A New Credit Bubble Gets Ready to Burst

Wall Street wiseguys have shifted from buying high risk corporate loans to making them directly.

By Steven Pearlstein and cross-posted from Greenwich Time.

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”…

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