Board of Governors of the Federal Reserve System

4. Funding risk

In the face of the COVID-19 outbreak and associated financial market turmoil, funding markets proved less fragile than during the 2007–09 financial crisis; nonetheless, significant strains emerged, and emergency Federal Reserve actions were required to stabilize short-term funding markets

As of the fourth quarter of 2019, the total amount of liabilities most vulnerable to runs, including those of nonbanks, had increased about 10 percent over the past year to $15.5 trillion (table 4). Banks rely only modestly on short-term wholesale funding and maintain large amounts of HQLA, in part because of liquidity regulations introduced after the GFC and the improved understanding and management by banks of their liquidity risks.

Table 4. Size of Selected Instruments and Institutions

Meanwhile, driven largely by increased clearing of over-the-counter derivatives, central counterparties intermediate a larger share of transactions across more markets than in the 2007–09 financial crisis. With the jump in volatility in March and resulting increase in transaction activity, central clearing, while mitigating counterparty risks, absorbed significantly higher amounts of cash and collateral; overall, market participants were well positioned and able to meet these increased liquidity demands.

However, as noted in previous Financial Stability Reports, recent growth in prime MMFs had increased the vulnerability in the system, and holdings of corporate debt by mutual funds grew notably in recent years. These vulnerabilities produced considerable funding strain in March.

Given the funding pressures, the Federal Reserve undertook several actions to ensure the smooth functioning of various markets. (See the boxes "The Federal Reserve's Monetary Policy Actions and Facilities to Support the Economy since the COVID-19 Outbreak" and "Federal Reserve Tools to Lessen Strains in Global Dollar Funding Markets.") In addition, federal banking regulators provided regulatory relief to support credit availability.

Banks had high levels of liquid assets and stable funding before the shock hit

Banks had strong liquidity positions as of the fourth quarter of 2019. At most large banks, liquid asset positions exceeded regulatory requirements significantly (figure 4-1). Businesses drew heavily on their lines of credit as the pandemic shock hit, although these draws were accommodated by bank capital and liquidity buffers. The box "Risks Associated with Banks' Corporate Credit Exposures through Credit Lines" provides more information about the extent of bank exposures to affected industries and the resilience of banks to unexpected drawdowns.

Moreover, bank reliance on the most unstable sources of funding stood at historically low levels (figure 4-2). As the shock hit, banks increased borrowing at the discount window and expanded Federal Home Loan Bank (FHLB) advances as part of their liquidity management. Banks also experienced heavy deposit inflows, consistent with investors becoming more risk averse and credit-line borrowers depositing the proceeds from line draws taken as precautionary measures.

Mortgage servicers will be put under strain as mortgage forbearance expands

The Cares Act provides a right to forbearance for up to 12 months to homeowners who have mortgages in pools guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae if they are experiencing hardships associated with the COVID-19 shock. Under the servicing contracts, mortgage servicers are responsible for advancing payments on behalf of a borrower who requests forbearance. This responsibility can cause strains for nonbank mortgage servicers because they do not have access to the same sources of liquidity as banks. Instead, nonbanks have relied on their internal cash or, in some cases, fairly expensive private-market financing to fund these payments. In the short term, these strains could lead to curtailment of mortgage credit, and in the longer term, large-scale forbearance could cause some nonbank mortgage servicers to fail. Recently, Ginnie Mae established a facility to lend against advances of principal and interest (but not taxes and insurance).

Money markets came under stress during the market turmoil in March and April, prompting response by the Federal Reserve and the Treasury...

Money-like liabilities that are prone to runs—an aggregate measure of private short-term debt that can be rapidly withdrawn in times of stress—stood at about 70 percent of GDP in the fourth quarter of 2019 (figure 4-3). The growth in runnable liabilities over the past couple of quarters was largely attributable to a surge in repos backed by Treasury securities that, in turn, is a consequence of the high volume of Treasury issuance that has occurred over this period.

Assets under management at domestic MMFs increased over the past year (figure 4-4). As described in greater detail in the box "The Federal Reserve's Monetary Policy Actions and Facilities to Support the Economy since the COVID-19 Outbreak," money markets came under severe stress in March, prompting a response by the Federal Reserve and the Treasury.

