The $12 Trillion Credit Risk Juggle
After the financial crisis, regulators were worried about too much risk being concentrated in too few hands.
They are still concerned, but the hands have changed.
The U.S. Treasury's Office of Financial Research is devoted to worrying about everything and anything that could spur another financial crisis, and near the top of the list is the post-crisis explosion in corporate credit. This pile of debt is “a top threat to stability,” according to this Treasury unit's latest report, as Bloomberg's Claire Boston wrote on Tuesday.
In particular, these researchers are wary of the changing composition of who owns these bonds. Big banks and hedge funds own a much smaller proportion, while insurers and mutual funds own much more of it.
More specifically, banks and household and nonprofits, a category that includes hedge funds, have reduced their holdings of U.S. corporate credit by $1.6 trillion since 2008, while insurers, mutual funds and the rest of the world have increased it by $3.6 trillion, according to data compiled by Goldman Sachs that includes foreign sovereign debt and asset-backed securities.
This is a salient matter. The Federal Reserve just raised rates for a second time in two years and predicts three rate increases next year, possibly marking the end of this era of financial repression that's spurred a record pace of corporate-debt sales.
Higher benchmark rates may signify a stronger economy that's good for corporations. It may also simply raise borrowing costs for these company, putting a strain on their profitability and spurring more defaults and losses. Which brings us back to the owners of these bonds.
In the years after the 2008 credit seizure, many individuals and institutions gravitated toward company debt as the Fed suppressed borrowing costs. In contrast, Wall Street's biggest firms cut their holdings of riskier assets drastically.
This is exactly what regulators wanted. It's harder to see the path from corporate defaults to a systemic credit seizure given the broader group of bond owners who are less leveraged than big banks.
And yet regulators are feeling uneasy about the ever-growing role these nonbank investors are playing in providing credit. The Treasury researchers propose stress-testing them, including mutual funds, pension funds and insurers, for a variety of scenarios, including severe losses on corporate debt, strained liquidity and crashing stock and commercial real estate markets.
It's normally hard to argue against more information and transparency, but it might be more prudent for the Treasury office to pick its spots given the incoming presidential administration's pledged hostility to regulation. It's not clear how a mutual or pension fund would pose a systemic threat. More valuable would be an examination of the new nodes of vulnerability given the new financial-markets environment. If regulators could pull together a report showing the derivative exposures of mutual funds and how well they're hedged with cash holdings, or the liquidity profile of insurers, retail funds and pensions, that would be incredibly illuminating.
The restrictions put on big banks after the financial crisis worked, and risk was pushed out to a broader range of participants. Regulators would be better off closely examining the stress points that could cause the next systemic crisis. The landscape has changed from the last one.
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Daniel Niemi at email@example.com