Fed escalates warnings on perils of risky company debt

Bloomberg

The Federal Reserve escalated its warnings about the perils of risky borrowing by businesses, saying firms with the worst credit profiles are the ones taking on more and more debt. The Fed also left a question unanswered: Is it going to do anything about it?
The US central bank’s latest financial stability report said leveraged-lending issuance grew 20 percent last year, and that protections included in loan documents to shield lenders from defaults are eroding. While the Fed board voted unanimously to approve the report, it didn’t indicate any course of action the govern-
ors might take to rein in the red-hot market.
Lawmakers, International Monetary Fund officials and even former central bankers have increasingly questioned whether the Fed and other watchdogs are adequately worried about leveraged loans, which often underpin mergers and acquisitions involving highly indebted companies.
A particular concern is that businesses that employ thousands could face severe financial stress and, in some cases, insolvency in an economic downturn. One group that has frequently discussed the market and is arguably the best positioned to take action is the Financial Stability Oversight Council, a US panel of regulators tasked with looking out
for hazards.

‘FED’S INTEREST’
“Making a recommendation to the FSOC that one of the regulators should do something is the right thing to do and hugely in the Fed’s interest as the lender of last resort,” Paul Tucker, the former deputy governor of the Bank of England who now chairs the private, non-partisan Systemic Risk Council, said in an interview.
In its report, the Fed said that credit standards seem to have slipped since it issued its last financial stability analysis in November 2018.
The central bank added that loans 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 said.
Still, it noted that default rates have been low amid a booming US economy. Fed officials also pointed out that the $1.2 trillion US leveraged lending market is much smaller than the mortgage sector that nearly brought down the financial system in 2008.

LIQUIDITY MISMATCH?
The leveraged loans are routinely packaged into the collateralised loan obligations, or CLOs.
Investors in those securities — including insurance companies and banks — face a risk that strains in the underlying loans will deliver “unexpected losses,” the Fed said, adding that the secondary market isn’t very liquid, “even in normal times.”
The Fed, highlighting another potential danger from the 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.