Overall, the U.S. economy, despite its recent ebbs and flows, remains strong and healthy, with only a low-key threat of the forces that led to the “Great Recession” that began in 2007.
Nevertheless, public companies might want to update their disclosed risk factors. The positive economic outlook from the Federal Reserve is undercut by a potentially problematic rise in corporate borrowing.
On Nov. 28, the Federal Reserve’s Board of Governors released its first-ever Financial Stability Report. It summarizes the central bank’s framework for assessing the resilience of the U.S. financial system and, in doing so, offers up a current assessment.
Much of the information collected from researching the report is expected to make its way into banks’ future stress test scenarios and setting capital buffers.
Amid an escalating feud with President Trump, Federal Reserve Chairman Jerome Powell, during a speech at the Economic Club of New York on Wednesday, addressed the report and the Fed’s still-evolving framework for monitoring financial stability.
There has been “a profound transformation since the global financial crisis in the Federal Reserve’s approach to monitoring and addressing financial stability,” he said, using the report to bolster arguments that the Fed should be free of political interference.
“By clearly and transparently explaining our policies, we aim to strengthen the foundation of democratic legitimacy that enables the Fed to serve the needs of the American public,” he said.
In Powell’s view, the “gradual pace of raising interest rates” has been “an exercise in balancing risks.”
Under its dual mandate, “jobs and inflation are the Fed’s meat and potatoes,” he added, turning the focus to financial stability, “a topic that has always been on the menu, but that, since the crisis, has become a more integral part of the meal.”
Powell and his Federal Open Market Committee colleagues, like many private-sector economists, are forecasting continued solid growth, low unemployment, and inflation near 2 percent. “There is a great deal to like about this outlook,” he said of the positive data, something that many investors on Wall Street took—with perhaps no small degree of wishful thinking—as a market-moving indication of less-aggressive interest rate hikes.
Powell did caution that “things often turn out to be quite different from even the most careful forecasts.”
To understand the current risk landscape, it may be illustrative to flashback to what predated, and triggered, the 2007-09 financial crisis.
As outlined in the new report, many parts of the U.S. financial system grew dangerously overextended. House prices were extremely high, and relaxed lending standards resulted in excessive mortgage debt. Financial institutions relied heavily on short-term, uninsured liabilities to fund longer-term, less-liquid investments. Money market mutual funds and other investment vehicles were highly susceptible to investor runs. Over-the-counter derivatives markets were largely opaque. Banks, especially the largest institutions, took on significant risks without maintaining resources sufficient to absorb potential losses.
Ultimately, a drop in house prices precipitated a financial panic, and a retrenchment in asset prices led to sharp withdrawals of short-term funding from a wide range of institutions. Financial institutions failed, and many more pulled back on lending. Mortgages, many held in complex financial vehicles that increased investor leverage, could not be refinanced.
Reforms undertaken since the financial crisis have made the U.S. financial system far more resilient than it was before the crisis, Powell said.
Banking institutions have built stronger capital and liquidity buffers that, together with reforms to the rules governing money market funds, strengthen the ability of institutions to withstand adverse shocks and reduce their susceptibility to destabilizing runs. Insurance companies have similarly strengthened their financial position since the crisis.
Post-crisis recovery and resolution plans have helped ensure that risks leading to the failure of financial intermediaries are borne by the institutions and investors taking the risks and not taxpayers. Reforms to derivatives markets made them less opaque and reduced credit exposures between derivatives counterparties.
Despite “this important progress, vulnerabilities may build over time,” the Fed report warns as it evaluates potential risks already lurking in the financial marketplace.
Among those concerns: “Valuation pressures are generally elevated, with investors appearing to exhibit a high tolerance for risk taking, particularly with respect to assets linked to business debt.”
While borrowing by households has risen roughly in line with household incomes, debt owed by businesses relative to gross domestic product is historically high (the tally of $2 trillion is the highest level of debt over assets in nearly 20 years) and increasingly risky. There are also signs of deteriorating credit standards.
The broad conclusion drawn by the Fed report: Financial stability risks are moderate. Powell, however, added yet another caution and caveat. “We have limited experience with this monitoring, and there is no widely accepted basis for reaching a bottom line,” he said.
Over time, some may be tempted to dismiss the reports or overdramatize any concerns they raise. “Instead, these reports should be viewed as you might view the results of a regular health checkup,” Powell said. “We all hope for a report that is not very exciting. Many baby boomers like me are, however, are reaching an age where a good report is, ‘Well, there are a number of things we should keep an eye on, but all things considered you are in good health.’ That is how I view the Financial Stability Report.”
This current approach to mitigating emerging financial risks, Powell explained, can be divided into three parts: build up the strength and resilience of the financial system, develop and apply a broad framework for monitoring financial stability on an ongoing basis, and explain the new approach as transparently as possible so that the public and its representatives in Congress can provide oversight and demand accountability.
