Monday, July 06, 2020

The Fed's latest move won't solve the underlying risk facing the economy

Mar 03. 2020
Steven Pearlstein, a Washington Post economics columnist and the Robinson professor of public affairs at George Mason University, is the author of  Can American Capitalism Survive?
Steven Pearlstein, a Washington Post economics columnist and the Robinson professor of public affairs at George Mason University, is the author of Can American Capitalism Survive?
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By The Washington Post · Steven Pearlstein · OPINION, BUSINESS, US-GLOBAL-MARKETS 

With its emergency interest rate cut of half a percent, the Federal Reserve is once again riding to the rescue of investors who have now come to expect that they will be shielded from the consequences of their own speculative excess.

The Fed and other central bankers would have you believe that their only mission is to prevent the global economy from falling into a nasty and unnecessary recession as the spread of the coronavirus disrupts supply chains and travel and forces offices and factories to suspend operations. But as many others have correctly noted, lowering interest rates does nothing to inoculate the economy from such a supply-side shock or the recession that may ensue. Cheaper money is unlikely to cause business or household to borrow, spend or invest.

Rather, their purpose is more psychological: to halt the stampede of investors out of stocks and risky loans and into safer government bonds. It was the plentiful, cheap money supplied by central bankers that encouraged the herd to continue to pile into those frothy markets in recent years, seemingly oblivious to the possibility of an economic downturn that might cut into profits or cause loans to go unpaid. Now that a downturn is upon us, central bankers and finance ministers feel they have no choice but to promise investors yet another tranche of cheap money. The clear message from the Fed: "We've got your back."

Of immediate concern are the sudden flows of capital out of countries that are most susceptible to the pandemic, and into Treasury bonds of countries like the United States and Germany. The effect has been to dramatically increase interest rates in the more vulnerable countries while pushing rates down to record low levels in the safe havens, roiling financial markets in both places. The yield on 10 year-year U.S. Treasury bonds now hovers just above 1 percent while in Germany it is negative. This plunge in long-term rates puts pressure on central bankers to lower the overnight bank-to-bank lending rate they control.

Moreover, given the sudden demand for safety, central bankers who spent trillions of dollars in longer term bonds to stabilize the economy after the 2008 crash should also consider selling some of their swollen pile into a market that can't seem to get enough of them, even as they push down short-term rates.

Longer term, the worry is that a full-blown recession could trigger a cascade of loan defaults by businesses that are now carrying more debt than they did before the financial crash of 2008.

Last week saw record outflows from mutual funds and exchange-traded funds specializing in risky "junk" bonds and business loans. The difference in yields between risky and safe instruments increased more than a full percentage point - the equivalent of a tidal wave in the staid world of bond markets. Given the turmoil, issuance of new bonds and package of business loans in that part of the credit market also came to a grinding halt.

Many of the investors who buy, package and trade these securities - or issue derivative instruments designed to insure them - do so with lots of borrowed money. And should the pandemic worsen and the sell-off resume, those investors and traders would face demand from their lenders demanding immediate repayment. As we saw during the 2008 crash, forced selling quickly spreads to other asset classes as investors sell whatever they can to raise cash. As prices fall, panic selling begets more panic selling, and more margin calls, creating a downdraft that pulls down the price of all but the safest investments.

"Exogenous shocks often expose bad leverage," one Bank of America analyst warned his investment clients last week. Or as Warren Buffett is fond of saying, it is only when the economic tide goes out that you can see who's been swimming naked.

Of particular concern are smaller oil and gas drilling companies that took on billions of dollars in debt in recent years to cash in on higher energy prices and fracking. Now, with the prospect of a global slowdown driving down energy prices, many of those companies have halted drilling and face the prospect of defaulting on those loans. Last week saw a sell-off in their debt.

There are similar concerns about retail companies, many of which were bought up by private equity firms that paid for the purchase by loading the companies up with debt. They, too, are likely to feel the effect of a recession and the pullback in consumer spending. Indeed, even before the threat of the coronavirus emerged, bonds issued by Macy's were downgraded by the rating agencies, and now trade as junk.

Indeed, looking across all industries at the end of 2019, Standard & Poor's calculated that there were three corporate borrowers who suffered credit rating downgrades in the final quarter of 2019 for every one that won an upgrade - the worst ratio since 2015 and a similar reading to just before the 2008 crash. The amount of lower-rate corporate debt now outstanding is the highest it has ever been. The lower the rating, the higher the risk that lenders and investors will not be repaid.

In a prolonged economic or market downturn, even companies that are able to service their loans could face the additional risk that they will be able to roll them over - that is, to get a new loan to pay off the old one, as is common practice. Tens of billions of dollars in risky business loans are set to come due this year, with the volume rising sharply in 2022.

Mindful of these credit market risks, and the risks they pose to the broader economy, the Federal Reserve recently told Wall Street banks that, as part of their annual "stress tests," they must prove they have enough capital and risk management capability to withstand a wave of corporate defaults and outflows from loan funds that cause the price of credit instruments to fall. Given the complex ways in which these loans are packaged and repackaged and sold off as securities, regulators don't really know who holds the ultimate risk associated with these credit instruments. That could include not only the investors and funds that hold them, but the banks that lend money to buy them, along with the investment banks and hedge funds that effectively insure them. And as we learned in 2008, when markets are that complex and opaque, when the market turns, panicked investors and lenders tend to sell off everything when they can't really tell the good risks from the bad ones.

Given year after year of record levels of lending to highly-indebted companies, it's hardly surprising that the Fed wants banks to calculate their exposure during a serious downturn or market rout. What's surprising is that it took them so long, and they don't have the information now, when they really need it.



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