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

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  • 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.”
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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.