In Hamlet, Polonius counsels his son, Laertes: “Neither a borrower, nor a lender be.” The size and breadth of the U.S. credit markets are proof that this Shakespearean advice has largely been ignored. The Securities and Exchange Commission (SEC) has examined how the U.S. credit markets functioned in the face of the early economic effects of the COVID-19 pandemic and, on October 5, published “U.S. Credit Markets: Interconnectedness and the Effects of the COVID-19 Economic Shock” (the Report). As the SEC’s press release notes, the Report addresses “the origination, distribution and secondary market flow of credit across U.S. credit markets” and “how the related interconnections in our credit markets operated as the effects of the COVID-19 pandemic took hold.” It is a “must read” for credit market participants seeking a comprehensive understanding of U.S. credit markets today.

A Roundtable, hosted by the SEC on October 14, supplemented the Report and concluded that the credit markets are in fact significantly interconnected (including in the United States and abroad) but in a different manner from the period during the global financial crisis of 2008 (the GFC). Since the GFC, credit has moved to a less regulated environment, but the credit markets demand liquidity, and many of the less regulated credit industry participants depend on the “infrastructure and plumbing” of the banking system to finance and operate their businesses. Roundtable participants also noted that certain COVID-19-induced stresses were addressed or mitigated by reforms arising from the GFC and rapid government action in March and April, which provided some measure of market stability. Other COVID-19-induced stresses remain “things to watch” and may result in increased workouts and distressed credits as well as a need for new liquidity solutions, shorter settlement processes, and increased growth to facilitate deleveraging, among other possibilities.

The purpose of this summary is to provide an overview of the Report and Roundtable, together with our observations about the possible effects on credit market participants, including banks and other intermediaries, investment funds, financial technology companies (fintechs), insurance companies and other investors, and both retail and commercial borrowers. The Report and Roundtable offer an in-depth case study of how the earliest days of the COVID-19 pandemic and resultant economic stresses laid bare the strengths, weaknesses, and increasing interdependence of all facets of the U.S. credit markets, making clear the importance of a deep understanding of these macroeconomic factors and an ability to distill them to inform the decisions of individual market participants.

But this cautionary tale is unfinished. As the possibility of additional pandemic-induced stresses arises during the winter months, and as the consequences of the election unfold, an ability to interpret and apply these early lessons of the Report and Roundtable will be all the more critical. Market participants and advisers will require sophistication and deep knowledge within each facet of the credit markets given the significant interplay among them to address challenges and find opportunities.

CHAPTER 1: Overview

Chapter 1 of the Report sets forth an overview of the U.S. credit markets and provides an organized framework for the rest of the Report. That is no small task. As it notes, there is at least $54 trillion of U.S. credit issued and outstanding. However, by dividing it into six main categories and then focusing for each category on how that credit is originated, to what end, whether intermediaries are used, and the direct and indirect ultimate holders of the credit, the Report attempts to explain the interconnectedness of the U.S. credit markets. This is no idle academic exercise. Credit markets became stressed in March 2020, and some functioned better than others. In times of stress, the interconnectedness of credit markets can both accelerate the spread of risk and facilitate the absorption of risk. The Report notes that only by understanding this interconnectivity may we begin to learn from and prepare for the next crisis.  The following figure was included in the Report to depict the connections among sources of credit risk and owners of credit risk. As noted below the figure, data sources and additional details are set forth in the Report appendix.



