Federal Reserve Chair Jerome Powell gave a speech a couple of weeks back that showed that financial regulators have learned many lessons from the 2008 financial crisis, but not the most important one, namely:
If regulators wait to act until they can say with certainty that a credit bubble is about to burst, they’ve waited too long.
That’s particularly true when it comes to the opaque and unregulated “shadow” banking system on Wall Street that has now supplanted regulated banks as the leading source of credit for businesses and consumers. This shadow system gets its money from big investors rather than depositors, and it revolves around hedge funds, investment banks and private equity funds rather than banks. These shadow banks have made borrowed money cheaper and easier to get, but they have also made the financial system and the U.S. economy more susceptible to booms and busts. And with another giant credit bubble ready to burst – this one having to do with business borrowing – we’re about to learn that painful lesson again.
The rise of the shadow banking system began in the 1980s with “junk” bonds, which for the first time allowed companies with less than blue-chip credit ratings to borrow more easily and cheaply from investors in the bond market than from banks on which they had always relied.
Then, beginning in the 1990s, shadow banks moved aggressively into home mortgages and other consumer debt – auto loans, student loans, credit card debt – which they bought from banks and other lenders, packaged together and sold to investors as bond-like securities. You know how that turned out.
After the crash in 2008, shadow bankers shifted their attention to business lending, using the same “securitization” process to buy and package “leveraged” loans – bank loans to big companies that were already highly indebted – into collateralized loan obligations, or CLOs. Investors couldn’t get enough of the CLOs, which promised higher returns than low-yielding government and corporate bonds, and corporations gorged on leveraged loans to fund mergers and acquisitions, buy back their own shares and pay special dividends to investors.
More recently, Wall Street wiseguys have shifted from buying loans to making them directly – in this case to midsize companies, long considered the last preserve of the traditional banking system. The new players are private equity firms, hedge funds, investment banks, insurers and once obscure entities known as “business development companies.”
In each of the last four years, investors poured more than $100 billion into these middle-market private credit funds, which now have combined assets of between $600 billion and $900 billion, according to estimates by Bloomberg News; Preqin, a data company; and Ares Capital, a leading direct lender. The banks’ share of middle-market lending has been nearly cut in half as private lenders have not only taken business away from the banks but also significantly expanded the market by making loans that banks are unwilling or unable to make.
“It’s a wild west space,” a top credit strategist from Bank of America told the Financial Times this year. “The whole thing has exploded in size, and everyone is getting into it.”
The banks’ initial retreat from the middle market was a result of the orgy of bank mergers in the 1990s, during which regional banks were rolled up into a handful of large national banks. While middle-market lending was the bread and butter of regional banks, the megabanks were focused on lending to the largest corporations. Moreover, to realize the cost savings that were promised from the mergers, the megabanks reduced the number of lending officers with the knowledge of and experience with companies and industries to make customized loans based on estimates of expected cash flows. Instead, the megabanks began offering middle-market customers a set of standardized loan products that required very little paperwork or evaluation.
This retreat from middle-market lending accelerated in the aftermath of the 2008 financial crisis, when regulators began requiring banks to set aside more capital as a financial cushion against loan losses. More capital was also required for loans to companies that already had lots of debt or that had gone through a year or two of hard times. Regulators also raised red flags whenever they saw loans without covenants that allowed the bank to demand that a loan be paid back if the company failed to hit certain business targets.
The shadow banks, however, were only too happy to step in and fill the void left by the regulated banks, lending directly to firms with lower credit ratings and lending with fewer covenants and more flexible terms. They were able to offer customized loan packages that incorporate a mixture of cheaper first-in-line “senior” debt with riskier and more expensive “junior” or “mezzanine” financing.
Loans could be approved quickly, without having to get approval from the loan committees found in most banks. And for all that speed, flexibility and additional lending risk, companies were willing to pay interest rates averaging 2 percentage points above what banks might have charged, according to a paper by Sergey Chernenko of Purdue, Isil Erel of Ohio State and Robert Prilmeier of Tulane.
To fund all this loan-making, the shadow banks have turned to insurance companies, pension funds, university endowments and wealthy investors, offering them a chance to buy into a diversified pool of loans that offer returns ranging from 6 percent to 13 percent, depending on the level of risk they are willing to assume.
And even though traditional banks may be making fewer loans to midsize businesses, they’ve been eagerly lending to the hedge funds, private equity firms and business development companies that are making more of those loans. In fact, the fastest growing category of revenue and profit for the banks in recent years has been lending to “non-bank financial institutions.” According to the latest report from the Federal Reserve, unregulated credit funds now have access to more than $1 trillion in lines of credit from regulated banks, an increase of 65 percent over five years. And there is evidence that, in the face of increased competition, the private funds are taking on higher and higher levels of debt to continue offering the same high yields to their investors.