Commercial real estate, business debt cause concern in Fed report

  • For the most part, the economy appears to be recovering from the pandemic's jolt last year, even though the pace of recovery has been slowing.
  • Still the Federal Reserve points to some concerns in its semi-annual report to Congress. One such area is commercial real estate values.
  • "Commercial real estate prices remain at historically high levels despite high vacancy rates and appear susceptible to sharp declines, particularly if the pace of distressed transactions picks up or, in the longer term, the pandemic leads to permanent changes in demand."
  • That risk looms over $430B of CRE debt that's due to mature in 2021.
  • In addition, business debt has risen over the course of 2020 from levels that were already elevated, bringing business leverage to near record highs.
  • A number of factors, such as low interest rates and recently improving earnings, may be muting risks for the time being. Still, "insolvency risks at small and medium-sized firms, as well as at some large firms, remains considerable," according to the report.
  • The report also points out that life insurance companies' leverage has risen to post-2008 highs, and "vulnerabilities from leverage at hedge funds remain elevated."
  • Liquidity deterioration across the dealer-intermediated markets in March 2020 brought to light potential fragility even with dealers' low leverage; that vulnerability was likely mitigated by the Fed's emergency lending facilities.
  • On the bright side, banks' profitability and capital positions improved in H2 2020 due to lower-than-expected losses, a better economic outlook, and restrictions imposed by the Fed on capital distributions by the largest banks. In fact, capitalization at U.S. global systemically important banks (GSIBs) actually increased during the pandemic.
  • The results of the Fed's stress tests on banks, released in June and December 2020, indicate that banks would generally remain well capitalized under extremely severe recession scenarios, the central bank said.
  • Stock and ETR sector watch: With the Fed calling CRE prices susceptible to sharp declines, keep an eye on commercial mortgage REITs such as Starwood Property Trust (STWD +2.7%), Blackstone Mortgage Trust (BXMT +1.9%), Colony Credit Real Estate (CLNC +3.9%), and Ladder Capital (LADR +2.8%). ETFs with exposure to commercial mortgages include (CMBS -0.2%), (PGZ +2.1%), (JLS -0.0%), (FMY +0.6%).
  • Insurance ETFs include:(KIE +1.1%), (IAK +0.7%).

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