THE FED OFFICIALLY KICKS OFF THE NEXT RECESSION
by Robert McHugh, Ph.D.
March 11, 2006
It is official. A recession is coming. How do I know? Because this week new Fed Chairman Ben Bernanke gave an official warning to bankers about commercial real estate loans. That is always the kickoff to a recession. It is the starter’s gun, the national anthem before a ballgame, the opening hymn at a church service. Here is how it works. The Fed has three official tools to control the money supply: Setting reserve requirements (telling banks how much of their deposits they cannot lend. The higher the reserve requirements, the less loans, the less money creation by the economy). The second tool is open market operations. Here they set the amount of money in the system by buying or selling securities. Third is setting the discount rate, the rate of interest banks must pay to borrow money at the Fed. Theoretically, the higher the rate, the less money banks will borrow, the less they have to lend, and the less money that is created by the banking system.
However, there is a fourth tool, a stealth tool, which has more power and impact than the other three. It is called the Federal Reserve Bank examiner. He/she is the person who goes into a bank about once a year and decides which loans are good and which are bad. Based upon their holy edict, a loan is classified in one of several categories which determines how much money the banks must set aside from earnings to reserve for possible losses. It is completely an estimation game. So the rules can and do change, based upon the whims of the examiner, taking his marching orders from the Fed Chairman. If the Fed wants the money supply to expand, then Fed examiners come in with reasonable standards for review of loans, and classify those loans with a general leaning that they will be repaid according to terms. Thus banks do not have to reserve as much for possible estimated losses and are in effect not discouraged from making more loans. When the Fed wants money supply to grow, aggressive lending standards often get passing grades. That’s when you business people will see your friendly bank commercial lender more often, jawing you into that expansion project you’ve been thinking about, inviting you to golf outings and ball games. They want more loans. They need your expansion project.
However, once the Fed Chair sounds the alarm about commercial real estate loans, it starts an entire chain of events that ultimately and unequivocally leads to economic recession. Here’s what happens. Out of the blue (that seems to be a favorite modus operandi for all Fed operations) those friendly back-slapping Federal Reserve examiners (not really, they are never overly nice — okay I’ve met two or three out of a pool of three hundred — Mike, Eddie, Eric, you know who you are and I know you read my stuff) show up with a scowl that droops like the golden arch. They ask for the files, a table, an outlet, a coffee pot, and the key to the little boys and girls room. About two days after they arrive, the banker knows something has changed, something serious, and he gets this knot in the pit of his stomach that will last for about three years. Examiner Margo asks for a meeting with banker Joe. She brings her supervisor to raise the fear level of the meeting. The Bank’s President, Joe, brings his top commercial lender for protection of his fanny, and that lender brings his junior lender who will ultimately be the sacrificial lamb and get the ax should things blow up.
