The Federal Reserve just released transcripts to all of its meetings from 2007, the year the U.S. housing market took a turn for the worse and the economy entered recession.
By the time the FOMC met in March, economic data had begun to weaken, and stocks and mortgage markets were starting to look shaky.
The president of the San Francisco Fed, Janet Yellen – now the Vice Chairman of the Federal Reserve and a possible candidate for the next chairmanship – relayed to the committee a story about the bubble brewing in private equity, and how it could lead to financial instability.
Below are Yellen's remarks:
Despite the recent turmoil in equity and mortgage markets, a reassessment of overall risk has yet to occur. We are still in an environment of low long-term yields, ample liquidity, and what appears to be a generally low level of compensation for risk.
For example, I recently talked with the principals of several major private-equity funds, who were not just amazed but also appalled about the amount of money their industry has attracted. [Laughter] One partner said that he would have no difficulty immediately raising $1 billion. Indeed, one of his biggest problems is would-be investors who get angry at him because he is unwilling to take their money.
This unwillingness reflects his difficulty in identifying deals that are likely to yield adequate returns even though, for the buyout firms, debt also is available in what they depict as very attractive so-called covenant-lite terms—perhaps too attractive given the vulnerability of some of the highly leveraged yields.
My contacts suggest that some private-equity firms with similar assessments of the shortage of profit opportunities are less restrained and do take additional money, partly because of the large upfront fees that are generated by these deals.
So just as we have seen in mortgage markets, the bubble in private equity, as my sources characterize it, and the overabundance of liquidity more generally raise the risk of a sharp retrenchment in credit and higher risk spreads with associated risks to economic growth and, conceivably, even financial stability.
Sure enough, a few months later, banks began taking big writedowns on credit investments and financing for private equity deals dried up, signaling a top in the market.
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