Fed Issues More Warnings on Danger of High-Risk Company Debt
(Bloomberg) -- The Federal Reserve escalated its warnings about the perils of risky borrowing by businesses Monday, saying firms with the worst credit profiles are the ones taking on more and more debt. The Fed also left a question unanswered: Is it going to do anything about it?
The U.S. central bank’s latest financial stability report said leveraged-lending issuance grew 20 percent last year, and that protections included in loan documents to shield lenders from defaults are eroding. While the Fed board voted unanimously to approve the report, it didn’t indicate any course of action the governors might take to rein in the red-hot market.
Read More: Fed Warned on Lending Risks, But Companies Keep Adding Leverage
Lawmakers, International Monetary Fund officials and even former central bankers have increasingly questioned whether the Fed and other watchdogs are adequately worried about leveraged loans, which often underpin mergers and acquisitions involving highly indebted companies.
A particular concern is that businesses that employ thousands could face severe financial stress and, in some cases, insolvency in an economic downturn. One group that has frequently discussed the market and is arguably the best positioned to take action is the Financial Stability Oversight Council, a U.S. panel of regulators tasked with looking out for hazards.
“Making a recommendation to the FSOC that one of the regulators should do something is the right thing to do and hugely in the Fed’s interest as the lender of last resort,” Paul Tucker, the former deputy governor of the Bank of England who now chairs the private, non-partisan Systemic Risk Council, said in an interview.
In its Monday report, the Fed said that credit standards seem to have slipped since it issued its last financial stability analysis in November 2018. The central bank added that loans to firms with especially high debt now exceed earlier peaks in 2007 and 2014.
“The historically high level of business debt and the recent concentration of debt growth among the riskiest firms could pose a risk to those firms and, potentially, their creditors,” the Fed said.
Still, it noted that default rates have been low amid a booming U.S. economy. Fed officials also pointed out that the $1.2 trillion leveraged lending market is much smaller than the mortgage sector that nearly brought down the financial system in 2008.
Leveraged loans are routinely packaged into collateralized loan obligations, or CLOs. Investors in those securities -- including insurance companies and banks -- face a risk that strains in the underlying loans will deliver “unexpected losses,” the Fed said Monday, adding that the secondary market isn’t very liquid, “even in normal times.”
The Fed, highlighting another potential danger from the leveraged lending, said there is a risk that mutual funds that invest in bank loans and high-yield bonds could face a liquidity mismatch. Such a situation can occur when funds holding difficult-to-sell assets face a wave of requests from investors to pull their money.
However, the central bank said the market received a bit of a stress test during rising volatility in December. Funds experienced large outflows and bid-ask spreads widened. Still, “mutual funds were able to meet the higher levels of redemptions without severe dislocations to market functioning.”
Regulators have been talking about leveraged lending more and more since last year. Fed Chairman Jerome Powell even discussed the issue with top financial regulators at a May 2 meeting of the President’s Working Group on Financial Markets, said a person familiar with the matter.
But bank regulators -- including Powell -- have been careful to argue that the institutions they oversee don’t appear to be in danger. And the most significant action that financial agencies have taken encouraged the loosening of standards.
Last year, regulators appointed by President Donald Trump said they wouldn’t enforce industry guidance that advised banks not to issue loans that exceeded certain risk levels. The upshot: banks are now free to compete more directly with non-bank firms that have little government oversight and have underwritten some of the riskiest loans.
In Monday’s report, the central bank also said that assets at hedge funds and broker-dealers grew “at a rapid pace” over the past year. For banks, mutual funds and insurers it was a different story, with growth falling below longer-term average rates. Even though leverage at broker-dealers edged up since the Fed’s last financial stability report in November, it has remained near historically low levels, the central bank said.
The Fed started releasing its financial stability reports last year. Wall Street has looked to the documents for clues as to whether the central bank considers systemic vulnerabilities to be “meaningfully above normal.”
Such a scenario could trigger the so-called counter-cyclical capital buffer, which is meant to increase capital demands at big banks when a robust economy starts to exhibit warning signs. The Fed board opted against using the tool in March, though Governor Lael Brainard dissented from the decision.
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