What Could Go Wrong? The Fed Warns On Corporate Debt

“So, if the housing market isn’t going to affect the economy, and low interest rates are now a permanent fixture in our society, and there is NO risk in doing anything because we can financially engineer our way out it – then why are all these companies building up departments betting on what could be the biggest crash the world has ever seen?

What is more evident is what isn’t being said. Banks aren’t saying “we are gearing up just in case something bad happens.” Quite the contrary – they are gearing up for WHEN it happens.

When the turn does come, it will be unlike anything we have ever seen before. The scale of it could be considerable because of the size of some of these leveraged deals.” – Lance Roberts, June 2007

It is often said that no one saw the crash coming. Many did, but since it was “bearish” to discuss such things, the warnings were readily dismissed.

Of course, what came next was the worst financial crisis since the “Great Depression.”

But that was a decade ago, the pain is a relic of history, and the surging asset prices due to monetary policies has once again lured both Wall Street and Main Street into the warm bath of complacency.

It should not be surprising warnings are once again falling on “deaf ears.”

The latest warning came from the Federal Reserve who identified rising sales of risky corporate debt as a top vulnerability facing the U.S. financial system in their latest financial stability report. Via WSJ:

Officials, for the second time in six months, cited potential risks tied to nonfinancial corporate borrowing, particularly leveraged loans—a $1.1 trillion market that the Fed said grew by 20% last year amid declining credit standards. They also flagged possible concerns in elevated asset prices and historically high debt owned by U.S. businesses.

Monday’s report also identified potential economic shocks that could test the stability of the U.S. financial system, including trade tensions, potential spillover effects to the U.S. from a messy exit of Britain from the European Union and slowing economic growth globally.

Specifically, the Fed warned a downturn could expose vulnerabilities in U.S. corporate debt markets, ‘including the rapid growth of less-regulated private credit and a weakening of underwriting standards for leveraged loans.’”

It has become quite commonplace to dismiss the current environment under the thesis of “this time is different.”This was also the case in 2007 where the general beliefs were exactly the same:

  1. Low-interest rates are expected to persist indefinitely into the future, 
  2. A pervasive belief that Central Banks have everything under control, and;
  3. The economy is strong and there is “no recession” in sight.
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Moon Kil Woong 9 months ago Contributor's comment

The main concern should be on the banks financing zombie debt. It is widely known a lot of small oil gambles are losses and are not able to ever pay up or be profitable. Yet big banks keep financing them because this is the only way they can keep paying their debt. Everyone know the outcome of such behavior yet it is still done. As for other corporate debt that can be financed off of revenue streams, they seem ok.

We will see 2022 when the debt payments spike how corporate debt does as a whole. I don't see an eminent trigger besides a full on trade war and financial unwinding. Trump's leverage at the table for trade wars has diminished as everyone should have known as his terms drag on. A deal is better than no deal and further tariffs will endanger the economy and ruin his re-election hopes. I hope better minds prevail for the US and the global economy. As we can see tariffs have done little from stopping the trade deficit from China besides taxing the US consumer to the ground.