POLITICO: Lurking Beneath the Market Turmoil, Years of Mounting Financial Risks
Among the concerns are corporate debt, program trading, exchange traded funds and Chinese accounting.
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U.S. financial regulators are facing one of their greatest challenges since the financial crisis: how to take control of mounting investor fears without stoking a panic.
The stock market's spectacular plunge this week, triggered by growing fears that authorities will be unable to halt the spread of the deadly coronavirus, comes after years of warnings by regulators that share prices were frothy and investors were getting too complacent.
But the Federal Reserve and other agencies recognize that moving too rapidly to head off any more damage, as some political leaders would like, could signal that risks are even worse than they are — squandering their credibility with investors.
Still, the pressure to respond in a big way will grow as the anxiety persists.
The virus “is arguably the biggest risk to global growth since the Great Recession,” S&P Global Platts Analytics said in a note to clients.
Fed Chair Jerome Powell attempted to reassure markets on Friday afternoon by signaling the central bank would step in with a rate cut next month if necessary.
In some of the more severe hypothetical scenarios of how this could play out, the outbreak threatens to expose lingering dangers that the Fed and other regulators have long been watching — from the record-high level of debt held by businesses to the unpredictable behavior of ultra-fast automated stock traders.
“[Any] recession will stress things in the financial system that people see coming and will uncover stresses in the financial system that people didn’t know were there,” said Aaron Klein, policy director at the Brookings Institution’s Center on Regulation and Markets.
These are among the top concerns that regulators have cited:
Corporate Debt: Perhaps the biggest vulnerability to the financial system is the estimated $1.1 trillion that banks and other financial institutions have loaned to companies that are already highly indebted.
If the coronavirus starts to affect Americans’ everyday behavior that could be a crucial blow because healthy consumer spending has been the economy's most powerful driver over the past year, even as business investment began to decline and the manufacturing sector contracted.
If people begin “going less to the movies, to bars, to restaurants,” said Torsten Slok, chief economist at Deutsche Bank Securities, that would be a “big deal” in economic terms.
For one thing, it could put further strain on U.S. companies in an environment where business debt is historically large compared to the size of the overall economy. If supply chain disruptions hurt some of those companies enough that they can’t make their payments, it could mean substantial losses for banks that are crucial to keeping money moving through the economy.
“There’s simply innumerable ways of counting the bad loans that you would be hit with in the banking industry if you had a severe recession driven by a pandemic,” said Dick Bove, a financial strategist at Odeon Capital Group.
If the virus starts affecting people’s ability to go into work, “banks will first lose the ability to make a lot of loans in a productive fashion because companies will be shuttering down,” Bove said. “The second thing that happens is existing loans start to go bad; in other words, companies that have taken out meaningful amounts of debt can’t repay the debt because they don’t have the revenues that allow them to do so.”
Problems on the business side would also blow back onto workers, he said. “If companies are not producing anything, then people are not going to get paid, and then they can’t pay their credit card loans,” Bove said.
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