Even Small Markets Can Move Much Larger Markets. A few themes highlighted in Chapter 1 recur throughout the Report. First, the size of the constituent part of the credit markets does not determine the effect it can have on the system. A small component of the credit markets as a whole can have an outsized effect on the overall system based on its connection with other key markets and depending on where the ultimate risk of that small component resides. Second, some of the markets, while not large in themselves, act as lubricants to many other credit markets. For example, repurchase agreements (repos), commercial paper (CP), and securities lending have an effect on any number of other markets. Accordingly, it is no coincidence that these were among the first areas of focus for the Federal Reserve when trying to unfreeze the credit markets in both 2008 and 2020. Treasury and Federal Reserve Intervention. Another common theme of the Report is that while the Treasury and the Federal Reserve forestalled some of the worst consequences of the crisis in March, we are not yet out of the woods. Economic history is being written while many of the main events are still occurring, and it is unclear how long various government initiatives will remain in effect. Connectivity Among Multiple Segments. Finally, the Report emphasizes the connectivity among the separate categories of credit highlighted in subsequent chapters. For example, leveraged loans constitute just 2% of the U.S. credit market, but the success or failure of the diverse borrowers underlying those loans can have a disproportionate impact. Half of all leveraged loans are owned by collateralized loan obligations (CLOs), and, in turn, various tranches of CLOs are largely owned by insurance companies, banks, and registered investment companies. Each of those respective entities itself has policyholders, depositors, shareholders … and so on. The same originator-intermediary-holder nexus creates connectivity among corporate bonds, pension plans, and pensioners; homeowners, home lenders, servicers, and holders of mortgage-backed securities (MBS); municipalities issuing bonds, and money market funds acting as a repository for “safe” funds. As the Report makes clear, nothing in our credit markets happens in a vacuum. If the economy sours and people cannot make car payments, then banks, mutual funds, and individual retirement accounts feel the effects. Pull a loose thread from any of these credit categories, and you can quickly find yourself without a sleeve (or even a sweater) just as the credit markets cool off. CHAPTER 2: Short-Term Funding Market

Flight to cash-impacted markets globally, leading to delevering; Federal Reserve intervention stabilized markets.

The first of the six markets addressed in the report is the $10 trillion short-term funding market consisting of related submarkets — repos, CP and commercial deposits, securities lending, prime brokerage, and money market mutual funds (MMFs). The COVID-19 economic shock caused a “dash for cash” — a sudden flight to extreme quality in the form of the safest and most liquid assets. The immediate results analyzed in the Report include liquidity contraction, volatility, lower valuations, price adjustments and attendant margin calls, increased collateral haircuts, increased spreads, and a mismatch between supply and demand for short-term funding. This affected both Wall Street and Main Street. For example, a constrained CP market limited liquidity sources for corporate issuers and decreased confidence among individual investors, resulting in significant redemptions and liquid asset balances in prime MMFs. 

Connections to Other Markets. Chapter 2 shines a spotlight on the interconnectedness among the cash, Treasury, and futures markets — domestically and abroad. It notes that strong selling and decreased valuations in agency mortgage-backed securities affected mortgage real estate investment trusts (mREITs) holding large portfolios, resulting in margin calls and a feedback loop. Deficiencies in short-term funding in the financial markets affected corporations, hedge funds, and households as well. Frozen CP markets caused corporate borrowers to draw down on bank revolving credit lines. Falling asset prices led to delevering by securities borrowers in the securities lending market, freeing cash collateral that was reinvested in safe assets like government MMFs rather than more traditional CP markets. Hedge funds delevered, affecting the broader banking system, repo markets, securities lending, and other short-term funding markets. The flight to cash shifted assets from prime MMFs to safer government MMFs or bank deposits. At the same time, market volatility drove increased margin calls by central clearing counterparties (CCPs), resulting in a net drain of liquidity from the markets. Significant drawdowns on bank lines of credit were supported by inflows of cash deposits. The Report makes the connectivity clear: There were no credit silos as markets responded.

Effects of Intervention; Things to Watch. Picking up a thread that weaves through the Report, Chapter 2 also highlights the positive effects of the Federal Reserve intervention, including open market purchases, bank capital relief, and other regulatory relief to encourage and support banks and dealers to act as intermediaries to stabilize the markets. The Report emphasizes the importance and success of key Federal Reserve liquidity facilities like the Primary Dealer Credit Facility, the Money Market Mutual Fund Liquidity Facility, and the Commercial Paper Funding Facility that provided stability and additional liquidity, along with improving market sentiment, beginning in March. Finally, this chapter of the Report highlights areas where the short-term funding market requires future attention, whether or not these areas showed weakness in March 2020. These include the economic structure of prime MMFs, which struggled to provide the immediate liquidity their investors expected in a disrupted market, concentration risk in cleared derivatives with CCPs (although the Report concludes that the benefits of central clearing outweighed the increased concentrations this time), and the need for contingent bank liquidity as a fallback to other liquidity sources. As these facilities reach the end of their terms, it remains to be seen whether there will be extensions or additional interventions and whether the initial stabilizing effects of the Federal Reserve intervention diminish as the COVID-19 pandemic continues. Accordingly, it may be too soon to declare victory in the short-term funding market.

