Long before the coronavirus pandemic would bring business to a standstill all across America, Surgery Partners Inc., a sprawling network of outpatient clinics, already had its share of financial problems.
This was no secret on Wall Street. Surgery Partners’s majority owner, the buyout firm Bain Capital, had loaded so much debt onto the company’s books that when it went to the market last year to refinance maturing bonds, investors demanded a 10% interest rate to compensate them for the risk. The debt was rated CCC, or eight levels below investment grade.
Even a moderate downturn, it was understood, was going to raise existential questions about the company. So by late March, with the economic effects of the outbreak in full force, frantic investors braced for default, pushing the price of those bonds below 55 cents on the dollar.
But then the Federal Reserve did something it had never done before. It pledged to buy risky corporate debt as part of its emergency financing package for the economy. The move was so aggressive and sparked a rally that was so powerful and broad-based that today those bonds are all the way back up near par value, and Surgery Partners was able to raise another $120 million from loan investors earlier this month.
It all has worked out so fortuitously for the creditors and equity holders of Surgery Partners -- and those of scores of other companies with similarly shaky balance sheets -- that the Fed’s actions carry a grave risk: that investors, rather than being chastened, will be emboldened to take greater chances and seek fatter returns in the future, believing that policy makers will be there to bail them out if they get in trouble.
Economists refer to this phenomenon as moral hazard, and it hasn’t been this big a concern in a long time, perhaps not even during the 2008 financial crisis.
“It’s an exquisite irony,” said Nathan Sheets, chief economist of PGIM Fixed Income. “What the Fed is doing is necessary to get the markets going again, but on the other hand they leave investors thinking the Fed has their backs.”
Decade of Warnings
That’s not to say the Fed’s policy approach doesn’t have its merits. In fact, it may well have helped avert another financial crisis and possible economic depression. But there are also very real, significant risks that come with such an aggressive response.
The central bank had spent more than a decade telling the public that it was unwavering in its resolve to force Wall Street to rebuild its capital buffers so it could lend both in good times and bad. Yet even after banks beefed up their reserves and cut back on risk-taking with their own funds, the financial system is yet again in need of extraordinary support.
“It’s as if they believe the banking system no longer works,” said Paul Tucker, former Deputy Governor of the Bank of England and chair of the Systemic Risk Council, a think tank of former regulators.
What’s worse, according to Tucker, is that the Fed might have altered incentives for years to come, inducing investors to continue to lever up companies beyond what’s prudent. That may create even more instability in the next downturn.
A spokesperson for the central bank declined to comment.