In a new staff report, the SEC Division of Economic and Risk Analysis considered the interconnections among six separate U.S. credit markets, and how three distinct types of stresses in each of the markets affected the products and participants during the COVID-19 pandemic.
The markets considered in the report include:
Short-Term Funding Market. The short-term funding market contains several submarkets, including (i) repo financing, (ii) commercial paper, (iii) securities lending, (iv) prime brokerage, and (v) lines of credit.
Corporate Bond Market. The U.S. corporate bond market is widely dispersed among insurance companies, registered investment companies, pension funds, and family offices.
Leveraged Loans and the Collateralized Loan Obligation Market. Collateralized loan obligations ("CLOs") account for about half of the syndicated leveraged loans currently outstanding in the U.S., and as the market for leveraged loans has expanded, the risk profile of CLO pools has increased.
Municipal Securities Market. The majority of municipal securities are relatively illiquid, and due to the effects of COVID-19, certain bonds (e.g., those backed by consumption taxes) face greater risk of impairment.
Residential Mortgage Market. Federal agencies and government-sponsored enterprises ("GSEs") intermediate most residential mortgage debt, but retain the credit risk. Reliance on short-term funding from nonbanks is a particular risk in this market.
Commercial Real Estate Mortgage Market. The entities that concentrate the most commercial real estate mortgage risk are banks (as the largest holders of such mortgages), followed by GSEs and insurance companies. Commercial real estate loans are often nonstandard mortgages with less stable future cash flows.
The types of market stresses that the SEC observed were divided into three categories:
Short-term funding stresses resulting from an increased demand for liquidity and increased risk aversion.
Market structure and liquidity-driven stresses resulting from an increased demand for dealers to take positions and intermediate trades.
Long-term credit stresses resulting from general uncertainty as to the long-term economic impact of the virus.
SEC staff observed that:
the demand for liquidity caused investors initially to sell U.S. government securities because, as the most liquid securities in the world, they were the easiest to turn into dollars without experiencing a loss; however, the market volatility and stress caused a substantial increase in bid-ask spreads;
while dealers initially expanded their inventories of U.S. government securities, they hit their risk limits, which in turn limited their ability to provide liquidity to the market;
declines in the prices for agency mortgage-backed securities "disproportionately and adversely" affected substantial holders of these instruments, given their very high ordinary levels of leverage;
the commercial paper market largely froze, as there were many sellers and few buyers;
there were substantial outflows from money market funds (other than U.S. government securities funds), which likely exacerbated problems in the commercial paper market; there were substantial inflows into U.S. government securities funds;
trading volume in corporate bonds increased substantially, as did bid-ask spreads; and
municipalities found it difficult to raise funds.