CHAPTER 3: Corporate Bond Market

Downgrades and fallen angels could change the investor base in the bond market; bid-ask spreads peaked in spring of 2020.

Changes in Investor Base Since GFC. The corporate bond market approximates more than $9 trillion, and the Report highlights important systemic, ownership, and structural changes that have taken place in this market since the GFC. For example, one of the most salient changes since the GFC is the decline in corporate bond ownership by banks. Insurance companies (31%), registered investment companies (19%), and pension funds (9%) now hold the majority of corporate bonds. With insurance companies holding almost one-third of corporate bonds outstanding, we agree with the Report’s assessment that downgrades and “fallen angels” may be more challenging for this group of investors as insurance companies continue to rely on credit ratings for fixed income asset classes like corporate bonds. If we continue to see more downgrades and “fallen angels,” these investors may be more likely to divest and less able to continue to invest “new money” in these same companies.

Bid-Ask Spreads Peak. The Report highlights the extraordinarily high trading volume of corporate bonds during the peak COVID-19 stress and prior to the Federal Reserve’s liquidity intervention: a 48% increase in the months of March and April 2020. During this time, bid-ask spreads were at historically high levels for high-yield (HY) bonds and investment-grade (IG) bonds, spiking to 100 basis point differentials for HY bonds and 150-200 basis points for IG bonds. The Report suggests that the “increase in spreads were likely driven by a combination of (i) structural issues in the market — in particular fragmented liquidity in the cash market and reduced dealer inventories—and (ii) elevated economic uncertainty.” Elaborating on the theme of changes in the markets since the GFC, the Report attributes this reduced dealer inventory in large part to the systemic change in the chief intermediaries in the corporate bond market as the dealer model shifted from dealers affiliated with the banks being risk-takers holding corporate bonds as inventory to an agency model matching buyers and sellers. The Report notes this resulted in a marked decrease in dealer balance sheets from approximately $225 billion in 2008 to approximately $50 billion today as the banks have eliminated their proprietary trading desks and downsized their market-making investment banking activities to conform to regulatory constraints imposed after the GFC. The Report points out that this fundamental change in dealer structure did create short-term stress in the beginning stages of the COVID-19 economic shock as relatively small dealer inventories impeded trading when many market participants tried to adjust their holdings. Although spreads have declined since these spikes in March, they still remain high compared with the pre-COVID-19 period. As this market uncertainty continues, signs of additional waves of COVID-19 infections emerge, and the political landscape remains somewhat clouded, investors may need to consider whether federal intervention will be as readily available and as fulsome as it was in reaction to the first wave. The Report makes clear that the Federal Reserve’s introduction of corporate credit facilities was necessary and “instrumental” in stabilizing the corporate bond market after the initial COVID-19 economic shock.

ETF Market Growth. The Report illustrates the exponential growth of the exchange-traded fund (ETF) market for corporate bonds since the GFC, with total net assets of $117.5 billion for IG ETFs and $66.4 billion for HY ETFs today vs. $3.7 billion and $0.6 billion in 2008 before the GFC. This increase in the ETF market evidences a migration of trading in corporate debt from the cash market to ETFs. The Report implies, and we agree, that this gradual shift is positive for the market as ETFs generally allow for the more liquid markets and efficient trading because the ETF exchanges provide for better and quicker price discovery. We also agree that the ETF market operation demonstrated efficient trading and resiliency in March 2020, consistent with the conclusion of a separate report on the “Experiences of U.S. Exchange-Traded Funds During the COVID-19 Crisis” that was issued under the auspices of the Investment Company Institute’s COVID-19 Market Impact Working Group and submitted as a public comment to the Report.

