6 takeaways from the Fed’s financial stability assessment

WASHINGTON — A Federal Reserve report released this week shows how financial markets' desire for higher yields creates the potential for losses, although capital and liquidity safeguards are tempering any concerns about a catastrophic crash.

The central bank's semiannual Financial Stability Report identified a sharp increase in both leveraged lending and corporate debt, as well as the threat of an economic slowdown at home and abroad, as the leading sources of risk to the financial system.

In general, there were few glaring differences between the report released Monday and the Fed’s inaugural assessment of financial stability in November.

“Investor appetite for risk appears elevated by several measures, and the debt loads of businesses are historically high,” the report said. “However, the financial sector appears resilient, with low leverage and limited funding risk. Despite volatility in financial markets late last year, our assessment of each of the four vulnerability categories is little changed since the November 2018 FSR.”

However, there are some important takeaways from the report — including not only the financial system’s potential vulnerabilities, but it’s potential sources of strength in a future downturn.

Leveraged lending is up amid poor underwriting standards
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The Fed’s most dramatic conclusion in the report was that corporate debt has increased since the end of the financial crisis. Furthermore, the least creditworthy borrowers account for a significant proportion of that growth, the report said.

“Debt owed by the business sector ... has expanded more rapidly than output for the past several years, pushing the business-sector credit-to-GDP ratio to historically high levels,” the report said. “The sizable growth in business debt over the past seven years has been characterized by large increases in risky forms of debt extended to firms with poorer credit profiles or that already had elevated levels of debt.”

Underwriting standards for leveraged loans have become even less stringent since the release of the November FSR, and has even exceeded previous highs in 2007 and 2014, according to certain debt-to-earnings metrics. Performance of these loans remains strong, however, despite the risks.

“Credit standards for new leveraged loans appear to have deteriorated further over the past six months,” the report said. “The share of newly issued large loans to corporations with high leverage … increased in the second half of last year and the first quarter of this year, and now exceeds previous peak levels observed in 2007 and 2014, when underwriting quality was poor.”
Equity prices and asset values remain high
A monitor displays stock market information on the floor of the New York Stock Exchange.
The Fed said in its report that, according to certain price-to-earnings metrics, certain commercial real estate, residential real estate and equity valuations are elevated — a trend that has persisted for several years.

“Asset valuations remain high relative to their historical ranges in several major markets, suggesting that investor appetite for risk is elevated,” the report said. “Equity prices relative to forecast earnings remain above the median value over the past 30 years. Prices have been growing faster than rents in commercial and residential real estate for the past several years, although price increases in residential real estate have recently slowed somewhat.”

Fed officials have expressed concern about elevated stock values for years, with the risk being that retail investors could lose significant portions of their principal if those values were to revert to the median and come in line with earnings. But the Fed report noted that though some metrics suggest overvaluation, those pressures are somewhat less acute than when the previous FSR was published.
Banks are strongly capitalized
Federal Reserve building.
The Fed reaffirmed that U.S. banks are strongly capitalized and hold ample liquidity, mitigating threats of an economic downturn.

“The Federal Reserve’s most recent stress tests indicate that the largest banks are sufficiently resilient to continue to serve creditworthy borrowers even under a severely adverse scenario,” the agency said.

Compared with the pre-crisis period, the financial system also has less leverage and funding risk, meaning a decline in asset prices would be felt much less, according to the report.

The Fed also outlined its post-crisis regime that requires systemically important bank holding companies to hold more high-quality capital and undergo rigorous stress testing.

“The annual stress test exercises stress a range of participating banks’ direct and indirect exposures to shocks from the business sector,” the report said. “The tests require that participating banks have sufficient capital to withstand material losses on these exposures and continue lending.”
Household borrowing is low and stable
A stack of credit cards viewed from the side.
Although businesses are borrowing at a historically high rate, household borrowing has remained at a modest level relative to incomes, and the amount of debt borrowers with below average credit scores has remained stagnant.

In the last decade, household debt has declined in comparison with GDP, while the growth of household credit has been concentrated among borrowers with higher credit scores.

“Excessive borrowing by businesses and households leaves them vulnerable to distress if their incomes decline or the assets they own fall in value,” the Fed said in its report. “In the event of such shocks, businesses and households with high debt burdens may need to cut back spending sharply, affecting the overall level of economic activity. Moreover, when businesses and households cannot make payments on their loans, financial institutions and investors incur losses.”

Two-thirds of total household debt is comprised of mortgage debt, mostly among less risky borrowers, which is “broadly consistent with stronger underwriting standards relative to the mid-2000s.” As such, delinquency rates for borrowers with higher credit scores are low, and even the delinquency rate for borrowers on the lower end of the credit spectrum has declined since November, standing at the lowest level in 20 years.

While student debt owed by households increased last year and has relatively high delinquency rates, the risk student debt poses to the greater financial system remains limited, the Fed said.
A "hard Brexit" could lead to financial disruption
A pro-Brexit campaigner holds a placard that reads "Leave the EU" near the Houses of Parliament in London.
The Fed report noted the risk of Brexit causing swings in global market. If the United Kingdom misses its deadline of Oct. 31 to finalize a withdrawal agreement from the European Union, there would be no transition period, and financial activities could be disrupted.

“Despite extensive preparation and contingency planning by both the public and private sectors, addressing all of the many legal and regulatory details would be challenging,” the Fed said in its report.

Although Treasury Secretary Steven Mnuchin said in April before the U.K.’s original deadline to come up with a Brexit deal that U.S banks were prepared for a “no deal” scenario, increased financial volatility in Europe would likely spill over to the U.S. and could cause investors and banks to pull back from riskier assets. This could “amplify declines in equity prices and increases in credit spreads,” according to the Fed.

“In addition, spillover effects from banks in Europe could be transmitted to the U.S. financial system directly through credit exposures as well as indirectly through the common participation of globally active banks in a broad range of activities and markets,” the report said.

Mnuchin agreed with this assessment last month during his annual testimony to the House Financial Services Committee.

“I think U.S. financial institutions are prepared, but I think there could be significant disruptions in the markets and in trade as a result of a hard Brexit,” he said.
Risk of an economic slowdown looms
Market participants remain concerned about the prospect of an economic slowdown in the U.S. posing a risk to financial stability, the report said. Such a downturn could negatively affect asset prices, as well as the balance sheets of both businesses and households.

“If the economy were to slow unexpectedly, profits of non-financial businesses would decrease, and, given the generally high level of leverage in that sector, such decreases could lead to financial stress and defaults at some firms,” the Fed said.

This could also lead to a reduction in investment, which would hurt U.S. banks’ lending abilities.

But even in the event of an economic slowdown, the Fed is confident that households wouldn’t feel the brunt, given the stable level of household borrowing and the high concentration of debt among less risky borrowers.