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Out of the Box: The Fed Issues a Warning

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“When the Fed warns, pay attention!”
-Mr. Trooper, the Sage

The Federal Reserve is now warning, once again, about the perils of risky corporate debt. They said, in a report issued yesterday, that this market grew by 20% last year. They also said that lending standards and specific covenants, continued to decline in value, and protection, for the debt holders.

In a particularly notable comment, the Fed said the businesses with the biggest existing debt loads are also the ones taking on the riskiest loans. They also commented that protections that lenders include in loan documents, in case borrowers default, are eroding. This was all in their twice-a-year financial stability report. The Fed board voted unanimously to release this document.

“Credit standards for new leveraged loans appear to have deteriorated further over the past six months,” the Fed said. They added that the loans made 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 stated in their report.

Since last year, the Fed has been highlighting the increasingly weak standards in leveraged lending. Many of these are loans underpinning mergers and acquisitions involving highly indebted companies. Still, default rates have been low amid an expanding U.S. economy and a Fed which has turned around, and decided not to keep raising rates, for the present time. If the Fed actually decided to lower rates, once again, then the outstanding bonds might increase in value, as interest rates decline, it should be noted.

Leveraged loans are routinely packaged into collateralized loan obligations, or CLO’s. Investors in those securities, including insurance companies, ETF’s, and banks, face a risk that the loans could deliver “unexpected losses,” the Fed said Monday. They added that the secondary market isn’t very liquid, “even in normal times. It is hard to know with certainty how today’s CLO structures and investors would fare in a prolonged period of stress,” the Fed stated.

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, highlighting another potential danger in 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 Fed said that 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,” they commented.

The Fed also revealed in its report that it had polled market participants about their views of what could constitute “salient shocks to financial stability’’ in the first quarter of this year. Trade frictions ranked first in terms of the percent of responses, while Fed policy ranked second, the central bank said. This was a bit of a surprise to me as, in my opinion, there is nothing and nothing and nothing more important than the Fed and its policies.

“Contacts were focused on risks related to the potential for monetary policy to become overly restrictive,’’ the Fed said. Following the Fed pivot in January, however, “some contacts noted the potential for excessive risk-taking, owing in part to a more accommodative monetary policy stance, than had been previously anticipated.’’

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 problems to be “meaningfully above normal.” Such a scenario could trigger the so-called “counter-cyclical capital buffer.” This is when the Fed would increase capital demands at the big banks as a strong economy starts to exhibit warning signs. The Fed board opted against using the tool in March, though Governor Lael Brainard dissented from the decision.

As an adjunct to the Fed’s comments, the SEC recently responded to a request from Senator Warren about the CLO market. The SEC stated that it “has observed a decrease in the average rating of the subordinated tranches of CLOS in each of the past two years, a potential indication of eroding credit quality in parts of the CLO market, increased risk appetite of certain CLO purchasers or some combination of these and other factors.” They also stated that the SEC is aware “of the rising debt-to earnings rations among certain leveraged loan issuers.”

Another area to be aware of is a new proposal that may come from the Fed. They have now floated a “Standing Repo Facility” as a possibility, that they might undertake. This would be a new type of “Quantitative Easing” in disguise, in my estimation. In this facility banks would be allowed to exchange their Reserves for Treasuries. This would also allow for the Fed to shrink its balance sheet without disrupting the markets, in the Fed’s apparent opinion.

The Fed ideally would like to see a lower reserve level, with the New York Fed putting the desired number from banks around $784 billion. The level of bank reserves at the Fed peaked at nearly $2.8 trillion in mid-2014 and is currently $1.55 trillion, or some $1.41 trillion above the desired amount. Reserves and the bond assets are on opposite sides of the balance sheet and thus tend to move in sync.

Peter Ireland, an economics professor at Boston College, and member of the Shadow Open Market Committee, which monitors Fed policy, stated, “The nice thing about the standing repurchase facility would be that the Fed would say to banks, Look, we stand ready in times of stress to supply reserves on demand. This would enable banks to decrease their hold of excess reserves, which is what the Fed wants them to do, increase their holdings of Treasuries, which is what banks want to do, while still guarding against a freeze-up of markets during times of stress.”

A lot to consider this morning. A lot to assess.

Mark J. Grant
Chief Global Strategist, Fixed Income
Managing Director
B. Riley FBR Inc.
U.S. 954-468-2366

Information herein is for general use; is not unbiased/impartial; is current at publication date, subject to change; may be from third parties; and may not be accurate or complete. Opinions are the Author’s, not B. Riley FBR, Inc., or their respective affiliates or subsidiaries. This is not a research report or solicitation or recommendation to buy/sell the subject securities. Investment factors are not fully addressed herein. B. Riley FBR Inc. and their affiliates may have a proprietary position in the subject securities.
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