Fed Chairman Jerome Powell warns business borrowing at ‘historic highs’ shouldn’t be ignored

  • There’s a “moderate” risk that “near record levels” of business debt will spill over into the broader US economy and spark another financial crisis, Federal Reserve Chairman Jerome Powell said on Monday.
  • Collaterized loan obligations (CLOs) have been a key funding source for riskier business borrowing, Powell said.
  • “Business debt has clearly reached a level that should give businesses and investors reason to pause and reflect,” Powell said. “Investors, financial institutions, and regulators need to focus on this risk today, while times are good.”

There’s only a “moderate” risk that surging volumes of business debt will spill over into the broader economy and potentially spark another financial crisis, Federal Reserve Chairman Jerome Powell said on Monday.

Business debt is “near record levels” and recent lending has been “concentrated in the riskiest segments,” Powell said at the Annual Financial Markets Conference at the Federal Reserve Bank of Atlanta in Florida. Specifically, he pointed to collaterized loan obligations (CLOs) — actively managed securitization vehicles that buy up riskier assets like leveraged loans — as a key source of funding for riskier business borrowing, given they hold 62% of outstanding leveraged loans.

“Regulators, investors, and market participants around the world would benefit greatly from more information on who is bearing the ultimate risk associated with CLOs,” Powell said. 

Business debt has “clearly reached a level that should give businesses and investors reason to pause and reflect,” Powell said. “Investors, financial institutions, and regulators need to focus on this risk today, while times are good.”

The central bank chief warned overly indebted firms could endure “severe financial strain” if the economy weakens, and a highly leveraged business sector could exacerbate an economic downturn as companies are forced to lay off workers and reduce investment.

However, the build up of business debt “does not present the kind of elevated risks to the stability of the financial system that would lead to broad harm to households and businesses should conditions deteriorate,” Powell said.

“In public discussion of this issue, views seem to range from ‘This is a rerun of the subprime mortgage crisis’ to ‘Nothing to worry about here,'” he added. “At the moment, the truth is likely somewhere in the middle.”

Powell acknowledged similarities between the recent spike in business debt and the lending boom that preceded the global financial crisis. Debt has surged to historic highs and outpaced growth in borrowers’ incomes, lenders have loosened their underwriting standards, and much of the borrowing is financed outside the banking system.

However, Powell argued the increase in business borrowing isn’t outsized given America’s prolonged economic expansion, it isn’t being fueled by a “dramatic asset price bubble” this time around, and CLO structures are “much sounder” than the structures used during the housing bubble.

Powell also emphasized America isn’t as vulnerable to shocks anymore. “The financial system today appears strong enough to handle potential business-sector losses, which was manifestly not the case a decade ago with subprime mortgages,”  he said. The Federal Reserve is also monitoring the issue closely, holding banks to strict risk-management standards, and using stress tests to ensure their resilience to shocks, he added.

The Federal Reserve looks at four key factors in assessing financial-stability risks: borrowing by businesses and households, valuation pressures, leverage in the financial system, and funding risk.

Powell pointed out that business debt has grown slower relative to GDP than household debt grew in the lead up to the financial crisis, and household debt-to-income ratios have steadily declined since the crash. 

Although equity prices have reached new highs, bond and loan spreads have narrowed, and commercial and residential property prices have risen, Powell said borrowing isn’t fueling excessive prices or investment in a critical sector such as housing.

Banks at the core of the US financial system are also “fundamentally stronger and more resilient,” Powell said, as larger capital requirements and stress tests have resulted in them retaining more capital. The largest US banks also hold only $90 billion of the roughly $700 billion in total CLOs, he added.

Finally, the US financial system isn’t as susceptible to runs as before due to large banks having significantly amounts of highly liquid assets, Powell said. CLOs also have stable funding as investors commit funds for lengthy periods and can’t use withdrawals to force asset sales at distressed prices, he added.

RBA Chief Hints Rate Cut In June

Reserve Bank of Australia Governor Philip Lowe signaled an interest rate cut in June to underpin growth in employment.

Addressing the Economic Society of Australia in Brisbane on Tuesday, Lowe said, “A lower cash rate would support employment growth and bring forward the time when inflation is consistent with the target.” At the May board meeting, policymakers assessed that inflation was likely to remain low relative to the target and that a decrease in the cash rate would likely be appropriate.

“Given this assessment, at our meeting in two weeks’ time, we will consider the case for lower interest rates,” he said.

Lowe said the Australian economy can support an unemployment rate of below 5 percent without raising inflation concerns.

The banker said there are a number of options to reduce the unemployment rate. These include further monetary easing, additional fiscal support, including through spending on infrastructure, and structural policies that support firms expanding, investing and employing people.

“Relying on just one type of policy has limitations, so each of these is worth thinking about.”

The minutes of the May meeting, released earlier today, showed that financial market pricing implied that the cash rate was expected to be lowered by 25 basis points within the next three months and again by the end of 2019.

Members noted that without an easing in monetary policy over the next six months, growth and inflation outcomes would be expected to be less favorable than the central scenario.

Marcel Thieliant, an economist at Capital Economics, said RBA is set to cut interest rates to 1.25 percent in June from 1.50 percent and follow up with another 25 basis point cut in August.

BoJ Chief Says Current Low Interest Rates To Stay Longer

Japan’s extremely low interest rates are likely to remain at the current levels for an extended period given the uncertainties surrounding economic activity and prices, Bank of Japan Governor Haruhiko Kuroda said Friday.

Kuroda said the Bank would “maintain the current extremely low levels of short- and long-term interest rates for an extended period of time, at least through around spring 2020, taking into account uncertainties regarding economic activity and prices including developments in overseas economies and the effects of the scheduled consumption tax hike.”

The governor observed that the momentum toward achieving the price stability target has been maintained. The bank forecast annual inflation to increase gradually toward 2 percent, although this will still take time.