Fed Resists Controls on Junk Bonds : Martin Sees Need to Monitor Investments in Them by Thrifts

The vice chairman of the Federal Reserve Board, testifying on the use of high-yield “junk bonds” to finance corporate takeovers, told a House subcommittee Friday that the nation’s central bank “does not believe that arbitrary controls on the use of credit can be desirable or effective.”

But the official, Preston Martin, also conceded that the practice of thrift institutions investing in such high-risk securities should be monitored carefully.

“Government is obliged to do what it can to ensure that certain kinds of risk taking do not jeopardize the stability of our financial system,” he said.

At the same time, Edwin J. Gray, chairman of the Federal Home Loan Bank Board, told the House banking subcommittee on domestic monetary policy that his agency, which regulates most savings and loans, is “gravely concerned” that savings institutions insured by the Federal Savings and Loan Insurance Corp. have, in some cases, invested excessively in these “below-investment-grade bonds issued to finance takeovers.”

This practice, he said, “would in effect provide a federal subsidy and implicate the . . . full faith and credit of the United States” to support such activity.

Despite the rapid growth in high-yield, low-grade bonds since banking deregulation began in the late 1970s, total holdings of so-called junk bonds by savings institutions is only $3 billion to $5 billion, Gray said. Of that amount, however, “a large percentage of these holdings appears to be in a very small number of institutions,” he said.

Martin noted that federally chartered banks are prohibited from investing in bonds rated below investment grade, while many state-chartered institutions are under no such restriction.

Some states, including California, in recent years have given thrift institutions wide authority to make commercial loans or to invest in corporate securities--far beyond the scope for such investment permitted for federally chartered thrifts.

Martin made clear, however, that, from the Fed’s perspective, this move by some thrifts into high-risk investments is something to watch closely but not necessarily to regulate at this point.

Total debt increased a scant 1% to 1.5% despite the heavy volume of debt-financed corporate mergers last year, he said, and these transactions had a nearly imperceptible effect on the components by which the Fed measures the nation’s money supply.

Moreover, he said, “approximately two-thirds of the large-merger bank loans extended in 1984 have been repaid.” He noted that the Fed last June issued specific guidelines for bank examiners at the 12 district Federal Reserve banks for use in “evaluating loans for financing leveraged buy-outs and for assessing the total exposure of a bank to such lending.”

“To date, we have seen no evidence indicating that the credit extended to finance mergers and leveraged buy-outs has resulted in significant problems for the surviving firms or the financial institutions that have extended credit to them,” Martin said.

Accordingly, “the Federal Reserve Board does not believe that arbitrary controls on the use of credit can be desirable or effective,” he concluded.

But from the FHLBB’s perspective, a problem exists over extending the ability of the FSLIC to underwrite such risky investments. Gray reminded the subcommittee that the board in March had proposed legislation to permit the FSLIC to charge higher premiums to institutions undertaking high-risk enterprises.

“Financial gains are potentially enormous for stockholders and managers if an insured institution takes a big gamble and wins,” Gray said. “But a federal agency like the insurance corporation that the bank board heads ends up picking up most of the cost if the gamble turns out a loser.”

“The combination of an insurance system straitjacketed by a flat-rate premium system which cannot account for the magnitude . . . of risk to be incurred--and which requires FSLIC to shoulder a range of new risks, including investment in below-investment-grade bonds--is irrational,” he said.