Fed Releases Financial Stability Report
November 15, 2021
On November 8, 2021, the Federal Reserve released its Financial Stability Report that assesses the reliance of the financial system.
The Fed notes that aggregate CRE prices continued to increase above pre-pandemic levels, though retail, hotel, and office valuations remained flat with limited transaction volume. While some strain continues, the Fed noted vacancy rates in most property types are generally in line with pre-pandemic levels, but office vacancies are elevated and hotel occupancy rates remain depressed. CMBS delinquencies continue to decline, yet still elevated compared to pre-pandemic levels. Banks reported strong CRE loan demand in Q2 and that lending standards remain tighter than pre-pandemic.
The report also highlighted potential fallout from stress in China’s real estate sector could have impacts on global markets and the U.S.
Overall, the headline vulnerabilities were:
- Asset valuations. Prices of risky assets generally increased since the previous report, and, in some markets, prices are high compared with expected cash flows. House prices have increased rapidly since May, continuing to outstrip increases in rent. Nevertheless, despite rising housing valuations, little evidence exists of deteriorating credit standards or highly leveraged investment activity in the housing market. Asset prices remain vulnerable to significant declines should investor risk sentiment deteriorate, progress on containing the virus disappoint, or the economic recovery stall.
- Borrowing by businesses and households. Key measures of vulnerability from business debt, including debt-to-GDP, gross leverage, and interest coverage ratios, have largely returned to pre-pandemic levels. Business balance sheets have benefited from continued sound earnings growth, low interest rates, and government support. However, the rise of the Delta variant appears to have slowed improvements in the outlook for small businesses. Key measures of household vulnerability have also largely returned to pre-pandemic levels. Household balance sheets have benefited from, among other factors, extensions in borrower relief programs, federal stimulus, and high aggregate personal savings rates. Nonetheless, the expiration of government support programs and uncertainty over the course of the pandemic may still pose significant risks to households.
- Leverage in the financial sector. Bank profits have been strong this year, and capital ratios remained well in excess of regulatory requirements. Some challenging conditions remain due to compressed net interest margins and loans in the sectors most affected by the COVID-19 pandemic. Leverage at broker-dealers was low. Leverage continued to be high by historical standards at life insurance companies, and hedge fund leverage remained somewhat above its historical average. Issuance of collateralized loan obligations (CLOs) and asset-backed securities (ABS) has been robust.
- Funding risk. Domestic banks relied only modestly on short-term wholesale funding and continued to maintain sizable holdings of high-quality liquid assets (HQLAs). By contrast, structural vulnerabilities persist in some types of Money Market Mutual Funds (MMFs) and other cash-management vehicles as well as in bond and bank loan mutual funds. There are also funding-risk vulnerabilities in the growing stablecoin sector.
On the Treasury market, the report noted yields remain low but within historical ranges, though an increase in yields without a stronger economic outlook could lead to downward valuation in many markets. The Fed also provided a positive outlook on the Treasury market volatility and functioning, “measures of Treasury market functioning have been stable since the previous report. In particular, liquidity metrics, such as market depth, have remained stable since recovering from the brief period of stress in February 2021.” This outlook appears to be diverging with the recent liquidity issues in the Treasury market.