MNI POLICY: Fed Says Near-Term Financial Risks 'Significant'

--Financial Institutions, Including Bank Sector, 'May Experience Strains'

--Strains on Household, Business Balance Sheets Will Last For 'Some Time'

By Evan Ryser

     WASHINGTON (MNI) - The U.S. Federal Reserve on Friday flagged significant

financial sector vulnerabilities in the near- and medium-term in the face of the

Covid-19 pandemic, placing strains on household and business balance sheets that

will last for some time. 

     In its latest twice-yearly review of financial stability, the Fed said

financial institutions including the banking sector had large capital and

liquidity buffers before the shock but "may experience strains" as a result of

the pandemic.

     In an effort to prevent the U.S. economy from spiraling, the Federal

Reserve has launched an unprecedented effort to keep money flowing, by slashing

interest rates to near zero, announcing nine emergency facilities and announcing

limitless asset purchases.

     "Forceful early interventions have been effective in resolving liquidity

stresses, but we will be monitoring closely for solvency stresses among highly

leveraged business borrowers, which could increase the longer the Covid pandemic

persists," said Governor Lael Brainard in a statement. 

     --SHOCK AMPLIED

     Asset prices since March have been volatile across many markets, the Fed

noted, and while spreads have narrowed in key markets, asset prices remain

vulnerable to significant price declines should the pandemic take an unexpected

course, the economic fallout prove more adverse, or financial system strains

emerge. 

     The Fed said despite regulatory reforms adopted since the 2000 financial

crisis, "the financial system nonetheless amplified the shock." 

     Covid-19 hit the U.S. economy, the Fed said, as historically high debt

relative to GDP was concentrated among the riskiest firms with weak credit

standards that resulted in widespread repricing of credit risk and appreciably

slower origination of leveraged loans and high-yield corporate bonds. 

     "While household debt was at a moderate level relative to income before the

shock, a deterioration in the ability of some households to repay obligations

may result in material losses to lenders," the Fed's Financial Stability Report

said. 

     -- MEDIUM-TERM RISKS ELEVATED

     The outlook for the pandemic and economic activity is uncertain, the report

noted, but near-term risks to U.S. and global economies remain high. There is

also further potential, the Fed said, for stresses to interact with preexisting

vulnerabilities stemming from financial system or for fiscal weaknesses in

Europe, China, and emerging markets to interact with underlying vulnerabilities

to "pose additional risks to the U.S. financial system."

     "All told, the prospect for losses at financial institutions to create

pressures over the medium term appears elevated," the Fed report said. 

     Before the pandemic, the largest banks were strongly capitalized and

leverage at broker-dealers was low, the Fed noted. "To date, banks have been

able to meet surging demand for draws on credit lines while also building loan

loss reserves to absorb higher expected defaults."

     But measures of leverage at life insurance companies and hedge funds were

at the higher ends of their ranges over the past decade, and broker-dealers

struggled to provide intermediation services during the acute March period of

financial stress. 

     Some hedge funds reportedly contributed to market dislocations, the Fed

said, and appeared to have been severely affected by the large asset price

declines and increased volatility in February and March. 

     -- FUNDING

     Funding markets, in the face of the Covid-19 outbreak and market stresses,

proved "less fragile than during the 2007-09 financial crisis," the Fed said,

adding that "significant strains emerged" requiring emergency Section 13(3)

facilities and dollar swap lines with foreign central banks to stabilize

short-term funding markets.

--MNI Washington Bureau; +1 202 371 2121; email: evan.ryser@marketnews.com

[TOPICS: MMUFE$,M$U$$$,MT$$$$]