Update 362 — The Economic Debate Offstage:
Corporate Debt and Emerging Financial Risks
All eyes will be on the first Democratic debate tonight in Miami. Starts 9:00 pm ET and ends at 11:00. Ten — half the qualifying field of candidates — will participate tonight. The other half will do so at the same venue tomorrow night.
Far fewer eyes have been following the narrower, recondite debate brewing backstage on corporate debt, leveraged loans, and other emerging systemic risks as a central economic policy issue. We explore and assess these risks below (and join our Progressive Congress Action Network call on this tomorrow at 3:00 PM ET).
Ten points if it comes up in the debate…
As of next Monday, the economy will be in the longest expansion in US history, begun in the early days of the first Obama administration. Unemployment is at its lowest level in half a century. Inflation is close to the Federal Reserve’s two percent goal, and US Q2 GDP is expected to be a modest but steady two percent. Smooth macroeconomic sailing all around.
The headline figures belie growing concern over nascent and growing areas of systemic risk that have not gone unnoticed by US regulators. Federal regulators are showing remarkable accountability in responding directly to these problems, in direct contrast to last crisis. But, is the remedy really to lower interest rates, adding fuel to a high-risk corporate debt fire?
Although crises rarely take the exact same form, history reveals several key warning signs, including excessive leverage, excessive exposure by banks and other regulated financial firms, and herd behavior/correlated risk-taking in financial markets. Many of these warning signs are flashing yellow today, if not red. Do we have the regulatory tools to identify and then handle different recession or crisis originators?
Leveraged Loans Market: Hot Yellow to Red
Leveraged loans are made to highly indebted businesses, with many subsequently securitized and sold in the secondary market in the form of Collateralized Loan Obligations (CLOs). Currently, there are about $1.2 trillion in outstanding leveraged loans, 80 percent of which are considered ‘covenant-lite,’ meaning lenders could be left on the hook if borrowers default. A large portion of leveraged loans are small business loans, carrying high interest rates. This creates systemic risk for Main Street in the event of a business downturn and/or rising rates environment.
Banks and insurance companies face exposure to CLOs and leveraged loans via multiple channels. In other words, regulated financial firms are heavily invested in, and exposed to, less-regulated shadow banking markets. Over a longer horizon, disruptions in shadow banking markets can destabilize regulated financial institutions, broader financial markets, and the entire economy. On Wednesday last week, Fed Chair Powell said “the risk isn’t in the banks.” This statement conflicts with reports yesterday that Deutsche Bank faces multimillion-dollar losses as a result of two leveraged loans it originated within its US investment banking unit.
Earlier this month, the House Financial Services Subcommittee on Consumer Protection and Financial Institutions held a hearing entitled, “Emerging Threats to Stability: Considering the Systemic Risk of Leveraged Lending.” The hearing considered the following legislative proposals (no bill numbers assigned):
- The Protecting the Independent Funding of the Office of Financial Research Act would maintain adequate funding levels for OFR and isolate its funding stream from an increasingly politicized appropriations process.
- The Leveraged Lending Data and Analysis Act would require OFR and other regulators to gather more information on the leverage lending market to increase transparency.
- The Leveraged Lending Examination Enhancement Act would require bank regulators to submit to Congress a quarterly report analyzing risk management of leveraged lending activities.
The growth in leveraged loans is analogous to the subprime mortgage market in a number of ways. In both cases, loans are being offered to high risk borrowers, with a secondary market trading these loans through complex collateralized debt instruments with unknown exposures. Regulators knew about the risks of the subprime market in 2004, but there was no interagency agreement until 2006. It took them two years to come to an agreement, by which time it was too late. Meanwhile today, regulators are turning off many of the safety and soundness rules for banks, including less stringent stress tests, living wills, and relaxed leverage and liquidity requirements.
Bond Market: Flashing Red
The Treasury yield curve inverted before the recessions of 1981, 1991, 2001, and 2008. Last December, the yield curve briefly inverted for the first time since the 2008 financial crisis. In March, the yield curve inverted once again, this time sustaining an inversion. The 10-year Treasury note closed at 1.99 percent yesterday, compared to the three-month bill which yielded 2.12 percent at market close.
The inverted yield curve suggests that investors are demanding longer-term bonds, even at relatively low prices, in an attempt to secure safe investments. In other words, investors expect that economic growth will not continue at its current pace. While the Fed remains sanguine about the chances of a recession in the coming months, at the same time, Fed officials have been more open to interest rate cuts to stave off economic downturn.
Overall Debt Levels: Flowing Red (Ink)
In the third quarter of 2018, household debt hit a record of $13.2 trillion. The majority of this debt is made up by mortgages, which rose by $139 billion in the first quarter of 2019 to $8.9 trillion. Total national student debt was at a staggering $1.4 trillion in 3Q18 — about $80 billion higher than it was in 3Q17. In one year alone, from 2017 to 2018, total credit card debt rose by over 20 percent, from $778 billion to $944 billion. With rising delinquency in the student and auto-loan debt markets, there is little room for cracks in the consumer credit system in the event of a downturn.
Start with Known Knowns
If the bond market signals that a recession is imminent, overall debt levels and leveraged lending can amplify that recession. Complex financial products expose banks, insurance companies, and pension funds. But they also disguise the risks these firms face. In 2007, many regulators and others were caught off guard by the rapid rise of systemic risk in the US housing market. The ensuing liquidity crisis wiped out trillions of dollars of national wealth.
Last time, regulators and the market at-large failed to see the crisis around the corner. Dodd Frank and its many titles gave financial regulators policy tools to help anticipate and mitigate future crises. History points to recurring warning signs to watch for: excessive debt and leverage in financial markets, large but obscured exposures by banks, insurance companies, and pension funds, and herd behavior in financial markets.
The challenge is for policymakers to look for these warning signs as they take new shapes and assume new forms. We need to improve transparency in financial markets, gather more data on threats to financial stability, and address shadow banking risks. But the existing DFA early warning mechanisms and protections are being methodologically eroded by the Trump administration, perhaps setting the stage for the inevitable end of this record-long expansion.