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Bernanke may have to grow up fast
Stock market crash greeted Greenspan. Will housing, hedge fund, debt crisis test next Fed chief?
By Chris Isidore, CNNMoney.com senior writer

NEW YORK (CNNMoney.com) - Alan Greenspan was Fed chairman less than 10 weeks when he faced his first major test -- the stock market crash of 1987.

Hopefully, any test incoming Fed chairman Ben Bernanke faces this year will be less severe.

Federal Reserve Chairman nominee Ben Bernanke could be tested by a number of potential financial crisis early in his term.
Federal Reserve Chairman nominee Ben Bernanke could be tested by a number of potential financial crisis early in his term.
What crisis do you think Bernanke will most likely face?
  Housing bubble pops
  Hedge fund crisis
  China stops buying U.S. debt
  Drastically higher energy prices
  GM, Ford file for bankruptcy
  Too soon to tell
or View results

But economists say there are several issues looming that could pose their own challenges for the man slated to succeed Greenspan on Feb. 1.

How Bernanke responds to these or other unforeseen problems will tell a lot about how successful he is as the nation's top central banker. And while several Fed watchers say he's up to the task, even his fans admit they can't be sure until he faces -- and passes -- one of these tests.

"He doesn't have the wide range of experience Greenspan did going into the job, which has served Greenspan well," said Mark Zandi, chief economist for Economy.com.

"Greenspan had worked more in the private sector; he had contacts to call upon in a crisis," he added. Experience "is more of an open question than it was for Greenspan. But Bernanke is well respected and has stature and that counts for a lot."

Anthony Chan, senior economist for JPMorgan Asset Management, said that potential problems in the housing and energy markets, and with the nation's growing dependence on foreign capital, were unlikely to turn into full blown crises in 2006. And he added that Bernanke's ability to deal with them shouldn't be underestimated.

"It's going to take him a while to be Greenspan, but then again when Greenspan came in they said he's no Volcker," said Chan, referring to Greenspan's predecessor, Paul Volcker.

Here are some of the more pressing issues the new Fed chairman may have to deal with in 2006.

Pop goes the housing bubble?

There is little disagreement among economists, builders and real estate execs that the white hot housing market is going to slow in 2006.

The question is whether it is a gradual slowdown or a more drastic, broad-based decline that sends home prices tumbling, rather than stabilizing or dipping gradually.

If it's the former, there's probably little for Bernanke to worry about. But if the so-called housing bubble does pop, it has potential to hit not just home sellers and builders but also the nation's financial markets and the broader economy.

"I would attach a reasonably high probability that there will be a problem in the housing or finance markets that will test the next Fed chairman," said Zandi.

Another hedge fund crisis?

One of Greenspan's greatest tests came in 1998, when the Russian bond default led to the collapse of Long Term Capital Management.

Greenspan moved quickly, lining up major investment banks to ensure that the damage from the collapse did not tip the global economy into recession. Some point to it as the outgoing chairman's finest moment.

Today hedge funds, which use highly leveraged investments, are much bigger players in the financial markets than they were in 1998. Some are concerned that the largely unregulated entities could have another stumble, due to housing, or wild swings in commodity prices or other markets.

But other economists say that the growth of hedge funds actually makes a repeat of 1998's crisis less, not more likely.

"We have about 700 hedge funds file for bankruptcy every year. They're just not Long Term Capital Management's size," said Chan.

Will China keep the spigots turned on?

One thing that's helped keep long-term bond yields unexpectedly low and the U.S. economy growing is that other countries have kept buying our bonds, effectively financing the U.S. budget and trade deficits.

But with a congressional election year ahead and the growing trade gap with China becoming a more prominent issue, there's a chance Congress could pass proposed legislation to impose stiff penalties on Chinese imports unless it sharply raises the value of its currency, which is now pegged to the dollar.

If that happened, China could slow or halt its purchases of U.S. debt, or even sell some of the debt it now holds. And that could cause a crisis in world financial markets.

"If protectionist sentiment boils over, that could be a precipitating factor for the dollar," said Zandi. "In a dollar crash scenario, it puts the Fed in a particularly difficult spot. Do they tighten policy (raise interest rates) to attract global capital or do they loosen it to help support the economy?"

New energy woes

Long before Hurricane Katrina sent gasoline spiking to $3 a gallon, Greenspan was warning anyone who would listen about the threat to the U.S. economy from rising natural gas prices.

Unlike oil, relatively little natural gas can be imported from overseas. And while gasoline prices have retreated, higher natural gas and heating oil prices could bite during the current heating season, cutting consumer spending and slowing economic growth ahead.

With the Fed committed to fighting inflation, the risk of a new spike or even just high energy prices poses another difficult choice for the new chairman -- keep raising rates to keep prices in check, or hold or trim rates due to concerns about slower economic growth.

What if the wheels come off GM, Ford?

General Motors and Ford are more than the nation's two largest automakers. They are also the largest issuers of corporate debt, although much of that finances their relatively healthy credit units.

With both companies's debt already cut to junk bond status, credit-rating agency Standard & Poor's has gone on record as saying a bankruptcy at GM is "not far fetched," despite repeated denials by GM officials.

Ford is also losing money due to the uncompetitive labor and retiree benefits also dogging GM, and some believe it might be forced to also file for bankruptcy if GM used a filing to shed labor costs.

While GM is looking to sell a majority stake in its finance unit, GMAC, to return it to an investment grade credit rating, the problems at the automakers are something Bernanke will have to watch as closely as any auto worker or investor.

"A GM-Ford bond default seems unlikely given the cash they have on hand," said Zandi. "Even if GM and Ford went into bankruptcy, it wouldn't cause a recession unless it undermined financial markets and sparked a liquidity or credit crunch.

"But that's possible, and that's where Bernanke would come in. The last line of defense between a financial market crisis and a recession is the Fed." Top of page

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