Opinion: More rotting assets are lurking in the shadows of the financial system
Like a lightning bolt that suddenly throws a landscape into sharp relief, higher interest rates have exposed where the financial system could buckle or break—but higher borrowing costs will last longer than a flash. The nonbank sector—made up of the thousands of private-equity funds, hedge funds, and insurance companies—now plays role the biggest banks used to dominate.
But it also looms large as a new epicenter of financial instability, a problem that demands fresh policy approaches.
“ Much of this subprime corporate debt reflects questionable accounting practices that allow borrowers to overestimate future earnings, thus downplaying leverage levels, something private-equity owners shrug off because of their own short time horizons. ”
$5 trillion in debt
Nonbanks, firms that are not traditional insured depositories, lie at the heart of a system that has created a $5 trillion debt load on companies in the U.S. alone, according to a new study by my organization, Americans for Financial Reform.
This mix of leveraged loans securitized into collateralized loan obligations, high-yield debt, and private credit have played a critical role in the private-equity industry’s leveraged buyout machine that has taken over tens of thousands of companies.
Corporate indebtedness is now higher than it was before the 2008 financial crisis.
We will find little positive left over from this lending. Our research suggests that only a tiny fraction—3%—went for identifiable corporate purposes. Instead, the debt supports further consolidation in an economy that already has a problem with monopoly power, and it allowed owners to draw cash out of companies, or refinance.
Federal Reserve Chair Jerome Powell called last week for “structural change” in the nonbank system, arguing for reform that stops short regulating them like traditional banks. Europe’s top financial supervisor has also cautioned of the impact of lending to highly indebted companies. There may be more rotting assets lurking in the financial system than we realize.
Cracks in the system
The pandemic foreshadowed cracks in the credit system that the Federal Reserve papered over with its massive injections of liquidity in 2021. The need to tamper resurgent inflation has now stripped central bankers of that tool. And the hangover of years of policy-driven, frothy credit provision are now showing, as default rates in the U.S. and Europe escalate.
The hangover from this subprime corporate lending will amplify any future downturn as companies struggling to service their debt laypeople off and reduce their capital investments amid a global economic slowdown. It will also test the financial system, daring central bankers to veer away from higher rates.
Much of this subprime corporate debt reflects questionable accounting practices that allow borrowers to overestimate future earnings, thus downplaying leverage levels, something private-equity owners shrug off because of their own short time horizons. It’s an echo of how Wall Street’s originate-and-distribute model of mortgage lending led to crisis in 2008 because it divorces decision-making from liability.
Also, the locus of the credit risk that this lending has generated remains unclear. There are signs that the core banking system avoided the worst loans, but a few were caught short when interest rates rose. Insurers appear to hold quite a bit of the risk left over from the corporate-sector binge.
We can start to wriggle free of the Catch-22 of financial instability or imprudent lending with policy changes that emphasize transparency and responsibility, especially among nonbanks.
Three things we can do
First, the U.S. Treasury Department should abandon the previous administration’s hesitancy to designate nonbank actors for special supervision by its committee of regulators, the Financial Stability Oversight Council.
If Powell is calling for structural change, greater supervision can hardly be controversial. The largest private-equity firms—Blackstone, Apollo and KKR—are now sprawling financial conglomerates that merit a close look.
Second, regulators should seek greater transparency and insight. All of them have research functions that, paired with supervisory powers, can be as vibrant as they choose to make them. Regulatory powers could ensure greater disclosure by issuers and enforcement against bad actors. Misleading financials could be policed more effectively.
Finally, regulators could address perverse incentives that encourage regulatory arbitrage. U.S. rules let insurers hold less capital when a portfolio of corporate loans is packaged into a CLO versus when they hold the loans themselves. Banks can use decades-old exemptions to avoid disclosing underwriting risks.
For all the abuses, much subprime corporate lending came from traditional banks, whose role creating CLOs provided insight, albeit limited, into the trend. In the most recent development, private credit—direct lending to companies by other divisions of leveraged buyout shops—is taking over as banks withdraw amid higher rates. Again, it’s an old story: activity retreats into the darker corners.
Monitoring the gray areas of the nonbank sector has proved challenging. Now it’s moving even deeper into the shadows, to the point where we risk not knowing enough to act effectively. Fortunately, we do know enough—now—to conclude that the time is ripe for policy change.
Andrew Park, a former Wall Street professional, is senior policy analyst at Americans for Financial Reform, a Washington-based coalition of over 200 civil rights, consumer, labor, business, investor, faith-based, and civic and community groups that was formed to fight for what became the Dodd-Frank Act in 2010.
More on risks in the financial system
U.S. runs up against its debt limit, so Treasury starts using ‘extraordinary measures’: Here’s what that means
This perfect storm of megathreats is even more dangerous than the 1970s or the 1930s, Roubini says
Central banks want to fight inflation, but they still need to keep the financial system functioning. The two goals may be conflicting.
For more updates check below links and stay updated with News AKMI.
Life and Style || Lifetime Fitness || Automotive News || Tech News || Giant Bikes || Cool Cars || Food and Drinks