The Fed’s outlined framework, he explained, distinguishes between shocks—trigger events that can be hard to predict or influence—and vulnerabilities, defined as features of the financial system that amplify shocks.
The assessment, as detailed in the new report, did not detect a broad-based buildup of abnormal or excessive leverage. Securitization levels are far below their pre-crisis levels, and those structures that do exist rely on more stable funding.
“We view funding-risk vulnerabilities as low. Banks hold low levels of liabilities that are able and likely to run, and they hold high levels of liquid assets to fund any outflows that do occur,” Powell said.
As for the aforementioned risks associated with corporate debt, the ratio of this debt to GDP is “about where one might expect after nearly a decade of economic expansion,” he suggested. “It is well above its trend, but not yet at the peaks hit in the late 1980s or late 1990s.”
There are, however, other reasons to be concerned.
Information on individual firms reveals that, over the past year, firms with high leverage and interest burdens have been increasing their debt loads the most. Some of these highly leveraged borrowers would likely face distress if the economy turned down, leading investors to take higher-than-expected losses.
“The question for financial stability is whether elevated business bankruptcies and outsized losses would risk undermining the ability of the financial system to perform its critical functions on behalf of households and businesses,” Powell said.
Another potential vulnerability—one that arises when asset values rise far above conventional, historically observed valuation benchmarks—is popularly referred to as a “bubble.”
“The contentious term ‘bubble’ does not appear in our work,” Powell said. “Instead, we focus … on the extent to which an asset’s price is high or low relative to conventional benchmarks based on expected payoffs and current economic conditions … We therefore pay close attention when valuations get to the extreme ends of what we have seen in history.”
For several years, for example, U.S. equity market indexes have been moving upward more quickly than forward-looking corporate earnings forecasts. Although this trend has reversed this year, the S&P 500 forward price-to-earnings ratio remains above its median value over the past 30 years.
“These reports should be viewed as you might view the results of a regular health checkup. We all hope for a report that is not very exciting. Many baby boomers like me are, however, reaching an age where a good report is, ‘Well, there are a number of things we should keep an eye on, but all things considered you are in good health.’ That is how I view the Financial Stability Report.”
Jerome Powell, Chairman, Federal Reserve
Nevertheless, the report concludes there is no major asset class, including the stock market, where valuations appear far in excess of standard benchmarks as some did, for example, in the late 1990s dot-com boom or the pre-crisis credit boom.
Equity market prices are broadly consistent with historical benchmarks such as forward price-to-earnings ratios, the Fed says.
“It is important to distinguish between market volatility and events that threaten financial stability,” Powell added.
Large, sustained declines in equity prices can put downward pressure on spending and confidence. “From the financial stability perspective, however, we do not see dangerous excesses in the stock market,” he said.
Other identified sources of risk include the unsettled state of trade negotiations, Brexit negotiations, budget discussions between Italy and the European Union, and cyber-related disruptions.
U.S. banks and broker-dealers participate in some of the markets most likely to be affected by Brexit, the report notes. The Fed and other regulators have been working with U.S. financial institutions that have operations in the European Union or the United Kingdom to prepare for the full range of possible outcomes to the negotiations.
An intensification of sovereign debt concerns or unresolved uncertainty about the implications of Brexit, for example, could lead to market volatility and a sharp pullback of investors and financial institutions from riskier assets, as occurred following the June 2016 Brexit referendum in the United Kingdom and, earlier, during the European debt crisis.
Spillover effects from U.K. and other European banks could be transmitted to the U.S. financial system directly through credit exposures as well as indirectly through the common participation of globally active banks in a broad range of activities and markets.
Because London is an important international financial center, U.S. banks and broker-dealers participate in some of the markets most likely to be affected by Brexit. There is also the prospect that an economic downturn in Europe, likely accompanied by dollar appreciation, would also affect the United States through trade channels, which could harm the creditworthiness of some U.S. firms, particularly exporters.
Beyond Europe, problems in China and other emerging market economies could similarly spill over to the United States.
In China, the pace of economic growth has slowed recently, and years of rapid credit expansion have left lenders increasingly exposed in the event of a slowdown. Chinese non-financial private credit has almost doubled since 2008, to more than 200 percent of the GDP.
Against this backdrop, developments that significantly strain the repayment capacity of Chinese borrowers and financial intermediaries—including an escalation in international trade disputes or a collapse in Chinese real estate prices—could trigger adverse and global fallout.
Other emerging market economies (EMEs) have also seen significant increases in either corporate or sovereign debt that could be difficult to service in the event of an economic downturn. This could ultimately affect the creditworthiness of U.S. firms, particularly exporters and commodity producers, the Fed report warns.