Fed's Lax Corporate Lending Terms Invite Trouble

(Bloomberg Opinion) -- During the past few weeks the spreads on corporate bonds relative to Treasuries with comparable maturities have risen sharply. This kind of increase is a natural part of recessions, as investors demand more compensation for the default risks of corporate debt issuers. But a key and unusual part of the government economic response to the pandemic (and the associated recession) has been to make sure that these natural increases in bond spreads are not passed along to corporate borrowers.

Thus, the Federal Reserve stands ready, through its new primary market corporate credit facility, to make attractive loans to investment-grade corporations. These subsidized four-year loans are a bailout of the corporate sector because companies will be able to borrow at interest rates that are not reflective of their true risks.

This need to try to contain rising bond spreads because of the decline in economic activity has little to do with the coronavirus pandemic. Rather, it has everything to do with the risky nature of corporate finance.

In its last financial stability report of 2019, the Fed highlighted how many nonfinancial corporations were making use of highly risky debt. The report pointed out that “a number of contacts expressed concern that a U.S. recession would expose highly leveraged sectors … concerns related to nonfinancial corporate debt were cited most frequently, with a focus on the growth in leveraged loans, private credit, and triple-B-rated bonds.”

The financial stability report, of course, made no mention of pandemics or social distancing. It didn't need to — the risk to the financial system and the economy is posed by any recessionary shock. The coronavirus just happened to be the first one that come along.

In the 2007-09 financial crisis, governments around the world engaged in large amounts of subsidized lending to financial institutions. These interventions were rightly seen by many as a subsidy to future risk-taking by those institutions — risk-taking that can deepen any recessionary shock. To prevent this moral hazard, financial institutions are now required hold a lot more capital — that is, be much less leveraged, thus lowering the need for future bailouts.

We shouldn't let the novel source of the 2020 downturn fool us: The interventions by the Fed and Treasury are creating the same sort of subsidy for risk-taking by nonfinancial corporations. We will need the same kind of post-recession policy response: Congress should use its power to tax or regulate to discourage or even bar the country's large corporations from being too highly leveraged or using risky financing instruments. Otherwise, corporation will be further incentivized to take on too much risk and force another, possibly larger, bailout when another recession hits.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Narayana Kocherlakota is a Bloomberg Opinion columnist. He is a professor of economics at the University of Rochester and was president of the Federal Reserve Bank of Minneapolis from 2009 to 2015.

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