Credit Rating Declines. In terms of downgrades and defaults, the Report stresses the decline in IG bonds’ average credit ratings over the past 20 years. In 2000, less than 30% of IG bonds were BBB rated, while today BBB-rated issuances equal almost 45% of IG bonds. We note that as the pre-COVID market was already concerned with this general decline in credit quality and the overall increase in the prevalence of BBB-rated bonds, these credits are particularly vulnerable to further downturns or stress in the economy. The Report illustrates that these concerns were warranted as fallen angels (those downgraded from IG to BBB or lower) numbered 24 in 2020 as of the time of the report, while in August 2020, the S&P list of potential fallen angels was at an all-time high of 120 issuers. The Report observes that although bond trading has stabilized for the moment, the COVID-19 economic shock may continue to reverberate and “stress the corporate bond market through its effect on the financial health of issuers.” In this regard, the Report notes that there already have been 59 defaults in the HY world with an overall default rate approximating 4.1%. Roundtable participants observed that the default rate for HY bonds in the energy sector is closer to 24%, suggesting that an already precarious sector was further decimated by the COVID-19 economic shock. The Report notes S&P Global’s dour outlook for 2021, predicting a 6% to 15% default rate for outstanding bonds, which would translate to approximately 112 to 289 defaults. Although the Report does not speculate on the market’s ability to absorb this marked increase in default rates, it does note that bond investors could incur “significant losses” depending on the shape, nature, and extent of the COVID-19-related stress.

Effects of Low Interest Rates. The Report also discusses how the extremely low interest rate environment, together with a robust bull market driving up stock market valuations, has allowed corporate issuers to increase debt in the past decade without negatively affecting their debt capacity. The Report further notes that investor behavior was affected by this sustained period of low interest rates as investors chased “yield” by investing in lower IG borrowers with higher rates of return. Although corporate bonds outstanding almost doubled from 2008 to 2019 from $3.6 trillion to approximately $6.5 trillion, the Report concludes that U.S. corporations’ ability to service their debt has not decreased during the past decade as measured by widely accepted indicators of debt capacity, for instance, interest coverage ratios and leverage ratios. Conversely, we believe the Report implies that if any of these variables reverses direction (i.e., a rise in interest rates or a significant drop in equity valuations), these same corporate issuers will become more vulnerable as debt capacity tightens and their ability to service debt declines.

CHAPTER 4: Institutional Leveraged Loan and CLO Markets

All sectors of the capital markets depend on well-functioning repo and CP markets; markets depend not only on banks but on many other nonbank lending institutions.

Chapter 4 focuses principally on the flow of syndicated leveraged loans into CLOs (i.e., special-purpose entities that acquire a portfolio of loans and issue securities, in classes, or tranches, of varying seniority and risk exposure) and underlying investors’ exposure to this class of sophisticated credit investment. While the GFC brought similar vehicles (e.g., mortgage-backed collateralized debt obligations (CDOs), and CDOs of CDOs) into focus (including, notoriously, in films such as Margin Call and The Big Short), the Report illustrates the useful functioning of the CLO market and the key role it plays in efficiently and effectively moving capital from corporate America to underlying investors. The Report identifies key, well-known risks in the market such as the financial health of underlying leveraged borrowers and the evolution of “cov-lite” loans that “could reduce the recoveries of holders of leveraged loans, both in absolute terms and relative to other creditors, in the event of a default.” The Report considers tranching risk and the prospect of AAA CLO tranches suffering losses, an important subject area for conservative investors seeking to minimize principal risk. In our view, the Report’s observations are consistent with pre-existing risk assessments and expert observations of the market. In the context of volatile leveraged loan prices as a result of the COVID-19 pandemic, the Report reminds us that “[t]o the extent the losses are concentrated among the equity tranches [of CLOs], the macroeconomic impact would be limited. One key factor balancing these considerations is that the overall enterprise value of the underlying corporate borrowers has held up well with the equity market bounce-back.”

Connected by the Need for Liquidity. As noted, the Report illustrates the connectedness between the functioning of the CP and repo markets. When the CP market went on tilt in March 2020 (i.e., effectively froze as liquidity dried up), this essential source of short-term borrowing was briefly (before government intervention) effectively lost (or perceived as being at risk of being lost), and net borrowers sought cash balances through drawings on bank revolvers and corporate lines of credit. The subsequent cessation, and reversal, of revolver drawdowns after this (brief) crisis has been a strong sign of market resiliency when the Federal Reserve acts promptly and vigorously. Without a functioning repo and CP market, the Report emphasizes that market makers “in virtually all sectors of the capital markets” suffer from the risk of liquidity shortfall and, consequently, a risk of dysfunction in all key sectors of the leveraged finance market (e.g., syndicated loans, HY, warehouse lines, and CLOs). The Roundtable discussion also noted that most banks divested or significantly downsized their market making business to comply with regulations promulgated in response to the GFC. Banks are still a conduit for liquidity, but banks have reduced the amount of this risk on their balance sheets, and therefore the markets are more dependent on other financial institutions, including fintechs.

