System is stable but business debt levels, leveraged loans are vulnerabilities, inaugural Fed report finds

The financial system is relatively stable, but debt levels of businesses at historic highs and signs of deteriorating credit standards are among potential vulnerabilities, according to the Federal Reserve’s first report on the condition of the national structure issued Wednesday.

In its 46-page Financial Stability Report (the first of what the Fed has said will be semiannual reports on the stability of the nation’s financial system), the central bank outlines four areas of potential vulnerabilities to the overall system. The Fed said it is monitoring those four areas as they are “aspects of the financial system that are most expected to cause widespread problems in times of stress.”

Of the four, only the report’s evaluation of “excessive borrowing by businesses and households” showed any vulnerabilities. “Borrowing by households has risen roughly in line with household incomes,” the report states. “However, debt owed by businesses relative to gross domestic product (GDP) is historically high, and there are signs of deteriorating credit standards.”

In particular, the report notes, growth in riskier forms of business debt – such as high-yield bonds and leveraged loans which had slowed to zero in late 2016 – rebounded in recent quarters. “The rebound reflected a decline in high-yield bonds outstanding more than offset by a notable pickup in growth of nonfinancial leveraged loans outstanding,” the report states. “On net, total risky debt rose about 5% over the year ending in the third quarter of 2018 and now represents over $2 trillion in debt outstanding.”

With regard to deteriorating credit standards for some business lending, the report notes that the share of newly issued large loans to corporations with high leverage has increased in recent quarters and now exceeds previous peak levels observed in 2007 and 2014, “when underwriting quality was notably poor.” The report defines corporations with “high leverage” as those with ratios of debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) above 6.

“Moreover,” the report notes, “there has been a recent rise in EBITDA add backs,” which add back nonrecurring expenses and future cost savings to historical earnings “and could inflate the projected capacity of the borrowers to repay their loans.”

“However, in part reflecting the strong economy, the credit performance of leveraged loans has so far been solid, with the default rate on leveraged loans at the low end of its historical range,” the report states.

The three other areas of vulnerabilities the Fed said it is monitoring – elevated valuation pressures, excessive leverage within the financial sector, and funding risks – are all within acceptable ranges, the Fed report indicated.

The Fed report also outlines three “near-term” risks to the financial system:

  • Brexit” (the United Kingdom’s withdrawal from the European Union) and euro-area fiscal challenges, which the report states “pose risks for U.S. markets and institutions.” The report notes the implications of Brexit could lead to “market volatility and a sharp pullback of investors and financial institutions from riskier assets, as occurred following the June 2016 Brexit referendum in the United Kingdom and earlier during the European debt crisis.” The report pinpoints two other Brexit risks: first, “spillover effects from U.K. and other European banks” that could be transmitted to the U.S. financial system directly through credit exposures and indirectly through the common participation of globally active banks in a broad range of activities and markets; and second, an economic downturn in Europe, which could harm the creditworthiness of some U.S. firms, particularly exporters.
  • Problems in China and other emerging market economies, which include possibly “sizable” dollar appreciation, declines in world trade and commodity prices, and a pullback from risk-taking by investors outside the affected markets. “In addition, the effect of a stronger dollar and weaker foreign economies on trade could affect the creditworthiness of U.S. firms, particularly exporters and commodity producers,” the report states.
  • Trade tensions, geopolitical uncertainty, or other developments which “could make investors more averse, in general, to taking risks.” In that regard, the report includes a somewhat ominous warning about investors becoming complacent toward interest rate changes by the Fed, especially as changes could occur rapidly. “Markets and institutions that may have become accustomed to the very low interest rate environment of the post-crisis period will also need to continue to adjust to monetary policy normalization by the Federal Reserve and other central banks,” the report states. “Even if central bank policies are fully anticipated by the public, some adjustments could occur abruptly, contributing to volatility in domestic and international financial markets and strains in institutions.”

Financial Stability Report