Asset prices could drop significantly if pandemic deepens Fed warns

The US Federal Reserve issued grim warning last Friday that asset prices could take a critical hit if the coronavirus pandemic intensifies. In its twice-yearly financial stability report assessing and flagging risks to the US banking system, the Fed made some bleak predictions. The real estate market, Fed foresees, would be among the hardest hit industries.

The report stated:

Asset prices remain vulnerable to significant price declines should the pandemic take an unexpected course, the economic fallout prove more adverse, or financial system strains reemerge.

The document highlighted that commercial real estate is particularly exposed to falling costs as “prices were high relative to fundamentals before the pandemic,” and the hospitality and retail industries have registered severe disruptions.

The report continued:

Prices of commercial properties and farmland were highly elevated relative to their income streams on the eve of the pandemic, suggesting that their prices could fall notably.

The report states that after 2008 there have been regulations put in place to avoid the same situation but there are still vulnerabilities in the financial system that intensified the economic impact from the pandemic.

The massive global shutdown of the economy caused uncertainty and volatility in the financial market generating dramatic swings in stock prices. The Fed flooded the financial system with liquidity which settled the markets down but there are still risks.

Federal Reserve Chairman Jerome Powell said:

Chairman Jerome Powell

Additional fiscal support could be costly, but worth it if it helps avoid long-term economic damage and leaves us with a stronger recovery.

In an effort to soften the coronavirus crisis hit on the economy, the Fed cut short-term interest rates almost to zero and purchased about $2 trillion Treasury and mortgage-backed securities. The Fed also announced plans for nine emergency lending programs with five of them already in action. Hundreds of billions of dollars were also poured into foreign central banks through swap lines and temporary Treasury securities purchases. Some rules and regulations were also loosened up to stimulate banks to increase lending to households and businesses affected by the pandemic.

Governor Lael Brainard commented in a Friday statement:

Forceful early interventions have been effective in resolving liquidity stresses, but we will be monitoring closely for solvency stresses among highly leveraged business borrowers, which could increase the longer the Covid pandemic persists.

The Fed report also stated:

Distress at a few large hedge funds with disproportionately high leverage can have outsize effects, as they may have to sell large amounts of assets to meet margin calls or reduce portfolio risk during periods of market stress. Such de-leveraging may have contributed to the poor liquidity conditions in financial markets in March.

The report also calls attention to dangers high-stakes leveraged lending market:

Defaults on leveraged loans ticked up in February and March, and are likely to continue to increase.

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