Continuing or Future Risks. For nonbank lenders, both the Report and the Roundtable underscored that the regulators have a deep understanding of the flow of capital and liquidity to nonbank credit platforms and are mindful that structural risks exist from time to time. For example, to the extent that certain of these platforms have a mismatch between assets and liabilities (e.g., duration, risk profile), this may become a pocket of weakness during liquidity crunches. To the extent that these platforms use a regulatory arbitrage that encourages systemic imprudent risk taking, certain Roundtable participants raised the prospect of extending prudential financial regulation to nonbank credit platforms.

Given that the COVID-19 pandemic is ongoing, the equity market bounceback may be temporary, and government stimulus is a moving feast (or famine), the Report is prudent in reminding us “there is a heightened level of uncertainty in the leveraged loan and CLO markets, and while these markets have fared reasonably well thus far, the disruption brought on by the COVID-19 economic shock is still ongoing and their risk assessment may evolve in the future.”

CHAPTER 5: Municipal Securities Market

Concentration of dealers in a heavily retail market and shift to ETF/fund investments create vulnerabilities; robust issuer disclosures may enhance stability.

Top 10 Control Over 50% of the Municipal Securities Market. The Report reminds us that the U.S. municipal securities market is an enormous engine room for financing states, counties, cities, school districts, and other municipal entities. The market is close to $4 trillion. These securities are typically fixed-rate, long-term, and exempt from federal taxation with average annual issuance of above $410 billion. The investors in these debt products are overwhelmingly retail (typically indirectly via funds/ETFs). Trading typically occurs through a decentralized over-the-counter dealer market, with significant offsetting trades in most instances. The top 10 dealers control over 50% of market volume. The Report emphasizes that “the combination of a small number of municipal dealers, a primarily long-term, buy-and-hold investor base, and a growing transition to fund/ETF holdings for active investors is a material source of interconnectedness in the market.”

Impact of Retail Outflows. During the peak of the pandemic crisis (March-April 2020), a significant reversal in retail flows occurred; after 15 months of consecutive net inflows (aggregating $127.8 billion), a total of $48 billion outflows occurred during this crisis period. These outflows put selling pressure on the municipal securities market, as measured by the par value of bids-wanted auctions, and coincided with yield increases all along the municipal yield curve. The Report notes that “increased trading activity and, more specifically, the nature of the trading activity, revealed a great deal about the pathways of liquidity in times of stress when asset managers suddenly become marginal sellers rather than marginal buyers.” Municipal bond dealer provision of balance sheet liquidity was constrained.

Interdependency of Primary and Secondary Markets. The Report goes on to link the secondary and primary markets. Bottom line, when secondary prices fall, access to the primary market for issuers is constrained “when such access might be acutely needed.” Without market makers who can hold significant balance sheet municipal assets, this dynamic is predictable and will repeat in future periods of market stress. The nature of the investor base is also a source of fragility; as the Report notes, “[t]here are relatively few non-retail oriented active investors in the market. This market structure creates a vulnerability that is compounded when large and sudden mutual fund and ETF outflows contribute to selling pressure in the market. When the most natural buyers become sellers, few other institutions exist to provide liquidity to the market.”

Investor Disclosure Issues. In terms of the impact of the pandemic and COVID-19 economic shock on issuers, the Report emphasizes the importance of “robust, timely, and accurate disclosures by issuers” to facilitate investor confidence during these uncertain times, which is likely to be voluntary issuer disclosure (as opposed to mandated annual financials and audit), which may be challenging for issuers to produce. Bottom line, investors want to understand the actual and likely impact of the COVID-19 economic shock in terms of revenue shortfalls (e.g., falling tax revenues) and pandemic-related costs as well as other material idiosyncratic issues that relate to individual issuers. As the Report concludes, “limiting information asymmetries and enhancing investor protection” would enhance this market’s function and stability during this uncertain pandemic period.

CHAPTER 6: Residential Mortgage Markets

Fiscal and monetary stimulus from Congress, the Treasury, and the Federal Reserve in early 2020 mitigated risks of household defaults, enhanced market liquidity, and reduced residential mortgage market risk.

The fifth credit market category analyzed in the Report is the $10.6 trillion residential mortgage market. The fundamental credit risk generally associated with the residential mortgage market is the risk of household defaults, a risk directly borne by two main players: the U.S. federal government and banks.

