Reuters
Federal Reserve Chairman Jerome Powell
Risky new loans are being made to already debt-laden companies at a solid pace in the first quarter and credit standards have deteriorated further, according to the second-ever Federal Reserve report on financial stability released Monday.
The share of newly issued large loans to corporations with high leverage, defined as those with a ratio of debt to EBITDA above 6, increased over the last nine months and now exceeds previous peak levels observed in 2007 and 2014, when underwriting quality was poor, the Fed report said.
There are worries that this small corner of the debt market could serve as a powder keg and heighten the economic pain from the next economic downturn.
Read: Here’s why the Fed and global regulators are ringing the alarm over leveraged loans and CLOs
Leveraged loans are floating-rate loans made to businesses rated below investment grade, often used to finance mergers and private-equity deals. The Fed tried to rein in the lending in 2013 but has faced a fierce push back from banks as well as Congress.
The broader corporate credit performance “remains favorable” with interest rates low by historical standards and debt service costs at the lower ends of historical ranges, even for risky firms.
Overall, the financial sector remains “resilient,” the Fed said.
Investors “continuing to exhibit high appetite for risk” and that has pushed valuations to elevated levels “in a number of markets,” the Fed said. Some pressures have eased a bit since the sharp market SPX, -0.45% sell-off in the fall, the central bank said.
Last week, Fed Chairman Jerome Powell told reporters that financial sector vulnerabilities remained moderate.
“Overall, we don’t see financial stability vulnerabilities as high,” Powell said.
In the wake of the global financial crisis, the Fed has been more alert for shocks and disruptions in financial markets. The central bank will update its report twice per year.
Household borrowing remains at modest levels and debt owned by borrowers with credit scores below prime has remained flat, the Fed said.
“With financial volatility easing since the end of last year, the [report] suggests stretched asset valuations and risky corporate debt merit continued vigilance against a backdrop of low-to-moderate vulnerabilities in the household and banking sectors,” said Fed Governor Lael Brainard, said in a statement.
