Fed Chairman Jerome Powell (Photographer: T.J. Kirkpatrick/Bloomberg)

Risky Corporate Debt Is Worrying the Fed

(Bloomberg) -- The U.S. economy is showing some vulnerabilities as investors increasingly buy up risky corporate debt and businesses rely on “historically high” borrowing levels, the Federal Reserve said Wednesday in its first-ever financial stability report.

Should the economy turn, money managers who’ve been chasing returns might be in for a rude awakening, with prices for leveraged loans and junk bonds potentially causing some of the steepest losses, the U.S. central bank warned.

“High leverage has historically been linked to elevated financial distress and retrenchment by businesses in economic downturns,” the Fed said in a section of its report highlighting how indebted companies are borrowing even more money. “Such an increase in financial distress, should it transpire, could trigger a broad adjustment in prices of business debt.”

Risky Corporate Debt Is Worrying the Fed

The Fed also cautioned that escalating trade tensions could lead to a “particularly large” drop in asset prices because “valuations appear elevated relative to historical standards.” Equity prices, in particular, are “somewhat high” relative to corporate earnings forecasts.

Fed Chairman Jerome Powell reiterated the central bank’s concerns about corporate borrowing and deteriorating credit standards in a Wednesday speech. He added that he believes lenders would weather any widespread failures of debt-laden businesses, while investors in securitized loans might not be as lucky.

“The question for financial stability is whether elevated business bankruptcies and outsized losses would risk undermining” financial stability, Powell said at the Economic Club of New York. “For now, my view is that such losses are unlikely to pose a threat to the safety and soundness of the institutions at the core of the system, and instead, are likely to fall on investors.”

The news in the Fed report wasn’t all bad. The report, which the central bank intends to issue regularly, noted that Wall Street lenders are “strongly capitalized,” broker-dealers’ leverage is much lower than it was before the 2008 financial crisis and insurance companies are healthy. Powell, in his speech, said his overall view is that “financial stability vulnerabilities are at a moderate level.”

The document’s release comes on the heels of a shake-out in financial markets. The Standard & Poor’s 500 Index has slipped recently on a variety of concerns, from worries about the U.S.-China trade war to doubts about lofty valuations of technology shares. Corporate bond spreads have also widened as investors have become more risk-averse in the face of higher interest rates from the Fed.

Fast Growth

Still, the economy is primed to rack up its fastest growth since 2005 this year and is on course to achieve its longest-running expansion ever in the middle of 2019. Unemployment is at a 48-year low, and inflation is right at the Fed’s 2 percent target.

Having noted that investors are “appearing to exhibit a high tolerance for risk-taking,” the report highlights particular concern with leveraged lending -- which often fuels mergers and acquisitions involving companies with heavy debt. The Fed found that the riskiest companies are increasingly the ones piling on the most additional debt.

Leveraged loans are most often packaged, or securitized, into so-called collateralized loan obligations, or CLOs. Standards have been deteriorating on what’s considered acceptable leveraged lending, and the pace for issuing CLOs is up by about a third over the year earlier -- reaching $71 billion in the first half of this year. The Fed said the CLO market will be important to monitor.

Leveraged Funds

Hedge funds were cited as another potential danger. The Fed’s analysis shows that fund managers have increased their leverage over the past two years by as much as a third, and that by some measures, the industry’s reliance on borrowed money is at “post-crisis highs.”

While leverage can boost hedge fund returns, the Fed said it also “exposes their counterparties to risks and raises the possibility that adverse shocks would result in forced asset sales” that could drive down asset prices. That said, the Fed added that hedge funds don’t play the same central role in the financial system as banks.

Besides flagging an escalation of trade tensions as a near-term risk, the Fed also listed as potential flash points the U.K.’s coming withdrawal from the European Union, Italy’s budget dispute with the EU and high debt levels in some emerging-market economies.

And heightened trade tensions might lead to financial turbulence in China that could spill over into the U.S., the Fed said. Economic growth in the Asian nation is slowing after years of rapid credit growth, leaving lenders there potentially more exposed to losses on their loans.

Housing Strong

On the positive side, the Fed was mostly sanguine about the U.S. housing market, which caused the financial crisis a decade ago. Mortgage debt seems to be backed by sufficient collateral, and even though property prices are “somewhat elevated,” their rise appears to have slowed significantly in recent months, the central bank said.

For Wall Street, Wednesday’s report could provide clues into the Fed’s thinking on when it might use an obscure but powerful tool: the so-called counter-cyclical capital buffer, a mechanism that many countries have established to increase capital demands at big banks when a robust economy starts to show strain.

When triggered, it forces lenders to set aside additional capital -- up to 2.5 percent of risk-weighted assets -- when times are good. The money would subsequently be released back to the banks when economic conditions deteriorated so that it would be available for lending.

Activating Buffer

The Fed’s rules say the counter-cyclical capital buffer will be turned on only when “systemic vulnerabilities are meaningfully above normal.’’ Both Powell and Fed Vice Chairman for Supervision Randal Quarles have suggested that criteria has not yet been met. But fellow board member, Governor Lael Brainard, has been more open to activating it, as have a number of regional Fed bank presidents who don’t have a vote on the issue. The Fed board is expected to consider the matter in January.

The Fed has lagged behind other major central banks in publishing a financial stability report, but it’s now expected to issue such documents twice a year.

©2018 Bloomberg L.P.