The Federal Reserve’s Interest Rate Increases Create Default Risks In Major Sectors

Market participants have their eyes on the Federal Open Markets Committee this week to see if its members vote to raise the federal funds rates again. The FOMC has raised rates nine times since March 17, 2022. Because inflation is nowhere near the Federal Reserve’s 2% target rate and due to JPMorgan’s recent acquisition of First Republic Bank
FRC
on Monday, I believe that the Federal Reserve will raise rates on Wednesday.

The FOMC is likely to raise rates 0.25% to a range of 5.0%-5.25%; this would put them at about a 16-year high. This level of rate increases has been an unpleasant surprise for many consumers and unfortunately, even bank risk managers, who have never experienced how interest rates can go up to curb inflationary pressures. The fact that three U.S. regional banks have failed in less than two months, primarily due to risk managers’ and executives’ inability to measure how interest rate risk can make banks illiquid, puts into question how much longer the Fed can keep raising rates after this week’s FOMC meeting.

Increasing Default Rates

My fear is that these rate increases are pushing both corporate as well as personal default rates up. The more that interest rates rise, the more cost of borrowing goes up for anyone holding variable rate debt or for those who need to refinance existing debt.

The expectation that default rates will go up significantly was very much on the mind of presenters at the S&P Global Market Intelligence’s “Global Credit and Risk Symposium” that I attended last Thursday. Numerous presenters and guests said they are expecting default rates to rise to more than 4% by the end of the year. This is not as high as the recent high of a slightly above 7% default rate in 2010; yet it is more than double where default rates are presently. I am not surprised that loan default rates started to rise toward the end of 2022, a couple of quarters after the Federal Reserve started raising rates.

Leveraged Companies’ Default Rates

The list of leveraged companies experiencing the pressures of rising interest rates is growing. Retail and telecommunications companies have higher default rates than the average. Broadcast and media, as well as businesses in leisure and entertainment, are experiencing default rates that are significantly more than double the average sector.

Real Estate Sector

There certainly has been significant concern about commercial mortgages. Given the notable decrease in office occupancy rates, commercial mortgages for those spaces are particularly vulnerable. Fitch Ratings analysts expect office loan delinquency rates for U.S. commercial mortgage-backed securities (CMBS
CMBS
) to increase to 3.5% to 4.0% by the end of 2023; this would be more than double the current 1.45% default rate. Defaults on commercial mortgages would adversely impact both bank and non-bank lenders.

Fortunately, for the American economy, the residential mortgage default rate has been very low. “Increased borrowing costs will definitely have an impact on those homeowners who have adjustable-rate mortgages,” Gregg Menell CEO, Managing Broker of the Pendulum Property Group told me in a recent interview. He explained that “these borrowers will see a substantial increase in their monthly payments and may be forced to sell. The problem is, where are they going to go? Their next mortgage will be just as expensive, and the rental market is frothy as well.” Most American mortgage holders have fixed-rate mortgages. This makes the residential mortgage sector less vulnerable to interest rate hikes, at least in the near term.

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