Potential economic pain from a corner of the corporate-debt market could hit the economy more quickly than the crisis that ravished Wall Street in 2008, Sheila Bair, former head of the Federal Deposit Insurance Corp., has warned.
As head of the FDIC, Bair was on the front lines of the subprime-mortgage bubble which rocked the global financial system more than a decade ago. The FDIC was one of the key policy makers which oversaw a wave of bank busts in the aftermath of the 2008-09 financial debacle.
Now, the former bank regulator worries that too little is being done to stave off another crisis, which could be sparked by leveraged lending, or risky loans made to companies with less-than-stelar credit.
The outspoken 65-year-old thinks that if debt-laden companies can’t repay their loans, the economic impact on the economy could hit jobs and economic growth faster than the slow-rolling mortgage crisis did a decade ago.
“I do think that we are going to see distress in the corporate market, which can have a very strong and significant impact on the real economy,” she told MarketWatch in an interview.
“With subprime, at least you had a bit of a flow-through,” she said. “It took a while. There was a market shock. But in terms of the real economic impact, it was more gradual.”
Subprime lending giant Countrywide Financial started to feel the pain of falling home prices and rising defaults in early 2007, but it still took months before the credit-rating firms acted and slashed billions worth of AAA-rated mortgage bonds to junk status. It was not until March 2008, that Bear Stearns, teetering on failure, was snapped up by JPMorgan Chase & Co. with the help of the Federal Reserve.
‘Here, I think the impact could be pretty immediate on jobs, because there are just so many of these companies that are just up to their eyeballs in debt’
While most home-loan borrowers need to be in default on their mortgages for more than four months before a bank foreclosure process begins, the whole process of eviction and bank sale can take a year or more.
Should credit to highly leveraged companies dry up after a decade of easy money, corporate restructuring could mean the loss of jobs more quickly, Bair argued.
The amount of leveraged loans outstanding globally stood at $2.2 trillion as of 2018, according to a Bank of England report published in January. That was nearly double the size of the U.S. subprime mortgage market in 2006.
“Here, I think the impact could be pretty immediate on jobs, because there are just so many of these companies that are just up to their eyeballs in debt,” Bair explained.
“I do wish people would focus on that, as well.”
Bair is far from the only person fretting about a potential blowup in leverage lending. Former Federal Reserve Chairwoman Janet Yellen earlier this year cautioned that America’s corporate debt binge has the potential to spark a deep recession when the next downturn hits.
In terms of market shocks, it would be hard to top the havoc caused by subprime mortgage lending.
Millions of homeowners lost properties to foreclosures. Lenders large and small failed. Credit froze up. Taxpayers footed the bill for massive, big-bank bailouts, though the government eventually received most of the money back.
But the piles of debt owed by U.S. companies have been causing heartburn too, with lawmakers, central banks, credit-rating firms and regulators each raising red flags.
Meanwhile, more funding has flowed to companies with weaker credit, with the B-rated part of JPMorgan’s leveraged loan index more than doubling to 48% as of May 2018 from 21% in 2016. Moody’s Investors Service considers companies with its B-ratings speculative and a high risk of default.
But despite the increased risks, yields have held near 5% on the closely-tracked S&P/LSTA leveraged loan 100 index for much of the past seven years, and only briefly spiked to 7% during in early 2016.
The low-yield environment has partly fueled growing appetite for arcane debt, like leverage loans, which can offer richer yields than government paper. And many monetary policy makers say a new round of economic stimulus may be needed to mitigate the effects of a global slowdown that is being exacerbated by battles over import tariffs between the world’s largest economies, China and the U.S.
Last Wednesday, the Fed left the door open for the first potential cut to benchmark interest rates in a about a decade.
Investors have thus far reacted to the central bank’s easy-money posture by sending the 10-year Treasury note
in about 21 months at about 2.03%, briefly falling below 2%, with yields for comparable German debt also falling to a record low of around negative 0.322%.
To be sure, debt crises unfold in ways that are hard to predict and sweeping reforms to financial regulations in the wake of the 2008 crisis have helped to shore up risks at major lending institutions over the past decade.
The new rules also are intended to help rein in the U.S. securitization market, which repackages a range of debt, from car loans to mortgages into bonds that are sold to an array of investors, including pension funds and insurance companies.
As a consequence, there no longer is an assembly line of toxic mortgages being quickly stuffed into funds that issue bonds called CDOs, which in the run-up to the crisis were stamped with top, AAA-ratings and sold to investors as relatively risk-less investments.
But there still are plenty of CDOs of leveraged loans, which Wall Street calls “CLOs.” And those bond funds now are the biggest buyer of leveraged loans with a 62% share of the market, according to the most recent data from Moody’s Investors Service.
Meanwhile, the Trump administration has been chipping away at regulations that were designed to keep lenders in check and prevent the next financial crisis.
For Bair, another key concern is that Wall Street has mostly become accustomed to the idea that money-center banks will be insulated from fallout in the corporate sector. In other words, there remains a prevailing sense that many of the nation’s largest banks are too big to fail and must be backstopped by governments using taxpayer funds.
“It is a classic moral hazard,” Bair said about the risk of making big bank bailouts routine. “The banks do interface with these markets, even if they are not making these loans,” she said. “We need to be prepared at the end of the cycle.”
Bair also noted the parade of nonbank mortgage lenders that failed in 2007 and 2008 as waves of borrowers defaulted on their mortgages as a cautionary tale.
“The need for credit flowed back to into the regulated banking system,” Bair said. “But the big banks didn’t have the adequate capital capacity to expand their balance sheets. It was just the opposite. They were shrinking their balance sheets and pulling in credit lines to maintain their capital base because they were too highly leveraged.”
To that end, Bair said regulators should ramp-up their stress-test assumptions and put banks in a position to retain more of their earnings and build up their capital buffers. However, bank CEOs have complained that their capital buffers are adequate and have warned that raising the bar now could limit their ability to lend.
”The parallels to the subprime crisis, are pretty striking, except you are dealing with corporate borrowers instead of households,” Bair said of today’s leveraged-loan market.
“There seems to be a lot of hand-wringing about this. But nobody is really doing anything.”