.8 trillion in mortgages from 2004 to 2006.

"You learn from experience," said John Lonski, chief economist at Moody's Investors Service in New York. "The theme here would be whenever you have higher-risk borrowing accelerate considerably, the risks of unexpected-debt-repayment problems rise."

The Fed chief maintained his forecast that the slump in housing won't have a broader impact on the economy.

Fed officials this year have cited the housing recession as a main risk to economic growth, which last quarter was the weakest in four years.

Bernanke's comments reflect the consensus of policymakers that the downturn in housing is unlikely to cause consumers to cut spending.

He said banks are appropriately reducing credit to the market for securities backed by subprime mortgages.

"We are likely to see further increases in delinquencies and foreclosures this year and next as many adjustable-rate loans face interest-rate resets," Bernanke told the Chicago Fed Bank's conference on bank structure and competition.

Still, he said, "The vast majority of mortgages, including even subprime mortgages, continue to perform well."

His words about leveraged buyouts reflect the fact that takeovers have been soaring.

Leveraged-buyout firms are private investment companies that use debt to cover about two-thirds of the price of their takeovers.

The bonds and loans would be at risk if the acquired company runs into financial trouble and can't meet its obligations.

In some of the past year's biggest deals, including the takeover of TXU, banks made short-term investments alongside the buyers in a new type of financing called "equity bridges."

The claims of equity investors are behind those of lenders in case of bankruptcy.

Because of their size, private-equity firms "can push terms that are favorable for the borrower," said Martin Fridson, head of FridsonVision, a New York-based research firm. "There has been a lot of spread contraction, and the covenant terms have been under attack" on buyout loans, he said.

Fridson, a former Merrill Lynch managing director of high-yield research, consults with the Fed on finance and leverage.

Bernanke stressed Thursday the subprime-mortgage market is already showing "signs of self-correction" and that markets work better than regulators when it comes to allocating capital.

The Fed's Open Market Committee has kept its benchmark lending rate at 5.25 percent for seven consecutive meetings and this month reiterated that inflation is its "predominant" concern.

The Fed's preferred price gauge has stayed at the top or above the comfort range of at least a half-dozen policymakers for three years.

Bernanke's comments were echoed Thursday by his Fed predecessor, Alan Greenspan, who retired in January 2006.

"The prime market is doing reasonably well," said Greenspan at a meeting hosted by the Atlanta Journal-Constitution in Atlanta.

"Some people are holding off on purchasing homes. Even so, we are getting a gradual rise in the prime market," he said.

The Fed has a hearing scheduled June 14 to examine how it might use its authority to prevent abuses in the mortgage market.

Sen. Charles Schumer, D-N.Y., said Thursday, "It's good news that Chairman Bernanke and the Fed may finally be cracking down on abusive lending in the housing market later this summer."

"Regulators must walk a fine line" in using their authority to prevent abuses while avoiding actions that would close the market for borrowers, Bernanke said.

He hinted he favors more disclosure and supervisory guidance instead of more rules. "Effective disclosures should be the first line of defense against improper lending."