What the Fed Chairman Really Said

Some quick headlines after covering the Ben Bernanke testimony today before the Senate Banking committee with Fox Business’s Ray Hennessey, Cheryl Casone, Tom Sullivan, Dagen McDowell and Stuart Varney, here’s what caught our attention:

*The DJIA was down about 30 to 40 points, but then started selling off, down more than 150 points, after news crossed the wires that Bernanke said he expected more bank failures this year. But he was talking about smaller regionals, not the big banks.

"I expect there will be some failures," Bernanke told the Senate Banking Committee, notably smaller regional banks who became heavily invested in real estate. "Among the largest banks, the capital ratios remain good and I don't anticipate any serious problems of that sort among the large, internationally active banks that make up a very substantial part of our banking system.”

As our DC correspondent Adam Shapiro points out, there are 76 banks on the FDIC’s watch list, all small to mid-cap banks. Three banks failed last year. That’s no where near what the US economy saw after the S&L crisis of the late 80s early 90s. Back then between 1988 and 1992 the FDIC administered 1600 bank failures.

Key point here: Watch out for banks exposed to both construction loans coupled with regular mortgages, given the downturn and way too high housing inventory still out there. The number of banks where construction loans exceed total capital has risen from 1,179 institutions to 2,368 since 2003, according to the FDIC.

*The U.S. economy now faces headwinds from "a broader set of issues" worse than the popping of the dot.com and telecom bubble in 2000-2001, Bernanke said. Tougher now, because the US faces a "less advantageous" fiscal situation, due to the weaker dollar now at record lows against the euro (brought on by lower rates). Tougher too, because the government ran a surplus a few years ago, Bernanke noted.

*Bernanke sees downside risks to inflation and unemployment, but he doesn’t see ‘70s era stagflation. The economy has become more flexible having been deregulated since the ‘70s, when bureaucrats really ruled the day. Which is interesting given the clamor out of the House’s hearing with Bernanke yesterday, where Congressmen demanded much more mortgage lending regulation. The free market is fixing itself seemed to be the message—though now Freddie and Fannie, meaning taxpayers, will be taking on even more mortgage paper in the form of mortgage asset-backed securities (meaning the government, meaning taxpayers, given the two mortgage finance companies' implicit backing from the government).

*Pulling aside the curtain on record bank writedowns: Best exchange for me of the day was between Senator Charles Schumer (D-NY), who queried Bernanke on what’s creating massive bank writedowns, a heated debate roiling Wall Street now that is picking up steam.

This is a critical issue for the stock market. The mark to market rules are somewhat controversial, as they are being criticized for causing record bank writedowns, which lead to credit rating downgrades, capital squeezes, market caps cratering, and CEOs being shown the door.

What’s happening is, the housing crisis is unfolding in slow motion due to the nature of how slowly adjustable rate mortgages reset to higher rates.

At the same time, the banks have to try to price-tag securities backed by mortgages in a credit market that’s frozen solid, where they can’t sell the securities.

If those rules were in effect during the Latin American Crisis or the Asian flu, markets there would still be in the drink, as I’ve noted to you in prior blogs. Instead, banks used historical book values.

Wall Streeters are arguing that the losses from asset-backed securities are really just on paper, that some of these assets are still tossing off cash flow, and the banks expect to recoup at least some of these assets when the markets recover.

Schumer asked Bernanke whether auditors “should delay using mark-to-market accounting rules” when scrubbing the banks’ books and when valuing their asset-backed securities.

Bernanke seemed to really sit up and listen, it seemed he was energized by the question and had given it thought. Because it is another “conundrum,” as central bankers like to say.

Bernanke said no, that doing so would make it seem like the “banks were hiding something." Instead he deferred to the Financial Accounting Standards Board which sets the rules, but seemed to suggest it’s something that’s on his mind and worthy of future debate.