Rising home prices not accompanied by falling credit standards, highly leveraged investing, financial stability report finds

Despite rising prices for houses, there is little evidence of declining credit standards for loans or highly leveraged investment activity in the housing market, the Federal Reserve’s Monday report on financial stability indicated.

However, the report noted, asset prices – including those for residential real estate – remain vulnerable to significant declines should investor risk sentiment deteriorate, progress on containing the virus disappoint, or the economic recovery from the financial impact of the coronavirus crisis stall.

The Fed’s Financial Stability Report presents the agency’s current assessment of the resilience of the U.S. financial system. It is published about every six months. The November 2021 report outlines the current vulnerabilities of the U.S. economy in four areas: asset valuations, borrowing by businesses and households, leverage in the financial sector, and funding risk.

The reference to declining credit standards and highly leveraged investing is to the economic crisis of 2008-10, when housing markets across the country collapsed after home values plummeted in the face of shaky lending standards and over-leveraged borrowers.

On assets other than homes, the report notes that prices of risky assets have generally increased since the last report (issued in May). In some markets, the report states, prices are high compared to expected cash flows.

Borrowing by businesses and households, the report states, has returned to pre-pandemic levels. Balance sheets, in addition, have benefitted from continued earnings growth, low interest rates, and government support, the report notes.

However, it states, the rise in the Delta variant of the coronavirus has closed improvements in the outlook for small businesses. For households, “the expiration of government support programs and uncertainty over the course of the pandemic may still pose significant risks,” the report warns.

Compressed net interest margins and loans in the sectors most affected by the COVID-19 pandemic are keeping conditions challenging for some in the financial sector, the report notes. Even so, the report indicates, bank profits have been strong this year, and capital ratios remained well above regulatory requirements.

Finally, the report found that, in funding risk, there are vulnerabilities in the growing stablecoin sector. Meanwhile, U.S. banks relied only modestly on short-term wholesale funding, the report found, noting that banks continued a sizable hold of high-quality liquid assets (HQLA). “By contrast, structural vulnerabilities persist in some types of MMFs (money market mutual funds) and other cash-management vehicles as well as in bond and bank loan mutual funds,” the report stated.

Financial Stability Report