Stock, bond markets could see sharp declines: U.S. financial watchdog

By Lisa Lambert

WASHINGTON (Reuters) - Stock and bond markets may be riding for a fall as equity prices soar and interest rates stay low, a federal monitor of U.S. financial stability said on Tuesday, warning that such a tumble could inflict serious damage on banks, life insurers and other important parts of the economy.

The Office of Financial Research found stock valuations, measured by comparing prices to earnings, have reached the same high level that they hit before "the three largest equity market declines in the last century."

At the same time, commercial real estate prices have climbed while capitalization rates, which measure properties' returns, are close to record lows, it found.

A price shock in one of these markets could threaten financial stability by hurting funds and banks that have high leverage or rely on short-term funding, the office added in its annual report on the leading risks to the financial system.

In the report it said there were also risks posed by large and interconnected banks, Brexit, computer hacking, swaps clearinghouses, shadow banking and pressures on life insurance companies.

President-elect Donald Trump's election victory has fueled a stock rally, with the S&P 500 and Dow hitting record highs on Tuesday, which could push valuations further upward. [.N]

The office also found nonfinancial firms went deeper into debt this year to take advantage of low interest rates. A possible wave of defaults by those companies could hurt their lenders: banks, mutual funds, life insurers and pensions. Credit to corporations is growing faster than the U.S. gross domestic product and the ratio of their debt to earnings "is historically high and rising," it said.

"In the last three decades, corrections in corporate debt, equity prices, and commercial real estate prices have often coincided," it said. "Continued low interest rates likely have strengthened the links among these markets."

Low long-term interest rates have given businesses incentives to borrow and pushed investors to pay more for higher-yielding assets such as equities and commercial real estate, it said.

Investors are now vulnerable to "to heavy losses from even moderate increases in interest rates."

The office was created in the 2010 Dodd-Frank Wall Street reform law to watch for warning signs of another financial meltdown on par with the 2007-09 crisis. It is housed in the Treasury Department, but its research supports the Financial Stability Oversight Council made up of the heads of all the financial regulators. While Trump and Republican lawmakers have pledged to roll back parts of Dodd-Frank, the office's research is expected to continue.

Currently the government is in a court battle over FSOC's designation of MetLife Inc (NYSE: MET) as "systemically important," which can lead to requirements to hold more capital.

In its report, OFR warned that low interest rates have pushed down insurers' earnings and that the companies are vulnerable to stock market declines. Also, major insurers are connected to large banks and institutions, and there could be spillover effects if one failed, it said.

OFR said that since the crisis the U.S. banks often considered "too big to fail" have become more resilient.

But it added the eight biggest banks "remain large, complex, and interconnected enough to pose potential risks to the U.S. financial system." The plans known as "living wills" that banks develop for managing a possible failure are weak and demonstrate that a bankruptcy could still threaten stability, it added.

Shadow banking, where companies that are not banks make loans, also poses a risk because lenders do not have government backstops and because there is limited data on the extent of its reach in the financial system, the report also said.

(Reporting by Lisa Lambert; editing by Linda Stern, David Gregorio and Jonathan Oatis)

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