SEC Study Finds Credit Markets Largely Absorbed COVID-19 Risk, But Still Have a Way to Go
October 27, 2020
A new report by SEC staff seeks to identify the extent to which interconnectedness and related interdependencies in the U.S. credit markets contributed to or mitigated risk – including systemic risk – during the market stress brought on by the COVID-19 pandemic. The report generally concludes that while the markets were able to absorb a significant amount of shock, they are not yet out of the woods. SEC Chairman Jay Clayton and Chief Economist and Director of the Division of Economic and Risk Analysis S.P. Kothari summarized the key takeaways from the report as follows:
- S. credit markets have changed significantly since the 2008 Global Financial Crisis.
- The credit markets are highly interconnected, which can both accelerate transmission of risk and facilitate risk absorption.
- The ability of market intermediaries like market makers to absorb large and rapid shifts in investor sentiment is limited.
- Relief from the Federal Reserve and the CARES Act was instrumental in ameliorating stress in the credit markets.
- Combined actions by the Federal Reserve, Treasury, and Congress were also extremely important in stabilizing prices.
- General economic and credit effects from COVID-19 are still unfolding and ongoing monitoring must continue.
The report, authored by Kothari and Director of the Division of Investment Management, Dalia Blass, along with Senior Policy Advisors and SEC Research Staff, examines six credit market areas of the U.S. economy covering $44 trillion of outstanding credit: the short-term funding market; the corporate bond market; the leveraged loans and collateralized loan obligations (CLO) market; the municipal securities market; the residential mortgage market; and the commercial mortgage market.
The report includes the following important findings and observations:
Outflows from Prime Money Market Funds. While money market mutual fund assets under management increased 29 percent from the end of February to April 2020, and government money market funds also saw significant inflows during the same time, there was a two-week period in March during which publicly-offered prime institutional money market funds experienced redemptions significant enough to drop some funds’ weekly liquid assets low enough to fall below the 30 percent minimum threshold required by SEC rules. Outflows from prime institutional money market funds that are not publicly offered were less dramatic.
OTC Derivatives Directed into Central Clearing Counterparties. The report highlighted the significant number of bilateral, OTC derivatives and swap transactions that have been directed into central clearing counterparties (CCPs) following the 2008 financial crisis. During the first quarter of 2020, the initial margin posted on new trades increased by $160 billion across all U.S. derivatives CCPs, which drew short-term liquidity away from market participants and into the CCPs. Conversely, the approximately $400 billion increase in variation margin in March largely resulted in “a redistribution of liquidity in the system from one counterparty to another.” Overall, the SEC staff views the inherent benefits of CCPs and lack of bilateral counterparty credit risk as positives, but at the same time acknowledges the potential concentration risk from having a small number of CCPs.
Collateralized Loan Obligation Market Protection from Disruption. Currently $1.2 trillion of syndicated leveraged loans are outstanding in the United States, about half of which are packaged into CLOs. While these loans account for a relatively small portion of total outstanding debt in the United States, the CLO market has connections “across a wide range of participants in U.S. capital markets” and thus “have the potential to contribute to certain market stresses.” CLO ownership across a diversified type of investor may help absorb risk.
Increased Mutual Fund Participation in Municipal Securities. From 1990 to 2020, indirect participation in municipal securities ownership through mutual funds has increased significantly as more retail investors hold these securities through registered funds rather than directly. However, retail investors, directly or through funds, still hold a large majority of the market (around 72 percent) and the buy-and-hold nature of retail ownership results in most municipal securities being relatively illiquid. Inflows and outflows can thus have a substantial impact on the municipal market.
Residential Mortgage Markets’ Potential Risk Due to Interconnectedness. The report flags the potential risk of residential mortgage markets’ reliance on short-term funding from nonbanks, including from REITs, government money market funds, and the Federal Home Loan Bank system.
The SEC staff hosted a virtual roundtable on Interconnectedness and Risk in U.S. Credit Markets on October 14 following publication of the report. The roundtable focused on the markets’ perspective on COVID-19’s impact on liquidity and price volatility in capital markets, the interconnectedness of banking and nonbanking entities, and the regulatory perspective and response to the pandemic.
SEC Chairman Jay Clayton moderated a fireside chat discussion on the interconnectedness of banking and nonbanking entities and intermediaries, which echoed the findings in the report. This discussion also focused on how electronic systems influence trading and interconnectivity, providing markets with instant data, concurrent pricing transparency, and rapid communications, yet simultaneously introducing risks such as acceleration of potential market declines. The discussion also reflected on how the already vague distinction between banking activity and nonbanking activity is becoming outdated. It was noted that, during the pandemic, trading infrastructure remained largely unhindered, continuing to handle record trading volumes throughout the crisis, largely as a result of the “muscle memory” retained following the 2008 financial crisis. That said, the speakers agreed that further preparedness is needed for any new emergency if this “muscle memory” fades, and suggested that credit market corrective solutions should include evidence-based recommendations based on daily liquidity, leverage ratios, international cooperation, and available relief credit for small/medium-sized enterprises.
The roundtable also addressed the price volatility and liquidity impact caused by the pandemic. The discussion focused on credit markets with over $40 trillion in outstanding debt combined, comprised of corporate bonds, leveraged loans, short-term funding, residential and commercial real estate, and municipal securities markets. Markers of increased market volatility during the pandemic included record-high bid-ask spreads and credit spreads, plus an increased percentage of mortgages originating from nonbank entities.
Speakers identified potential future precautions against unseen market disruption: counter-cyclical buffers; improving the supplemental leverage ratio for commercial dealers; and minimizing commercial credit risk. They stressed that the industry must acknowledge the long-term effect of low interest rates as well as the increased default rate across various industries during the pandemic. Finally, they addressed the adverse impact of social distancing on demand in markets such as office real estate. There appeared to be a consensus that these impacts are likely to be short-term and that markets will recover in the long-term.
A separate panel, focused on regulatory perspective, evaluated the effects of the COVID-19 economic shock to U.S. and international financial markets and the effectiveness of worldwide monetary interventions and fiscal measures, looking at where the markets functioned well, where they showed signs of stress, and where vulnerabilities may remain.
The roundtable closed out with remarks from economist Mohamed El-Erian, who noted that the world is over-reliant on leveraging public and private credit in the pursuit of persistent economic growth. This overreliance, according to El-Erian, adversely affects diverse communities, curtailing equity growth for some but not others. He urged markets to become less reliant on credit, leverage, and the Federal Reserve in times of instability. Instead, he called for a reduction in total public and private debt to promote longer-term stability.
TAGS: Jay Clayton, Dalia Blass, COVID-19, Coronavirus, DERA