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Dallas Fed’s Kaplan says firm debt could be next financial calamity

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Dallas Fed's Kaplan says firm debt could be next financial calamity

Dallas Federal Reserve President Robert Kaplan is worried about surging levels of corporate debt and laid out a scenario where it could suddenly become a big problem for the economy.

“The thing I am worried about is if you get two or three BBB credit downgrades to BB or B, that could lead to a rapid widening in credit spreads, which could then lead to a rapid tightening in financial conditions,” Kaplan said in a Tuesday interview with CNBC’s Steve Liesman.

“We’re got a record level of corporate and to be specific BBB debt has tripled over the last 10 years,” he said on “Squawk Box.” “Leveraged loans as well as BB and B debt have grown dramatically.”

Total corporate debt has swelled from about $5 trillion in 2007 as the Great Recession was just beginning to $9.5 trillion halfway through 2019, quietly surging 90%, according to Securities Industry and Financial Markets Association data.

Investors have pointed to historically low interest rates both as the reason for the high levels of debt and justification for not panicking about its size just yet. The Fed has cut the overnight lending rate three times in 2019, most recently at its October meeting when it reduced the federal funds rate to a range between 1.5% and 1.75%.

But a sudden slide from low investment grade such as BBB-rated debt to junk quality could trigger concern over the credit markets and spark a widening in spreads. Investors usually see such divergence as a bad sign as higher-quality bonds, which have less chance of default offer lower interest rates while lesser-quality bonds need to offer higher rates to entice investors.

General Electric has long been eyed as the largest company at risk of triggering such a domino effect, though company officials insist they are doing everything they can to prevent a credit downgrade.

Still, should a company that big slide, it could remold the high-yield market as investors would be counted on to snap up those bonds, but require even higher yields.

“The problem with ’08-’09 was that the lenders were overleveraged. Right now, we have an issue where the borrowers are highly leveraged,” Kaplan added. “My concern is if you have a downturn where we grow more slowly it means that this amount of debt could be an amplifier.”

Correction: The Fed has cut the overnight lending rate three times in 2019. An earlier version misstated the year.

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