Fed Warns of Financial Risks as Coronavirus Downturn Persists

Among the areas the Fed flagged:

Wild swings tested the financial system’s resilience.

Even the market for Treasury securities — the deepest and most liquid in the world — ceased to function normally as investors became attuned to the economic risk and cashed out their holdings.

• “While the financial regulatory reforms adopted since 2008 have substantially increased the resilience of the financial sector, the financial system nonetheless amplified the shock, and financial sector vulnerabilities are likely to be significant in the near term,” the report said.

• In March, “funding markets proved less fragile than during the 2007-09 financial crisis. Nonetheless, significant strains emerged, and emergency Federal Reserve actions were required to stabilize short-term funding markets.”

• In the Treasury market — where the Fed has bought securities at a rapid pace since mid-March to restore functioning — the difference between selling prices and buyer asking prices has declined to more normal levels, but “some measures, such as market depth, have shown only modest signs of improvement.”

Hedge funds may have worsened turmoil.

As investors pulled cash from money market mutual funds and the market for short-term business debt looked shaky a more surprising weakness surfaced in the market for Treasury bonds, especially older ones. Speculation has been rampant that hedge funds contributed to the turmoil, and the Fed acknowledged that in its report.

• Some hedge funds buy and sell securities frequently to make small amounts of money that add up over a large number of trades. They are forced to sell their holdings if markets become hard to trade in, which “can lead to a rapid unraveling of market liquidity under certain circumstances,” the report said.

• “The concentration of hedge fund leverage has increased markedly,” it said, and funds “may have to sell large amounts of assets to meet margin calls or reduce portfolio risk during periods of market stress.”

The Fed’s intervention has calmed markets.

The Fed jumped in to ease the strains, rolling out a series of emergency lending facilities.

• “Effectively, the ability of creditworthy households, businesses, and state and local governments to borrow, even at elevated rates, was threatened,” the Fed said. Together with the Treasury it “took a series of steps to support the flow of credit to households, businesses, and communities.”

Worries remain.

Corporations went into the current crisis with huge debt loads, a vulnerability that threatens to continue.

• “Economic activity is contracting sharply, and the associated reduction in earnings and increase in credit needed to bridge the downturn will expand the debt burden and default risk of a highly leveraged business sector,” the report said.

• “Widespread downgrades of bonds to speculative-grade ratings could lead investors to accelerate the sale of downgraded bonds, possibly generating market dislocation and downward price pressures in a segment of the corporate bond market known to exhibit relatively low liquidity,” it warned.

• “Defaults on leveraged loans ticked up in February and March and are likely to continue to increase,” it said of loans to already-indebted companies

Asset prices still have room to fall.

The Fed noted that stock prices had “swung widely,” and said other assets could be in for lower prices.

• “Asset prices remain vulnerable to significant declines should the pandemic worsen, the economic fallout prove more adverse or financial system strains re-emerge,” the Fed warned.

• “The severe disruptions in economic activity following the outbreak could reduce house prices by bringing down household incomes and restricting access to mortgage credit,” the report said, though a decline in supply could limit that effect.

Article source: https://www.nytimes.com/2020/05/15/business/economy/fed-financial-stability-coronavirus.html