The minutes of the December 17-18 Federal Open Market Committee meeting, released Wednesday afternoon, make for generally upbeat reading. The Fed feels quantitative easing did what it needed to do and will proceed “cautiously” with winding it down. But the conversation did turn to potential systemic risks that Fed officials need to keep an eye on, one of which being the “increase in issuance of leveraged loans this year and the apparent decline in the average quality of such loans.”
Indeed, with volumes returned to pre-financial crisis levels in the junk bond market and the leveraged loan market hitting a record high of $605 billion in 2013, it appears that banks once again have abandoned credit risk pricing in favor of gobbling up fees and passing on toxic paper to CLOs and institutions. According to LCD, the average yield at which BB rated loans are clearing this month is 3.52 percent – about half a point higher than the yield on 10 year Treasuries.
However, Fed officials are not too concerned about this since most zombie companies have refinanced their loans and now have a couple years of breathing space. Indeed the fact that any company that can drag itself into a bank lobby can get a loan has driven the default rate down to below 2 percent.
The Fed finds a few other developments worrying. The minutes show that, “several participants commented on the rise in forward price-to-earnings ratios for some small cap stocks, the increased level of equity repurchases, or the rise in margin credit.”
Because of these concerns, “A couple of participants offered views on the role of financial stability in monetary policy decision-making more broadly. One proposed that the Committee analyze more explicitly the potential consequences of specific risks to the financial system for its dual-mandate objectives and take account of the possible effects of monetary policy on such risks in its assessment of appropriate policy.” It remains to be seen whether the Fed can overcome its instinct to coddle bankers when they get into trouble.