On the Day Biden's COVID Task Force Launched, Fed Says "Asset Risks Remain If Pandemic Continues"

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[Asia Economy Reporter Jeong Hyunjin] The U.S. Federal Reserve (Fed) has warned that if the spread of the novel coronavirus disease (COVID-19) is not contained, defaults could occur one after another in the financial markets. This once again emphasized that the COVID-19 pandemic could become a trigger shaking the financial markets amid a significant increase in household and corporate debt.

In the financial stability report released on the 9th (local time), the Fed pointed out that "uncertainty remains high" and "if the economic recovery outlook darkens or efforts to curb the spread of COVID-19 disappoint, investor risk sentiment could change rapidly." It added that although most assets have held up well so far, "if the economic recovery weakens further, asset prices that are in a vulnerable state could fall significantly."

The Fed expressed the greatest concern over the sharp increase in corporate and household debt due to the COVID-19 crisis. Regarding household debt, the Fed warned that "loan defaults could increase as many households face difficulties." For corporations, it noted, "As revenues declined, companies increased borrowing to cope," and "a sharp drop in economic activity and the resulting overall decline in corporate earnings reduce companies' ability to repay loans." This means that if economic activity halts again due to a resurgence of COVID-19, the ability to repay already increased debt will decline, potentially impacting the financial markets.

The Fed pointed out that "record-high corporate debt and weakened household finances could bring significant vulnerabilities to the financial system." The Wall Street Journal (WSJ) assessed that "the COVID-19 pandemic remains the greatest risk to the U.S. financial system."

The Fed's concerns are gradually materializing. According to an analysis by global credit rating agency Moody's at the end of last month, the number of companies worldwide likely to become so-called 'fallen angels'?firms whose credit ratings fall from investment grade to speculative (junk) grade due to the impact of COVID-19?reached a record high of 89 as of the end of September.

This means that there are more companies currently rated Baa3, which is investment grade, but with a negative outlook, making them likely to be downgraded to speculative grade compared to before. Notably, the debt held by these companies stood at about $512 billion at the end of the third quarter, an increase of $3 billion from the previous quarter. The debt held by U.S. companies also reached a record high of $254 billion.

The U.S. real estate market is also facing difficulties due to COVID-19. The Fed explained that vacancy rates for commercial real estate such as office buildings are rising, and rent increases have slowed or even declined in some cases. It added that the proportion of mortgage payment deferrals is 7%, higher than the pre-pandemic level of 5%.

While the Fed said that, so far, the burdens on companies and households have been relatively eased through government stimulus measures and low interest rates, it expects that financial markets could be affected depending on the future COVID-19 situation. The Fed warned, "If the pandemic lasts longer than expected, especially if vaccine development and distribution are delayed, downward pressure on the U.S. economy will break the initial recovery momentum and tighten the financial markets."

Lael Brainard, a Fed governor who is a leading candidate for the first U.S. Treasury Secretary under the Joe Biden administration, drew attention by mentioning the need for financial reform. In a statement released with the report, she said, "During the COVID-19 crisis last March, demand for certain funds was greater than during the 2008 financial crisis," and added, "The renewed vulnerabilities in the non-bank financial sector in the current crisis underscore the importance of re-implementing financial reforms."

For the first time, the Fed included an analysis of the economic impact of climate change in this financial stability report. Governor Brainard analyzed that "acute risks such as storms, floods, and wildfires can cause investors to rapidly change their perceptions of the value of real and financial assets."

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