After years of risky companies taking on unprecedented amounts of debt, weakening lender safeguards and blurring earnings math to appear more credit worthy, some now argue the Fed is turning everyone into a winner, distorting asset prices in the process.
“Once you start fixing prices, the information content is lost and they no longer tell us anything about risk and reward to help allocate resources,” said Peter Fisher, a professor at Dartmouth College’s Tuck School of Business and former head of fixed income at BlackRock, which is managing some of the Fed lending facilities.
Even more troublesome is that the Fed had been warning for more than a year about corporate leverage buildups amid the record economic expansion.
In a financial stability report published last year, the central bank noted that the share of new loans to large corporations with debt-to-earnings ratios above 6 times had increased past peak levels previously seen in 2007 and 2014 when underwriting quality was poor.
Distorting Incentives
Srinivas Dhulipala, a former prop trader at Bank of America Corp., said he shuttered his hedge fund last year after falling behind rivals partly because he was unwilling to take outsized risks on his credit bets. He believes the Fed is distorting incentives in the marketplace.
“The Fed is saying if you were willing enough to take too much risk, then don’t worry, we will bail you out,” he said in an interview. “Of course the virus was a big hit,” he added, but the market “was trading with absolutely no cushion for any type of a shock.”
Matthew Mish, a strategist at UBS Group AG who has often highlighted risks building in corporate debt, has a more generous assessment of Powell’s actions so far. He argues the central bank needed to prevent an economic crisis from turning into a financial one and that the benefits filtering through to the riskiest borrowers have so far been minimal.
“What I am concerned about is if the Fed ultimately has to expand the credit box, because the next time they expand it is going to be bailing out highly levered, private-equity owned companies,” Mish said. “That would be the definition of moral hazard.”
For some, that bridge has already been crossed.
“If they now provide a significant amount of support to get those firms that were heavily leveraged through this, everybody will assume that they will do it next time,” said William English, the former director of the Division of Monetary Affairs at the Fed Board who is now a professor at the Yale School of Management. “They will have to be clear that they are only doing this with gritted teeth.”
--With assistance from Sridhar Natarajan.
This article was provided by Bloomberg News.