COVID-19 Financial-Policy Crisis
March 13, 2020
As the global pandemic wreaks market havoc, U.S. regulators have reached no conclusions
about how to stem growing liquidity and even solvency risks, relying wholly on Fed monetary
and market intervention that have yet to put a corral around the flight-to-safety stampede. This won’t work – the 2020 crisis is structurally different than 2008, poising risks for which regulators are ill-prepared and requiring urgent action yet to be seen.
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Friday the 13th seems an apt time to consider the week that was and its financial-system carnage. Fiscal policy may still pull the U.S. back from the brink, but we believe market fragility is now so extensive as to make the financial system vulnerable to any one of the continuing exogenous forces that cannot be stopped until the COVID-19 crisis ebbs, oil market stabilize at sustainable levels, and productivity resumes its lackluster course. Monetary policy may stabilize markets – at least a little – and Fed liquidity support has so far prevent still worse. However, this crisis is structurally different than 2008 because:
1) The U.S. is far more unequal than it was in 2008 and inequality is on its own a cause of financial crises and slow recovery. Although high-wealth households are suffering due to market losses, painful inequality-reduction surgery does not correct for the fact that hundreds of millions of Americans live hand-to-mouth no matter their middle or even upper-middle class income. U.S. households are also more leveraged than ever before, with debt burdens vulnerable to shock no matter the borrower’s credit score. Living and health-care cost increases due to COVID-19 further reduce financial resilience, making consumer-finance markets far more fragile than the subprime-mortgage sector heading into 2007.
2) Yield-chasing has sharply exacerbated market illiquidity exposing, solvency risk across the “zombie” sectors. This is particularly true in the leveraged-loan arena, which lenders thought they could escape risk by shortening terms even as billions more flowed to still more highly-leveraged borrowers. With a rude awakening, the leveraged and even lower-risk corporate debt markets are closed tight. The recent avalanche of line-of-credit drawdowns will defer financial distress, but cannot deter it absent quick financial-market recovery.
3) The flight to safety has also led to record cash inflows into the largest banks. U.S. banks are far better capitalized than in 2008, but hundreds of billions of cash inflows are outside the thresholds in recent stress tests and thus drain capital and liquidity buffers. Line draws do the same due to the higher risk weightings of on-balance sheet commitments. Absent changes to capital buffers or new liquidity facilities from the Fed, banks will be even less willing and able to serve as shock absorbers.
4) Asset managers are ill-prepared for fund outflows, with stress already evident across an array of funds. Post-crisis redemption restrictions may create some relief, but the first big fund to raise its gates may also send panic ricocheting across the sector. Contagion risk in this sector could prove systemic.
5) Nonbanks now provide more than half of all U.S. mortgage originations, subsuming them in the refi wave bursting in the wake of record low rates. All these refis buttress fee income, but nonbanks are nonetheless exposed to severe structural risk. The refi boom craters prepayment speed on existing mortgage servicing assets (MSAs), eviscerating value. Because MSAs account for 150% of the largest nonbanks’ equity, significant near-term solvency risk is possible. Nonbanks also depend on warehouse lending from banks to make it through each day. For the reasons specified above, this will be very, very hard to find if stress continues into next week.
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