The Treasury Department warned Tuesday that corporate borrowing represents one of “several threats to financial stability” to have emerged during the post-2008 economic recovery.
The third annual Congressional report published by the department’s Office of Financial Research found that significant corporate loan exposure, the possibility of a liquidity shortage during a downturn, and an increase in activity in “difficult to assess” sectors cast a pall over the US economy.
“Assets under management have increased ten-fold over the last five years, driven by a search for yield and a hedge against an eventual rise in interest rates,” the report stated. It described the trend as having caused increased risk “concentrated in nonbank entities that are not directly regulated by banking supervisors.”
Richard Berner, the office director, said that the financial system “has continued to recover and strengthen” and that threats to the system “are moderate.”
“But that relatively benign backdrop is no cause for complacency,” he added.
Treasury researchers said that the recent period of relatively low interest rates has encouraged “excessive risk-taking” and that corporate borrowers have been spurred by “low long-term borrowing costs” to expand leverage to proportions exceeding “peak levels prevailing in 2005-07.” While the market broadly expects a gradual rise in interest rates, a sudden 1 percent increase in interest rates could cause US bond mutual funds to lose 5.6 percent of their value.
The Treasury Department also concluded that the corporate credit market is “currently somewhere between the expansion and downturn phase” while houses and banks are still recovering from the collapse of 2008. A recent increase in financial innovation hint at what the report termed “a hallmark of late-stage credit cycles.”
Compounding the problem are entities playing fast and loose with credit.
“Nonfinancial corporate balance-sheet leverage is still rising, underwriting standards continue to weaken and an increasing share of corporate credit risk is being distributed through market-based financing vehicles that are exposed to redemption and refinancing risk,” the report stated.
It said that corporations are using proceeds from early-cycle long-term debt to borrow more–to finance “stock buybacks, dividend increases, mergers and acquisitions, and leveraged buyouts, rather than to support business growth.”
A key measure of debt to earnings was up to 7.7 in October, Treasury said, noting that the gauge is approaching its 2007 peak.
“Even an average rate of default could lead to outsized losses once interest rates normalize, given the expansion in corporate debt,” the report warned.
Giving that fear added weight is the lower quality of corporate debt.
“High-yield debt accounts for 24 percent of total corporate debt issued since 2008, compared with 14 percent during past cycles, and low-rated credits dominated new issuance volumes over the past year,” the report found. It also said that two-thirds of credit issued during the current cycle lack strict legal agreements. In previous cycles, Treasury said, this proportion was at 33 percent.
“These attributes are likely to lead to lower recovery rates on defaulted credit instruments once the credit cycle turns.” Department researchers said that the volume of securities backed by corporate loans and leveraged loans – “higher-risk bank loans often sold to institutional investors” – has surpassed the apex of the previous credit cycle.
The report did claim, however, that regulators are aware of problems and “have responded with guidance and exhortations to banks.”
It said that “better liability management” could help corporations weather any storms on the horizon, but said that potential pitfalls could grow rapidly “as the cycle turns from expansion to downturn.”
Read the full report here.