Traditional Risk Holders. The U.S. federal government plays a leading role in this market through the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Government National Mortgage Association (Ginnie Mae), which together intermediate about $7 trillion of mortgages. In total, more than 95% of residential-MBS are guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae (collectively, agency MBS), and this percentage has increased since the GFC. As a result, the federal government assumes the credit risk on a large share of single-family mortgages. (Note, however, that since the Federal Housing Finance Agency put Fannie Mae and Freddie Mac into conservatorship in 2008, those government-sponsored enterprises have increasingly sought to mitigate and transfer household mortgage default risk through three channels: (i) private mortgage insurance companies; (ii) credit risk transfer securities; and (iii) (re)insurance of mortgage pools.)

Additionally, banks, in their role as originators, securitizers, investors, and lenders to nonbanks, play a critical role in the residential mortgage market, and, as a result, retain a large direct exposure to mortgage credit risk.

Growing Role of Other Participants. While the central credit risk in the residential mortgage market originates from defaults on mortgage payments, those defaults can have spillover effects that affect the rest of the mortgage finance system, including with respect to nonbanks, mortgage REITs (mREITs), and the Federal Home Loan Bank (FHLB) system. Many of these follow-on risks emanate from the residential mortgage market’s ever-increasing dependence on short-term funding, including the repo and CP market discussed above.

The share of residential mortgages originated by nonbanks has been on the rise in recent years and currently sits at about 70% (nonbanks originate an even higher percentage of mortgages for lower-income borrowers.) Additionally, nonbanks service approximately 50% of all mortgages. Nonbanks are generally not subject to the same capital and liquidity requirements as banks and cannot raise deposits. Nonbanks fund their mortgage origination and mortgage services operations with short-term credit, including warehouse lending with major banks. As a result, any contraction in the warehouse lending market from banks could have a severe effect on the availability of credit for mortgage borrowers, especially for lower-income borrowers.

MREITs invest primarily in longer-dated securities such as MBS, and they finance their portfolios mostly with short-term mark-to-market repo funds. This causes mREITs to operate with a high maturity mismatch, which in turn causes them to demand large amounts of liquidity in stress situations, subjecting them to the risk of potential constraints in short-term funding. Since the GFC, the mREIT sector has grown more than $500 billion to nearly $700 billion in assets. As large users of agency MBS repos, mREITs can significantly affect short-term liquidity in the repo market, which can cause a ripple effect through the financial system, as many financial institutions use agency MBS as repo collateral.

The FHLB system is a significant source of capital in the residential mortgage market. The FHLB system has also grown to over $1.2 trillion in assets, most of which ($900 billion) is advances to members collateralized by mortgages. A majority of funding that finances the residential mortgage loans and investments of the FHLB system’s members comes from short-term notes purchased by government MMFs. Additionally, FHLB securities make up a significant portion (about 20%) of the assets of government MMFs. Given the interdependent nature of the FHLB system and MMFs, if either the FHLB system or MMFs come under economic pressure, the volume of mortgage origination undertaken by the member banks of the FHLB system could be significantly affected.

Stabilization Efforts. As the effects of the COVID-19 pandemic intensified, there was apprehension that mortgage delinquencies would also surge, which led to a tightening of the liquidity in the MBS markets. A number of actions by the U.S. government helped to mitigate some of the potential negative economic impact of the COVID-19 pandemic. In particular, Congress’ passage of the Coronavirus Aid, Relief, and Economic Security (CARES) Act and the Federal Reserve’s monetary actions have been effective. The CARES Act authorized a one-time cash payment to certain households, temporarily increased unemployment benefits, allowed borrowers of federally backed mortgages to postpone mortgage payments, and imposed a temporary moratorium on evictions. The banking agencies also took steps to encourage their supervised institutions to work with borrowers to avoid defaults. Collectively, these actions reduced home mortgage delinquencies and foreclosures. Additionally, the Federal Reserve assisted in moderating the impact of the economic shock by lowering the federal funds rate (which lowered mortgage rates, allowing existing mortgagees to refinance into loans with lower monthly payments, reducing default risk) and purchasing over $1 trillion in agency MBS (which directly increased liquidity in the MBS market).

