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Securities and Exchange Commission Roundtable on U.S. Credit Markets

Securities and Exchange Commission

Roundtable on Interconnectedness and Risk in U.S. Credit Markets

Wednesday, October 14, 2020

 

Opening Statements

S.P. Kothari, Chief Economist and Director of the Division of Economic and Risk Analysis, SEC

In his opening remarks, summarized the agenda and discussed the staff report titled U.S. Credit Markets: Interconnectedness and the Effects of the COVID-19 Economic Shock. Kothari stated that the report focuses on the interconnections among various market segments as well as examines how those markets functioned in March 2020 in response to both the COVID-19-induced economic shock and the related monetary and fiscal policy responses. He emphasized that the timely intervention by the Federal Reserve, Treasury Department, and Congress was extremely important in stabilizing prices, increasing confidence in the market, and sustaining economic activity. Kothari continued that a crisis such as this clearly demonstrates the importance of market structure as well as the need to continually improve the functioning and resilience of financial markets. He concluded with a caveat that general economic and long-term credit stresses from the initial COVID-19 shock are still unfolding and that the SEC will continue to monitor these developments.

Panel I: Market Perspective

Panelists:

  • David Finkelstein, Chief Executive Officer, Annaly Capital Management
  • Dawn Fitzpatrick, Chief Investment Officer, Soros Fund Management
  • Steven Goulart, Executive Vice President and Chief Investment Officer, MetLife, Inc.
  • Barbara Novick, Vice Chairman, BlackRock
  • Thomas Wipf, Vice Chairman of Institutional Securities, Morgan Stanley
  • Sumit Rajpal, Senior Policy Advisor, SEC (Moderator)

The first panel focused on the economic impact of COVID-19 on six credit markets spanning over $40 trillion of outstanding debt, including the short-term funding, corporate bond, leveraged loan, residential and commercial real estate, and municipal securities markets. Rajpal began with a discussion of the Federal Reserve lending facilities established in response to the COVID-19 pandemic, specifically highlighting that the fact that only four facilities (PPLF, MMLF, PMCCF, and SMCFF) had significant uptake while the others did not. The panelists agreed that the mere announcements by the Fed of these facilities restored market confidence and stability as well as signaled to credit markets that the Fed is ready to step in to support the markets, including in the future. Goulart highlighted the need for central banks and regulators to develop an exit strategy so the markets can return to providing their central responsibility of price discovery.

Rajpal then noted the significant widening of bid-ask spreads as a result of the COVID-19 induced economic shock. Novick commented that this crisis was a “perfect storm”, resulting in a “dash for cash” and creating market conditions that led to additional stresses for both banks and proprietary trading firms. She continued that the pressures faced by both of these types of entities should be examined in the context of trying to improve overall market structure.

Rajpal asked for each of the panelists to outline one change that should be made to avoid a repeat of the market conditions observed in March and April of 2020. In response, Wipf highlighted the importance of expanding central clearing in the Treasury repo market. He continued that a well-functioning Treasury repo market is critical and that there is a need to remove counterparty credit risk and intraparty credit risk as much as possible. Fitzpatrick added her belief that the Fed should have a standing treasury and repo facility that is accessible to banks.

Rajpal turned to a discussion regarding the corporate bond market, noting that the structure of this market has evolved significantly over the past decade. Wipf spoke about the shift from risk taking to risk transfer but added that large firms have expanded their commitment to this market since the previous financial crisis. Novick added that swing pricing should be made available as a tool for use in the U.S.

Regarding corporate credit, Goulart stated that there is currently an increased concentration of corporate credit at the lower end of the corporate rating curve and that he expects default rates to continue to grow. He then added that despite this trend, he does not expect default levels to reach the high levels of projection that were put forth early on during the pandemic. He concluded that CLOs do not pose a systemic threat to the insurance industry as the industry invests at the higher end of the credit curve.

The panel concluded with various conversations regarding the growth of non-banks in the residential mortgage market as well as the commercial mortgage market more generally. Of note, Finkelstein stated that non-banks stepped into the fill the void left by banks in the residential mortgage market following the last financial crisis but that many of these entities are thinly capitalized. Fitzpatrick added that capital requirements as well as liquidity and stress testing need to be improved in this space. Finkelstein also outlined his belief that over the long term, the commercial mortgage sector is going to recover and adapt to the new realities of a post-COVID world.

Fireside Chat

Panelists:

  • Mark Carney, COP 26 Finance Adviser and UN Special Envoy
  • Gary Cohn, former Director of the U.S. National Economic Council
  • Glenn Hutchins, Chairman, North Island
  • Lorie Logan, Executive Vice President, Markets Group, Federal Reserve Bank of New York
  • Jay Clayton, Chairman, SEC (Moderator)

The fireside chat began with Clayton asking panelists about the state of the market and their predictions as to where the economy will trend. Cohn said that regulators took steps to stabilize the market, but more fiscal stimulus is needed for small businesses and the hospitality industry. Carney agreed and noted that while the capital markets are relatively stable, small businesses continue to face difficult credit realities.