. . . as did long-term mutual funds that hold less liquid assets

U.S. corporate bonds held by mutual funds more than tripled over the past decade, reaching more than $1.6 trillion in the fourth quarter of 2019 (figure 4-5). Mutual funds are estimated to hold about one-sixth of outstanding corporate bonds and to purchase about one-eighth of newly originated leveraged loans. Total assets under management in high-yield corporate bond mutual funds, which primarily hold riskier corporate bonds, and in bank loan funds increased notably over the past decade to about $330 billion through February 2020 (figure 4-6).

These open-end mutual funds engage in liquidity transformation by offering daily redemptions to investors, notwithstanding the liquidity profile of a fund's underlying assets. Funds investing substantially in corporate bonds and bank loans may be especially exposed to liquidity transformation risks, given the relative illiquidity of such assets. While bank loan mutual funds experienced moderate outflows in the six months ending in February, outflows increased substantially in March as investors became more risk averse (figure 4-7). Total net assets of high-yield bond mutual funds decreased 16 percent, and bank loan mutual funds decreased 26 percent.

Separately, bond mutual funds that invest primarily in investment-grade corporate bonds may face heightened selling pressure in the event of large-scale corporate downgrades from investment grade to below investment grade. While current regulation does not require such funds to sell "fallen angels," funds may start to divest to avoid future losses. In the midst of negative economic news, recent downgrades of large issuers were accompanied by particularly strong withdrawals from investment-grade bond funds. To support the corporate bond market that ultimately supports the credit needs of employers, the Federal Reserve created the PMCCF and the SMCCF.

While funding risk at CLOs is limited, leveraged investors may face pressure if CLOs are downgraded

CLO issuance was robust in 2019 after reaching a record level in 2018. These securities fund more than 50 percent of outstanding institutional leveraged loans—loans that have been under significant price pressures, as previously discussed. Unlike open-end mutual funds, CLOs do not generally permit early redemptions and do not rely on funding that must be rolled over before the underlying assets mature. As a result, CLOs avoid the run risk associated with a rapid reversal in investor sentiment. Still, many lower-rated CLO tranches have been put on negative watch by rating agencies, indicating that material downgrades to those tranches are likely in the future. Some CLO investors such as hedge funds purchase lower-rated tranches using leverage. Downgrades of CLO tranches could result in margin calls on leveraged investors, forcing them to reduce their exposure by selling their holdings. Such sales have the potential of putting additional pressures on leveraged investors.

Mortgage REITs came under funding pressure...

Nonbank institutions known as mortgage REITS (mREITS) invest in real-estate-backed securitized products such as MBS and CMBS. As of the fourth quarter of 2019, mREITs held about $500 billion of securities backed by property loans. Most securities held by mREITs are agency MBS—MBS issued by Fannie Mae, Freddie Mac, and Ginnie Mae—which minimizes credit risk. In addition, these securities are generally very liquid. However, because mREITs invest in long-term assets and often have high leverage that can include a significant amount of short-term debt, mREITs can have considerable funding risk. After the large decrease in interest rates in late February to early March, prices of mortgage-linked assets fell considerably, which triggered margin calls from mREIT lenders. Asset sales by mREITs, combined with already existing strains on dealer balance sheets, resulted in liquidity in MBS and CMBS markets drying up, which set up an adverse feedback loop between asset sales and margin calls at mREITs. FOMC actions announced in March, which included purchases of agency MBS and CMBS as well as U.S. Treasury securities, mitigated strains on dealers' balance sheets and gradually improved liquidity conditions and market functioning in these markets.

. . . and the liquidity risks at life insurers have been increasing

Over the past decade, life insurers have been increasing the share of risky and illiquid assets on their balance sheets. At the end of 2019, CRE loans, CLOs, corporate loans, and high-yield corporate bonds accounted for about 17 percent of general account assets, up from 13 percent in 2012. CLO issuance by U.S. insurers has been particularly strong since 2017. Across a large sample of CLOs issued by U.S. life insurers since 2010, each insurer remains directly exposed to about 15 percent, on average, of its issuance through its general account holdings. Any losses on these CLOs would lower the insurer's surplus and could affect the life insurer's ability to access wholesale funding, which has edged up over the past few years (figure 4-8).