Consumer Credit. Chapter 6 also briefly touches on the $4.2 trillion of outstanding credit from other consumer finance markets, which include credit cards, personal loans, student debt, and auto loans. As one would expect, the principal risk relating to these consumer nonmortgage loans lies in the creditworthiness (or lack thereof) of the ultimate borrowers behind them. The economic shock resulting from the COVID-19 pandemic has also directly affected individual consumers’ ability to repay these loans (especially subprime auto loans). As was the case with the residential mortgage market, the fiscal and monetary stimulus provided by Congress, the Treasury and the Federal Reserve have buoyed these markets by reducing the default probabilities on this consumer debt, boosting market liquidity.

Continuing or Future Risks. As elsewhere in the Report, left unsaid in this chapter is what economic effects will result from continued or additional surge(s) of the pandemic. Particularly if Congress, the Treasury, and the Federal Reserve fail to continue the initial programs or otherwise to take action or are unable to act as effectively as they did in response to the first wave of COVID-19, we are likely to see significant effects across the residential mortgage and consumer credit markets resulting from increased default risks. Governmental action — or inaction — will likely determine whether heightened default risk transforms into tighter short-term funding or otherwise significantly impairs market liquidity.

CHAPTER 7: Commercial Mortgage Markets

Having grown significantly since the GFC, the CRE mortgage market remained relatively stable in 2020, subject to disparate effects in certain sectors.

Since the GFC, the commercial real estate (CRE) mortgage market has grown significantly from $3.1 trillion to $4.6 trillion while maintaining stable or falling loan-to-value ratios (LTVs). This stability in the CRE mortgage market has been driven in part by a parallel increase in real estate value associated with the underlying collateral. Strength in the market for CRE has been aided by falling interest rates over time. Chapter 7 breaks down a broad array of real estate assets comprising CRE, including multifamily, office, retail, industrial, and hospitality. The Report notes that the CRE mortgage market has experienced relative price and loan performance stability at a macro level, with property prices having generally returned to pre-COVID-19 levels as of July 2020. However, within the silos of CRE mortgage markets, the varied effects of COVID-19 on certain sectors are more evident.

Interconnectedness. The CRE mortgage markets connect to a network of banks, insurance companies, servicers, and investors. As one would expect, much of the CRE mortgage market is sourced through banks that give regulators some view of the broader CRE market. The Report explores how banks play a central role in the creation and securitization of CRE mortgage debt. In the fourth quarter of 2019, banks held $1.8 trillion of commercial-mortgage-backed debt and $513 billion of multifamily debt. Bank-originated debt is generally composed of CMBS loans and balance sheet loans. CMBS loans are generally fixed-rate loans secured by stable, income-generating properties and are securitized for sale to investors. Balance sheet loans are generally riskier than CMBS loans, as they often have nonstandard terms and are often floating-rate loans secured by nonstabilized properties. Correspondingly, balance sheet lenders often have more flexibility to renegotiate loan terms over the life of the loan, including in response to distress scenarios such as the COVID-19 economic shock. Government-sponsored enterprises (GSEs) are large participants in the securitization markets. Following the GFC, the GSE multifamily market has grown significantly from $92 billion to $380 billion. Regulators monitor this segmentation of loans heavily to track instability indicators that manifest through increases in defaults as cash flows weaken from broader economic factors.

Insurance companies also act as direct lenders, often underwriting higher-quality loans with lower risks of default. At the end of 2019, insurance companies held $772 billion in CRE mortgage debt with the large majority in the commercial sector and most of that held by life insurance companies. The steady streams of cash from products such as multifamily, office, retail, and industrial make up an important portion of insurance company invested assets.

Sector-Specific Effects. Similar to the broader economy, the Report highlights that the effects of the COVID-19 economic shock have varied based on sector, which could result in materially different long-term outcomes. The hardest-hit sectors continue to be lodging and hospitality, which have seen delinquency rates jump to 20% and 15%, respectively, while other sectors such as industrial, office, and multifamily remain below 5%. In addition, the effects of the COVID-19 economic shock may be drawn out over time, as current pricing data are based on transaction volumes that have dropped by more than 50% year over year as of June 2020. Chapter 7 does note that intervention of governments and regulators through the adoption of moratoria on foreclosures and evictions may still have an impact on the CRE mortgage market going forward.

