The coronavirus outbreak upended markets in March, and the Federal Reserve said on Friday that the financial system had exacerbated that turmoil and warned that highly indebted businesses remained a vulnerability that could hurt the broader economy.

The financial system “amplified the shock” as short-term funding markets in particular seized up in March, the Fed said. Some hedge funds were “severely affected” and “reportedly” contributed to market dislocations, according to the central bank’s financial stability report.

The Fed used the annual report to sound a warning bell on persistent weaknesses that have the potential to worsen the fallout in markets — which could then spill back into the rest of the economy — as coronavirus lockdowns slow growth, spurring job losses and causing consumers to pull back spending.

Businesses went into the crisis highly indebted, the Fed pointed out. As they miss out on sales and income, they may default on their debts. That could have knock-on effects: Credit losses could pair with low interest rates to hurt profitability at banks, which entered the crisis well capitalized and are, at least for now, holding up and lending steadily.

“We will be monitoring closely for solvency stresses among highly leveraged business borrowers, which could increase the longer the Covid pandemic persists,” Lael Brainard, a Fed governor, said in a statement accompanying the release. She noted that the Fed’s early interventions “have been effective in resolving liquidity stresses.”

The Fed’s report is the most detailed glimpse yet at how the central bank understands the financial gyrations that took hold as coronavirus cases began surfacing in America.

Among the areas the Fed flagged:

Wild swings tested the financial system’s resilience.

Even the market for Treasury securities — the deepest and most liquid in the world — ceased to function normally as investors became attuned to the economic risk and cashed out their holdings.

• “While the financial regulatory reforms adopted since 2008 have substantially increased the resilience of the financial sector, the financial system nonetheless amplified the shock, and financial sector vulnerabilities are likely to be significant in the near term,” the report said.

• In March, “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.”
• In the Treasury market — where the Fed has bought securities at a rapid pace since mid-March to restore functioning — the difference between selling prices and buyer asking prices has declined to more normal levels, but “some measures, such as market depth, have shown only modest signs of improvement.”

Hedge funds may have worsened turmoil.

As investors pulled cash from money market mutual funds and the market for short-term business debt looked shaky — echoing what happened in the 2007-9 downturn — a more surprising weakness surfaced in the market for Treasury bonds, especially older ones. Speculation has been rampant that hedge funds contributed to the turmoil, and the Fed acknowledged that in its report.

• Some hedge funds buy and sell securities frequently to make small amounts of money that add up over a large number of trades. They are forced to sell their holdings if markets become hard to trade in, which “can lead to a rapid unraveling of market liquidity under certain circumstances,” the report said.
• “The concentration of hedge fund leverage has increased markedly,” it said, and funds “may have to sell large amounts of assets to meet margin calls or reduce portfolio risk during periods of market stress.”
• “Such deleveraging may have contributed to the poor liquidity conditions in financial markets in March,” the Fed said, referring to the process by which households and businesses get rid of debt by selling assets.

The Fed’s intervention has calmed things down.

The Fed jumped in to ease the strains, rolling out a series of emergency lending facilities aimed at money markets, a type of short-term business debt called commercial paper, and, more recently, corporate and municipal bonds.

• “Effectively, the ability of creditworthy households, businesses, and state and local governments to borrow, even at elevated rates, was threatened,” the Fed said, so together with the Treasury it “took a series of steps to support the flow of credit to households, businesses, and communities.”

But worries remain — namely, business debt.

Corporations went into the current crisis with huge debt loads, a vulnerability that threatens to percolate throughout the financial system as the downturn drags on.

• “Economic activity is contracting sharply, and the associated reduction in earnings and increase in credit needed to bridge the downturn will expand the debt burden and default risk of a highly leveraged business sector,” the report said.
• “Widespread downgrades of bonds to speculative-grade ratings could lead investors to accelerate the sale of downgraded bonds, possibly generating market dislocation and downward price pressures in a segment of the corporate bond market known to exhibit relatively low liquidity,” it warned.
• “Defaults on leveraged loans ticked up in February and March and are likely to continue to increase,” it said of loans to already-indebted companies.
• In a survey of market contacts included in the report, a “corporate debt/credit cycle turn” was the third-most-cited potential shock for the next 12 to 18 months — behind the coronavirus and the global policy response, and ahead of the U.S. election.

And asset prices still have room to fall.

The Fed noted that stock prices had “swung widely,” and said other assets — most notably commercial real estate — could be in for lower prices if the coronavirus lasted.

• “Asset prices remain vulnerable to significant declines should the pandemic worsen, the economic fallout prove more adverse or financial system strains re-emerge,” the Fed warned. It said declines could be “especially pronounced” in markets like commercial real estate, where prices were high relative to fundamentals even before the pandemic.
• “The severe disruptions in economic activity following the outbreak could reduce house prices by bringing down household incomes and restricting access to mortgage credit,” the report said, though a decline in supply could limit that effect.