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.
Middle-market lending, of course, is just part of the biggest expansion in corporate borrowing the U.S. economy has ever seen, a result of eight years of cheap and easy money engineered by the Fed and other central banks after the 2008 financial crisis.
The ratio of corporate borrowing to a variety of metrics — profits and assets, book value or the size of the overall economy — is at or near an all-time high. So is the riskiness of the loans, reflecting the amount of debt companies have taken on, the absence of covenants and the rosy assumptions made about the amount of cash flow companies will have to cover debt service.
Meanwhile, the difference in interest rates between the safest loans and the riskiest — in financial jargon, the “spread” — is at historically low levels, a reliable indication of too much money chasing too few good lending opportunities. According to the latest “financial stability” reports from the Federal Reserve and the International Monetary Fund, all of these measures have gotten worse in the last two years, with many flashing yellow and red on their dashboards of systemic financial risk.
“Anytime you have this much money chasing loans, you are going to have accidents,” a banker told me recently.
If all this newly borrowed money were being used to create new technology or enhance productivity, piling up all this debt might be a risk worth taking. But the evidence suggests that what it is mostly doing is artificially stimulating the economy. Companies have used much of this newly borrowed money to buy back their own shares, pay special dividends to private equity investors and acquire other companies, all of which have the effect of inflating stock prices. The recent wave of richly priced mergers and overpriced stock offerings, and the declining returns offered by recent commercial real estate deals, are all good indications of a credit bubble waiting to burst.
So, is this a replay of 2008?
In some ways no, as Fed Chairman Powell noted in his May 20 speech.
For starters, the regulated banking system is much better capitalized, with banks easily passing stringent “stress tests” now required by regulators to assess their ability to withstand the economic and financial equivalent of a Category 4 hurricane.
And household debt has grown no faster than household income and is concentrated in households best able to pay it back.
Even in the shadow banking system, the structure of investments has changed in ways that make it more difficult for investors to pull their money out at the first sign of trouble, making a “run” on the system less likely. Moreover, unlike regulated banks, shadow banks are not required to immediately “write down” the value of the loans in their portfolios when prices fall on the open market. That limits the amount of forced or panic selling.
But in other ways, there are troubling parallels between the 2008 mortgage bubble and today’s bubble in corporate credit.
As before, too much of the lending growth is driven by investors’ search for yield rather than borrowers need for new capital.
And as before, this excess of supply relative to demand has led to a deterioration of lending standards that started in the shadow banking system and has now spread to regulated banks anxious about a further reduction in their market share. (My favorite stat: During the first three months of this year, according to Trepp, a data company, interest-only loans — loans requiring no payback of principal until the loan is due — accounted for three-quarters of all new commercial real estate loans.)
As before, regulated banks have discovered that they can make almost as much profit selling and lending into the shadow banking system as they can making and holding loans themselves.
And as before, regulators don’t know what they don’t know about the shadow banking system. They don’t know exactly where the risks are concentrated or how investors will respond to a turn in sentiment or an increase in defaults. They don’t know how much leverage the shadow banks have taken on and how much forced selling there will be if loan values fall. They don’t know all the indirect ways in which the regulated banks are exposed to the shadow banking system.
Another worrisome similarity is the way bankers have used their political clout with Republican politicians to fight off attempts by regulators to restrain their risk-taking.
Two years ago, when career bank regulators issued guidance meant to crack down on leveraged lending, for example, bankers went running to Republican leaders in Congress, who threatened a congressional veto unless they withdrew it.
And tucked into last year’s budget compromise was a Republican rider allowing business development companies, which have been springing up like mushrooms in a rain forest, to double the amount of money they can borrow relative to the amount of equity capital they raise from investors.
Perhaps the biggest similarity between the previous credit bubble and this one, however, is the stubborn reluctance of regulators to let some of the air out of the credit bubble before it bursts.
After the 2008 crisis, the United States and a dozen other industrialized countries created a clear and simple mechanism for doing so, known as the “countercyclical capital buffer.” The rationale behind the buffer is that when unemployment is near historic lows and asset prices are at record highs, when credit quality is declining and spreads are narrowing, banks should be required to set aside extra capital to protect against a downturn and reduce the amount of credit in the financial system.
Yet in March, with nearly all of those key indicators flashing red, the Federal Reserve’s Board of Governors voted 4 to 1 not to trigger the countercyclical capital requirements. The lone dissenter was Lael Brainard, a veteran of the Clinton White House and the Obama Treasury.
Randal Quarles, the Fed’s vice chairman and point man on bank supervision, declared afterward that the United States didn’t need to use countercyclical buffers because other regulatory controls were now so effective that the American banking system could weather any turbulence without them. In a subsequent talk at Yale University, Quarles, a onetime partner at the Carlyle Group, a private equity firm deeply involved in the shadow banking system, blamed — who else? — the media for overplaying and oversimplifying the risks from the rapid expansion of business lending.
And in his recent speech, Powell, who spent most of his life as a Wall Street lawyer and banker, assured his audience that regulators “will always act to address emerging risk” — which might ring true if you consider “acting” to mean monitoring, studying, sharing data and “working to ensure that banks are properly managing the risks they have taken on.” In other words, doing everything except actually requiring banks to throttle back on their riskiest business lending.
Meanwhile, the Financial Stability Oversight Council, comprising all the government’s financial market regulators, has also been sitting on its hands, monitoring everything but doing nothing. The council was created by Congress as part of the Dodd-Frank financial reform bill as a last line of defense against financial crises. But as with most other provisions of the law, the policy of the Trump administration has been to ignore or undermine it. The council is headed by Treasury Secretary Stephen Mnuchin, a former Goldman Sachs investment banker who eventually made more than $10 million buying and selling — with partners — a California bank that, after engaging in aggressive mortgage lending, failed during the last housing crisis.
Powell, Quarles and Mnuchin are overconfident for the same reason Fed chairmen Alan Greenspan and Ben Bernanke and Treasury Secretary Henry Paulson were overconfident during the Bush years.
They place too much faith in the ability of financial firms to self-regulate and financial markets to self-correct when pricing of risk gets out of whack.
They place too much faith in outdated models of the economy and the financial system that do not account for the rapid growth of the shadow banking system.
And they ignore the “precautionary principle” — that, in an environment characterized by uncertainty, effective financial regulation requires taking the relatively modest risk of acting too soon — and sacrificing a bit of economic growth, corporate profits and investment returns — to avoid the much greater risk of acting too late and winding up with a financial and economic train wreck.
Powell, Quarles and Mnuchin are inclined, either by biography or ideology, to adopt a stance of watchful waiting while assuring us that today is nothing like 2008 and the situation is well in hand.
So remember those names: Powell, Quarles and Mnuchin. When the corporate credit bubble bursts — when companies can’t repay their debts and the shadow banks collapse and lending dries up and stock prices plunge and the economy again falls into recession — they are the ones who should be hauled up before the court of public opinion and called to account.
Steven Pearlstein is a Post business and economics columnist. He is also Robinson professor of public affairs at George Mason University.