The Federal Reserve has issued another warning about corporate debt.
But the Fed’s concerns seem a bit ironic considering its own easy-money policies have made all of this borrowing possible.
Last fall, the Fed warned about the rising tide of risky corporate debt. According to the Federal Reserve’s most recent Financial Stability Report, things have only gotten worse.
“Borrowing by businesses is historically high relative to gross domestic product (GDP), with the most rapid increases in debt concentrated among the riskiest firms amid signs of deteriorating credit standards.”
According to the Fed, the growth in business debt has outpaced GDP growth for the last decade.
“Although debt-financing costs are low, the elevated level of debt could leave the business sector vulnerable to a downturn in economic activity or a tightening in financial conditions.”
Note that “tightening financial conditions” means rising interest rates. Economies built on debt don’t do well when interest rates rise, which is one of the main reasons the Fed suddenly turned dovish at the first sign of shakiness in the markets last fall. It’s also one of the main reasons Peter Schiff has been saying the “Powell Pause” won’t be enough and the central bank will eventually cut rates and launch another round of QE.
Total business debt has risen to $15.2 trillion. Of even greater concern is the nearly $1.1 trillion in outstanding leveraged loans. These are loans made to firms already deeply in debt. Think subprime loans for corporations.
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According to the Fed report, the amount of outstanding leveraged loans grew by 20.1% in 2018 alone. According to the S&P/LSTA Leveraged Loan Index, the total leveraged loan market has doubled since 2008. According to the Federal Reserve, the share of newly issued large loans to corporations with high leverage increased in the second half of last year and the first quarter of this year and now exceeds previous peak levels observed in 2007 and 2014.
In simple terms, these are companies that are already deeply in debt taking on even more debt. They are staying afloat on credit. This is only possible because interest rates are so low.
Thank you Federal Reserve.
So far, the default rate on these risky loans remains at nominal levels, but what happens if interest rates rise, or if the economy starts to tank?
Last fall, analysts were already worrying about all of this risky debt. The concern is that the high level of corporate indebtedness could make the next economic downturn “difficult to manage.” While few think it could cause the same kind of cascading meltdown we saw with the subprime mortgage market in ’08, it does “risk handcuffing companies and lenders trying to react to a downturn, possibly making it more painful,” according to a Reuters report last November.
“In a worst-case scenario that would faintly echo the financial crisis a decade ago, the defaults could worsen any downturn by destabilizing big non-bank lenders, such as private equity firms and hedge funds, and hitting employment across US industries. Leveraged loans are typically made to already indebted firms with low credit ratings, and the concern is that the loans would be difficult to either collect or resell in a downturn, putting both the borrower and lender at risk.”
The release of the most recent Financial Security Report highlights the problem, but it doesn’t offer any solutions. As Bloomberg put it, “The Fed also left a question unanswered: Is it going to do anything about it?
A lot of pundits in the mainstream want the Fed to “do something.” This is ironic since that Fed is a big part of the problem in the first place. The November Reuters article even acknowledged this.
“The central bank itself may have contributed to the ballooning $1.12-trillion US leveraged loan market by holding interest rates near zero for seven years in the wake of the recession to encourage lending and investment.”
The Fed isn’t going to “fix” this problem. As Peter Schiff summed up succinctly last fall, we basically have a repeat of the years leading up to 2008.
“They kept interest rates at 1%, which at that time was the lowest they’d ever been. They left them there for an entire year, and then it took two or three years to normalize back to 5%. But we took on a lot of debt when interest rates were artificially low. A lot of it was mortgage debt. And the bubble popped. But this time, the Federal Reserve injected far more monetary heroin into the economy. They kept interest rates at zero for six years. They’ve been raising them for three years, and they’re just now back at 2%. So, you have nine years so far of extremely artificially low-interest rates, which have caused a much bigger credit bubble than the one that popped in 2008.”
Subprime corporate debt is just one of the many market distortions caused by the Fed’s monetary policy. Along with piles of corporate, government and household debt, we have massive asset bubbles. The Fed seems to have bought the economy a little more time with the Powell Pause, but at some point a pin pricks one of these bubbles.
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