This article was published by The McAlvany Intelligence Advisor on Wednesday, May 8, 2019:
That’s what makes the latest report from the Federal Reserve, its semi-annual Financial Stability Report, so laughable. It’s worried about a paltry $1.1 trillion that has been lent to companies with less than stellar credit ratings, while ignoring entirely the $22 trillion investors are lending to the U.S government – which sports even worse ratings.
No one remembers the last time that any of the three major credit rating agencies attempted to tell the truth about the government’s shaky financial foundation: it cost the CEO his job.
It was Standard & Poor’s that had the temerity to even suggest that U.S. government debt wasn’t quite as secure as people wanted to believe. It downgraded its assessment of U.S. government debt from AAA by one notch, to AA+, four days after the 112th Congress voted to raise the debt ceiling in 2013 above the $14 trillion level.
The outrage that followed, from left and right, Democrat and Republican, led 18 days later to the head of Standard & Poor’s, Deven Sharma,stepping down as CEO, and leaving the company altogether at the end of the year. He was replaced by a top executive of Citibank.
Now, with federal debt more than 50 percent larger, the silence about any concern over its safety and security is deafening. Instead, the Fed is expressing its concern over a piddling trillion dollars that is being lent to companies with less than stellar credit ratings.
Its Financial Stability Report, released on Monday and issued twice a year, repeated its concerns over rising corporate debt burdens, particularly those being incurred by companies already carrying the most debt.
It said that “leveraged lending” – lending to companies whose debt already exceeds four times their earnings – jumped more than 20 percent last year. And since the first of the year, nearly 40 percent of those loans went to the most highly indebted companies – those with debt levels that exceeded six times their earnings.
Said the report: “Detailed balance sheet information of publicly traded non-financial firms reveals that, over the past two years, the firms with the most rapid increase in their debt loads have higher leverage, higher interest expense ratios, and lower cash holdings.”
Part of the driving force behind this increased leverage is the increased hunger for yield from investors, mutual funds, insurance companies, hedge funds, and banks. As the Fed has kept interest rates abnormally low ever since the Great Recession, which ended in 2009, bond buyers were willing to take on extra risk to obtain higher yields.
And companies enjoying the good times – increased revenues, improved profit margins, expanding market shares – were only too willing to take advantage of those investors by issuing more bonds to satiate their mutual thirsts. Said the Fed in its report: “Investor appetite for risk appears elevated by several measures, and [consequently] the debt loads of businesses are [now] abnormally high … the most rapid increases in debt [are] concentrated among the riskiest firms amid signs of deteriorating credit standards.”
That debt is either issued directly to bond mutual funds or grouped together in something called collateralized loan obligations, or CLOs. Slices of those CLOs are then offered to hungry investors seeking yield through hedge funds, insurance companies, and banks. CLOs are sold on the basis that if one bondholder defaults, it doesn’t bring down the entire collection or group of bonds.
The trouble is, as the Fed pointed out, with something called a “liquidity mismatch.” That occurs when an investor, or many of them all at once, decide they want their money back. The “secondary market” – the back door out – is very thinly traded. If the demand for funds grows, then the entity holding those CLOs must liquidate other assets to meet it. That is called the “domino effect,” and was the basis for the film “The Big Short,” which revealed how it worked to trigger the beginning of the Great Recession.
In fact, the Fed was forthright enough to make the comparison between today’s levels of high-risk corporate debt and those just before the Great Recession. It said that credit standards seem to have slipped since it issued its previous financial stability report last November. It said that loans being made today to firms with especially high debt loads relative to earnings now exceed earlier peaks seen in 2007, just before the Great Recession.
The Fed Governor heading up the committee that drafted the report, Lael Brainard, said that it “suggests stretched asset valuations and risky corporate debt merit continued vigilance” by the Fed’s Board of Governors. The report itself said that “the elevated level of debt could lead the business sector vulnerable to a downtown in economic activity or a tightening in financial conditions.”
This is “FedSpeak” for “recession.” Janet Yellen, the former Fed chair, is now able to speak more plainly about the risks: “If the economy encounters a downturn, we could see a good deal of corporate distress. If corporations are in distress, they fire workers and cut back on investment spending. And I think that’s something that could make the next recession a deeper recession.”
It should be noted that the national debt of the U.S. government is not $22 trillion. When unfunded liabilities under Social Security, Medicare, Medicaid and other promises to future generations are taken into account the real debt is 10 times larger. (See Sources below) The only way the Fed can keep people from worrying about the larger issues is to focus its attention on the smaller ones.
FederalReserve.gov: The Fed’s latest Financial Stability Report (May 2019)
The Wall Street Journal: Fed Flags Risky Business Debt as Vulnerability for U.S. Financial System
The New York Times: Federal Reserve Warns as Risky Corporate Debt Exceeds Peak Crisis Level
Financial Times: Fed warns leveraged lending could exacerbate a downturn