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Geithner Mum on Private Equity Leverage Ahead of Crisis

NEW YORK (TheStreet) -- Timothy Geithner wasn't worried about private equity bubbles during the private equity bubble of 2007.

In 2007, officials at the Federal Reserve called the private equity industry a "bubble," and the next shoe to drop as credit markets began to implode, but Geithner had little to say about the state of the buyout industry prior to the financial crisis.

Transcripts released by the Federal Reserve show that starting in early 2007, officials at the Fed expressed concerns about the size and leverage of private equity deals, and their potential impact on credit markets and the financial system.

While some at the Fed may have sounded alarm bells, a survey of transcripts conducted by TheStreet shows few direct references to the private equity industry from Geithner, who was president of the Federal Reserve Bank of New York and the vice chair of the central bank at the time.

"A very large amount of LBO financing that is yet to be closed, distributed, and placed is still working its way through the system. As in the past, we could see a deal or two get hung, the music stop, and that force some broader repricing. People get stuck with stuff they don't want to hold or did not expect to hold," Geithner said, according to a transcript of the Federal Open Market Committee's (FOMC) June 2007 meeting.

"For now I think it is a relatively healthy, still pretty modest, and quite contained shift toward a more cautious assessment of risk, but these things generally don't tend to unfold gradually," he added.

Geithner's comments, released on a five-year lag, provide an important insight into his thinking about the private equity industry as he prepares to join buyout giant Warburg Pincus as a president and managing director next year.

Those transcripts show that some of Geithner's peers at the Fed were far more vocal in expressing worries about the private equity industry.

"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," Janet Yellen, then the president of the Federal Reserve Bank of San Francisco, said in a March 2007 FOMC meeting.

"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," she added.

Yellen was recently appointed by President Barack Obama to succeed Ben Bernanke as chair of the Federal Reserve, a post she could assume in early 2014 if she is confirmed by the Senate.

Others at the Fed had similar reservations about the money rushing into the private equity industry.

Jeffrey Lacker, president of the Federal Reserve Bank of Richmond said at the FOMC's August 2007 meeting that leveraged private equity deals were among the factors driving a squeeze in credit markets.

At the time, banks were beginning to take leveraged structured investment vehicles of toxic assets onto their balance sheets causing overnight interest rates to surge. To quell a cash crunch, the Fed and other central banks injected emergency liquidity into the financial system.

"As far as we can tell at this point, the heightened turbulence of the past month is all pretty closely related to subprime and nontraditional mortgages and the leveraged financing of private equity buyouts in the corporate sector," Lacker said during the August 2007 FOMC meeting.

Lacker advocated that Fed express its perception of problems emerging in private equity markets in its release of FOMC meeting minutes to the public.

"I think that the minutes should acknowledge the problems in subprime and private equity markets, and I also think the minutes should educate financial markets that the mitigation of volatility in asset prices is not an FOMC objective," Lacker said. Minutes from the August 2007 Fed meeting did not explicitly mention the private equity industry.

At the September 2007 FOMC meeting, Richard Fisher, president of the Federal Reserve Bank of Dallas, characterized a slowing of private equity deals as a "relief" to businesses in his district, given irrational leverage and exuberant prices.

"One relief that's been provided here is that the private equity firms have been taken out so that bids of, say, seventeen times EBITDA, which is an actual case, with no due diligence, are no longer the case. Four of the companies I spoke with are now able to make strategic acquisitions, and they plan to proceed," Fisher said.

Just months earlier, TXU, now known as Energy Future Holdings, completed the largest private equity buyout in history, in a $45 billion deal that put the Dallas-based utility in the hands of PE giants KKR and Texas Pacific Group. The company is now fighting to stave off bankruptcy and service approximately $40 billion in outstanding debt.