Clayton then asked panelists for suggestions as to how the SEC should move forward and which issues they should be focusing on. Carney responded that the SEC must recognize the interconnectedness of the financial markets. Cohn suggested regulators free up cash and margin requirements to increase market speed. He added a recommendation that the SEC create a permanent memory bank of lessons learned during the COVID-19 response to analyze and improve upon. Hutchins stated that regulators should improve the functioning of the Fed facilities to better distribute credit to small and medium sized businesses.

Clayton asked Logan about the Fed’s expansion of U.S. dollar swap lines to foreign central banks, which he characterized as having a stabilizing effect around the world. Logan said the Fed’s work to enhance the availability of dollars and lower the cost of swap lines and added maturity were effective. Carney joined the discussion on international cooperation, focusing on the areas of central clearing between the U.S. and U.K., daily liquidity funds invested in illiquid assets, and what should be included in leverage ratios. Hutchins added that global cooperation in implementing various lending facilities created calmness in the market and led to normalized rational repricing.

Clayton asked panelists to discuss the regulation of non-banking activities. Carney said properly structured, market-based finance is complimentary and demands tailored regulation. He added that regulators need to be thoughtful about the nature of credit remediation. Cohn discussed unregulated fintech and the dependence on the banking community to originate loans.

The fireside chat concluded with Carney explaining that firms should not be expected to insure themselves for systematic risk, adding that it is the job of government to intervene with fiscal support and lending facilities. Cohn echoed Carney’s remarks, noting that central banks are critical during times of crisis to provide credit to ease the stress of market participants.

Panel II: Regulatory Perspective 

Panelists:

  • Tobias Adrian, Financial Counsellor and Director, Monetary and Capital Markets Department, International Monetary Fund
  • Natasha Cazenave, Deputy Secretary General of Policy and International Affairs, AMF
  • Andreas Lehnert, Director, Division of Financial Stability, Board of Governors of the Federal Reserve System
  • Brent McIntosh, Under Secretary for International Affairs, U.S. Department of the Treasury
  • S.P. Kothari, Chief Economist and Director of the Division of Economic and Risk Analysis, SEC (Moderator)

The second panel began with Kothari asking panelists to discuss actions taken by the Fed and Treasury to stabilize the economy at the beginning of the pandemic. Adrian said that in late March, swift action was needed to prevent serious disruptions in funding markets, swap lines, and the long-term credit market. McIntosh said that the design choices of both Fed and fiscal support facilities worked well to stabilize the economy, but their effectiveness was hurt due to delayed congressional action. Cazenave noted that actions taken by the Fed and Treasury restored confidence in the face of uncertainty and volatility.

Kothari then asked panelists to comment on the effect that U.S. action has had on international markets. Cazenave explained that some measures taken by U.S. regulators were directly designed to have international influence and worked effectively at “smoothing the system.” Adrian explained that in March, an initial selloff of risky assets hurt emerging market stock and bond prices, but swap lines and the rollout of Fed repo facilities stabilized global markets.

Kothari turned to economic recovery efforts and asked panelists where they see the economy trending in the future. Adrian explained that economic recovery progresses in a lopsided fashion, with the degree of lopsidedness changing across countries and industries. He noted that the Fed and financial regulators have helped cushion the economic fallout and is optimistic about the outlook. Mcintosh noted concerns that recovery efforts may add hazard to the financial system as the response was fundamentally not driven by risk.

Kothari noted that at the beginning of the COVID-19 pandemic, there was little concern from financial press or regulators from a systematic risk standpoint. He asked panelists to explain why the situation in the credit markets warranted policy intervention and if there are consequences of repeated interventions. Andreas responded that access to credit markets at reasonable spreads was a critical element of the response to the pandemic and that monetary policy easing should pass through to the underlying borrowers. He characterized the emergency facilities as providing a backstop so that investors could continue to trade with confidence. McIntosh stated that the goal of various interventions domestically was to keep the economy running, thereby supporting businesses and households. He defended the Treasury for injecting liquidity into credit markets, saying it was the most direct route to ensure workers remained supported despite the shutdown of the economy.

Closing Remarks

  • Mohamed El-Erian, President of Queens’ College, Advisor to Allianz and Gramercy

In his remarks, El-Erian congratulated the SEC for documenting policy responses and market outcomes, and in doing so, establishing a record to ensure that lessons are not forgotten. He supplemented the conversation by putting it in a more general framework, focusing on the contrast between meeting the narrow objective of restoring normal market function and trying to make that consistent with the systemic health of the system as a whole. He criticized the fact that we have gotten “hooked” as society on using public and private credit and leverage to pursue economic growth. El-Erian stressed that it is it is socially and politically imperative that the U.S. does not grow accustomed to this.

El-Erian continued his remarks, highlighting the fine line between good and excessive risk taking. He stated that increasingly, the financial system is irresponsibly taking risk. In closing, El-Erian said regulators need to plan for many more potential outcomes though scenario analyses and develop a range of contingency plans.

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