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Fed Chief Concerned With Rising Debt of Highly Leveraged Companies

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In addition to remarks that suggested fewer rate hikes, Fed Chairman Jerome Powell highlighted the risks posed by heavily leveraged companies at his speech before the Economic Club of New York on Wednesday.

Although Powell described an economy that “is close” to achieving maximum employment and price stability,” he noted that “there are reasons for concern,” including the rising debt loads and growing interest burdens of highly leveraged firms and the deteriorating quality of debt underwriting.

Firms with high leverage and interest burdens have been increasing their debt loads the most, according to the Fed’s first Financial Stability Report that was released on Wednesday and a focus of Powell’s speech.

(Related: In Leveraged Loans, It’s Beginning to Look a Lot Like 2008)

“Some of these highly leveraged borrowers would surely face distress if the economy turned down, leading investors to take higher-than-expected losses – developments that could exacerbate the downturn,” said Powell.

He doesn’t expect such losses would pose a risk to the U.S. financial system, only to those investors who own such “vehicles like collateralized loan obligations” of highly leveraged firms. Powell noted that the Fed will continue to monitor developments in this sector.

(Related: CLOs Are Hot. Plan Accordingly.)

The excessive debt load of businesses and households is one of four vulnerabilities identified by the Fed as playing a prominent role in past financial crises. These vulnerabilities are distinct from shocks in the framework that the Fed uses to monitor risks to the stability of the financial system but can amplify them.

The three other vulnerabilities, according to Powell, are excessive leverage in the financial sector and funding risk for banks and nonbank financial entities, and financial bubbles.

Powell was generally sanguine about these vulnerabilities currently.  He said the Fed does not detect excessive leverage, funding risk or asset valuations although valuations of riskier forms of corporate debt and commercial properties “are in the upper ends of the post-crisis distributions.”

(Related: U.S. Household Debt Soars Past 2008′s Q3, NY Fed Says)

“We see no major asset class, however, where valuations appear far in excess of standard benchmarks as some did…. in the late 1990s dot-com boom or the pre-crisis credit boom.”  …We do not see dangerous excesses in the stock market… Overall financial stability vulnerabilities are at a moderate level.”

Asked by economist Martin Feldstein if Fed monetary policy should take into account financial stability, Powell said, it was “preferable to use regulatory tools” for that purpose but he noted that the Fed should keep in mind the crises that ended past business cycles, namely, the savings and loan crisis, bubble and mortgage bubble, which precipitated the financial crisis.


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