Continued Disparate Effects. The Report concludes that reactions in the CRE mortgage market will continue to be “heterogeneous” due to the uneven effect of COVID-19 on the various sectors. Its full impact is yet to be fully apparent as CRE is a long-term market, and the effects on both the demand and supply of CRE remain unknown. However, it is clear that the effects will be disparate and may bring long-term structural changes in the sector.


In addition to a robust discussion of the effects of and reactions to the COVID-19 economic shock on specific categories within the credit markets, and the overall connectedness of such markets, the Report and the Roundtable included additional commentary to the effect that the reforms arising from the GFC generally performed as intended, with a few surprises such as that the capital requirements imposed on banks constrained their ability to absorb shocks in the market and caused them to be more on the sidelines, and other intermediaries or “market makers” did not step in. In addition, the liquidity structures that were developed for the GFC formed the basis for many of the Federal Reserve actions in 2020, allowing for faster action, and the facilities provided a stabilizing effect, even those that market participants did not ultimately use. However, Roundtable participants noted that financing in disadvantaged communities of color is not as connected to the overall U.S. credit markets, with interest rate interventions creating bigger gaps between Main Street and Wall Street.

The Report and Roundtable also provided specific insights for fintechs and participants in the derivatives markets.

Fintechs. In response to regulatory reform stemming from the GFC, certain trading and lending activities that are critical to the markets and were previously performed within U.S. banking institutions are now performed by fintechs, the result being that these functions are no longer under bank regulators’ oversight. Financial institutions have made a significant investment in trading technology but not as much in clearing and settlement infrastructure. As a Roundtable participant noted: “A transaction can be executed in seconds but clears in days.” It should not surprise anyone that markets are interconnected, but the question of how the technology is connected must also be considered.

Although the report is focused on the U.S. credit markets, the Roundtable noted that markets are global, and technology, regulated and unregulated, is what connects the global trading platforms. A system is only as good as its weakest point. As such, we anticipate more regulation in the coming years to be applied to fintechs to the extent that they assume a greater role in our financial markets.

Derivatives. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act) implemented a comprehensive regulatory scheme over the derivatives markets for the first time. Part of this regulatory scheme involved moving a significant portion of the bilateral derivatives market into central clearing with CCPs, pursuant to which the CCPs impose daily, and in some cases intraday, margin requirements on the participants. The CCP margin requirements require that the parties post cash or other highly liquid assets and include not only variation margin (VM), which is passed from one party to the other based on the net mark-to-market position of their derivatives trades, but also initial margin (IM), which the CCP retains to protect against market volatility in a closeout situation. The Dodd-Frank Act also mandates that most financial entities (including investment funds, insurance companies, and pension plans) exchange similar margin for any derivatives trades that are not cleared with a CCP and requires that any such IM-related margin be segregated and held with an unaffiliated custodian (Uncleared Margin).

The Report notes that during the first quarter of 2020, CCP IM calls increased by $160 billion and CCP VM calls increased by $400 billion, in each case over their normalized levels. While the $400 billion of VM posted by one side of the derivatives market was received by, and created liquidity for, the other side of such market, the IM was not. Because posted IM (in the case of both CCPs and Uncleared Margin) is segregated and held by the CCP or a third-party custodian, increased calls for IM during periods of market volatility, such as during the COVID-19 crisis, result in a strain on cash and highly liquid securities as they are posted to satisfy IM calls. During such crises, such strain on cash and highly liquid securities occurs at the very same time that others in the market are fleeing to the same, resulting in higher demand and an adverse impact on price, further compounding the effect of the crises. While the CCP and Uncleared Margin regulatory requirements are generally viewed as providing more safety and stability to the derivatives markets, the effect of these regulatory requirements on the broader financial markets during times of stress is a topic that requires further consideration.


The Report provides an insightful early assessment of the market and governmental reactions to the COVID-19 economic shock, even as the pandemic continues. Interconnectedness within the $54 trillion U.S. credit markets will continue to drive policy and profits as the history of the pandemic is written and our markets continue to evolve in terms of market participants, government involvement and financial ingenuity. Attention to the weakest links in the interconnected U.S. credit markets will allow policy makers to take steps to ensure liquidity and increase systemic resiliency. Attention to linkages, coupled with an understanding of likely market and government responses, will allow market participants to identify new opportunities and hedge risk. In each case, the Report will provide those fluent in it with helpful tools and methods for achieving success even when, to return to Polonius, it seems that all “may be madness.”