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Stein's Credit Bubble May Trump Bernanke Taper Talk Friday

NEW YORK (TheStreet) - Treasury and mortgage yields have surged in the past week on speculation recent comments by Federal Reserve chairman Ben Bernanke about the U.S. economy indicate an end to the central bank's easing policies. An alternate explanation, however, is that the Fed's communications sought to cool an overheating in credit markets amid its bond buying efforts, which could have undermined financial stability.

There is reason to believe Bernanke's signaling of a so-called 'taper' to the Fed's $85 billion a month in mortgage and long-term Treasury bond purchases was intended to smoke out aggressive behavior among financial institutions, most notably the nation's largest commercial banks.

Investors would be wise to listen to Friday comments on monetary policy from Fed Governor Jeremy C. Stein, who has recently spoken in detail about how the central bank may look use its regulatory and monetary purview to prevent threats to the financial system.

In February, Stein detailed his view of the Fed's policy options if, at a time of historic monetary expansion, it perceived that efforts to support asset prices were causing systemically important banks to chase risk in a manner that would undermine the central bank's post-crisis efforts to repair Wall Street.

While the Fed has taken on a far wider regulatory authority under the 2010 Dodd Frank Wall Street Reform and Consumer Protection Act, Stein argued the Fed could also use its monetary policy prevent dangerous behavior by banks.

"I can imagine situations where it might make sense to enlist monetary policy tools in the pursuit of financial stability," Stein said in February. He argued the Fed's regulatory authority might be insufficient in preventing firms from reaching too far for yield and that the central bank's regulatory powers might not impact all markets given a dramatic expansion of its policy toolkit since the crisis. Monetary policy, on the other hand, might be more effective.

In his speech, Stein mentioned junk bonds used to finance leveraged buyouts, bond exchange traded funds (ETFs), agency real estate investment trusts (REITs) and the available for sale (AFS) holdings of large banks as some areas where systemic asset bubbles could form outside the Fed's regulatory power.

Last year broke new records in junk debt issuance as ratings agencies such as Moody's noted a degradation in bond covenants. Leverage, meanwhile, has increased meaningfully in private equity buyouts in recent quarters.

Banks such as Wells Fargo (WFC), JPMorgan (JPM), Citigroup (C) and Bank of America (BAC) have grown their assets in the past year through increases in AFS holdings, predominantly purchases of treasuries, agency and non-agency mortgage bundles, municipal bonds and other asset-backed securities.

The bond ETF and mortgage REIT sectors have taken in large amounts of new assets and multiplied in size since the financial crisis.

Seeing this aggressive behavior in the less-heralded parts of the debt markets, the Fed may have decided to create a bit of uncertainty about its policy action, causing markets to react. Stein's February comments indicate the Fed could even change the nature of its bond buying to cool asset bubbles.

Changes to the Fed's balance sheet and the impact such moves have on the yield curve, Stein noted, could "complement" the central bank's post-crisis efforts to promote financial stability.

"Waiting for decisive proof of market overheating may amount to an implicit policy of inaction... Indeed, in some cases, it may be that the only away to achieve a meaningfully macroprudential approach to financial stability is by allowing for some greater overlap in the goals of monetary policy and regulation," Stein said, in conclusion to his February speech.

Stein will be speaking at the Council of Foreign Relations on Friday about the Fed's monetary policy.

Any elaboration of his February discussion might give new insight to markets about the Fed's intent in its recent twist in communication.

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