February 27, 2019
By Joy Wiltermuth and Kristen Haunss
NEW YORK (LPC/IFR) – Former Federal Reserve (Fed) Chair Janet Yellen warned on Tuesday that America’s corporate debt binge could end up sparking a deeper recession when the next downturn hits.
Rock-bottom rates and easy lending standards have allowed US companies to pile on record levels of debt, sparking concern from regulators about the risk the credit markets may pose to the U.S. economy.
When asked about asset bubbles and potential fallout when the current US economic expansion cools down, Yellen singled out high corporate debt levels as a worry, according to a recording obtained by LPC/IFR, divisions of Refinitiv.
“I have expressed concerns about leveraged lending,” Yellen said during a keynote discussion that was closed to the press. “I do think non-financial corporations have run up, really, quite a lot of debt.”
The comments were made during a standing-room only panel at the annual Structured Finance Industry Group conference in Las Vegas.
“What I would worry about is if the economy encounters a downturn, we could see a good deal of corporate distress. If corporations are in distress, they fire workers and cut back on investment spending. And I think that’s something that could make the next recession a deeper recession,” said Yellen, who served as Fed Chair from 2014 to 2018.
A record $923.8 billion of U.S. institutional loans was arranged in 2017 followed by $730.4 billion in 2018, according to LPC data.
At the same time corporate buyout leverage, the amount of debt a company has compared to its earnings, rose to 6.6 times last year, up from 6.4 times in 2017, while lender protections weakened in the third quarter to a record low, according to Moody’s Investors Service.
When U.S. regulators, including the Fed, updated existing leveraged lending guidance in 2013, apprehensive at the time of deteriorating lending standards, they warned that leverage that exceeds 6.0 times “raises concerns.”
Yellen also sees potential for trouble in how the market reached its current size – the US leveraged loan market now tops $1 trillion.
“I have concerns about the deterioration in lending standards that we have seen,” Yellen said. “A large share of it is covenant-lite and some of the explicit ways in which covenants have weakened are a concern to me.”
Covenants are included into credit agreements as protection for lenders and consist of financial limits and conditions.
A spokesperson from the Brookings Institution, where Janet Yellen is a Distinguished Fellow in Residence with the Economics Studies Program, did not return email communications by press time.
While loan defaults remain low – Fitch reported a 1.75 percent rate at the end of 2018 – if loan defaults were to increase in a downturn, that could weigh on Collateralized Loan Obligations (CLO), the largest buyer of U.S. leveraged loans. Issuance in the $585 billion U.S. CLO market, which large US corporations rely on for financing, hit a record $128.1 billion in 2018.
Moody’s is forecasting first-lien loan recoveries to be just 61 percent in the next default cycle, down from the historical average of 77 percent. Second-lien loans may recover just 14 percent.
But Yellen also underscored that unlike the proliferation of toxic mortgage Collateralized Debt Obligations (CDOs) in the run-up to the financial crisis, there is currently less leverage in the system. Potential fallout from future write-downs also would appear to mostly reside outside of the banking system, and thus, have less far-reaching consequences than in the past.
“The holders are not by and large leveraged entities,” Yellen said.
While US households were at the epicenter of the global financial crisis a decade ago, after easy mortgage lending standards allowed many borrowers to use their homes as automated teller machines, homeowners, this time around, are not keeping Yellen up at night.
“I am not worried about households with respect to leverage and debt,” she said. “Households are in good shape.”
Yellen also elaborated on an interview published earlier this week that quoted her challenging President Donald Trump’s grasp on macro-economic policy.
“I doubt that he would even be able to say that the Fed’s goals are maximum employment and price stability, which are the goals that Congress have assigned to the Fed,” Yellen said in an interview with Marketplace.
When asked during the keynote about her response, Yellen said the question was unexpected and that she had answered it honestly.
During the approximately 50 minute discussion, Yellen also stressed that the Fed has done a good job of maintaining its independence over the past decade and staying out of politics.
“I don’t think there has been a lot of pressure. But I am more worried about it now with President Trump’s criticisms of the Fed,” she said.
Current Fed Chair Jerome Powell has said that independence and non-political decision-making is the Congressional mandate. The tradition in recent decades had been that Presidents do not comment on the Fed, Yellen said.
“No comment was the stance of President Clinton, President Bush, President Obama,” she said. “That was the way things were during my time.”
(Reporting by Joy Wiltermuth and Kristen Haunss.; Editing by Michelle Sierra and Lynn Adler)