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AP Photo/Mary Altaffer
Wall Street lenders have been richly rewarded for playing the middleman during this year’s U.S. debt boom, but without shouldering much of the risk.
Essentially, that’s what the Federal Reserve’s unprecedented slate of emergency lending facilities announced in March were designed to do — keep credit flowing to businesses and communities no matter how dire the pandemic might get.
But as large regulated banks become more reluctant to lend and bond issuance booms, some see parallels to 2008, when the shock waves of the global financial crisis led major banks to cede significant ground to other debt providers willing to fill the void.
“We’re seeing a bifurcated outcome. Public markets are completely open, spreads have tightened. But if you look at lending standards among banks, they’re now tighter,” Dec Mullarkey, managing director of investment strategy at SLC Management, told MarketWatch.
U.S. financial institutions have looked to protect their balance sheets from the uncertainty presented by the COVID-19 pandemic. Smaller, local banks and nonbank lenders already have faced pressure from souring loans extended to now-empty stores, offices and other businesses.
Randal Quarles, the Fed’s governor in charge of supervision of banks in the U.S., pointed to the “fragile” position of nonbanks that now hold almost two-thirds of all U.S. business and household debt, in a speech this month.
The first eight months
While it is hard to compare one crisis to the next, several months of pandemic-era data now show patterns starting to emerge.
A clear trend has been public capital markets that have asserted a fresh level of dominance in swaths of U.S. debt finance. That means more of the upside — and downside risks — of lending to the U.S. economy during the pandemic rests in the hands of investors, retirement funds and pension plans.
Meanwhile, banks over the past eight months have shown a hesitancy to lend, while waiting for the full scope of the pandemic’s economic toll on households and companies to play out.
Total loans from banks rose to $10.5 trillion in September, up around 6% from a year prior, according to Fed data. But the Fed’s most recent senior loan officer survey also showed banks have raised the cost of borrowing and tightened their lending terms in a July survey.
That contrasts with borrowing costs in the booming public debt markets that have come down sharply, in some cases to record lows, following the Fed’s interventions to support corporate credit.
Read: Fiscal stimulus may not be enough to boost bank stocks, says J.P. Morgan
U.S. bond boom
Falling yields, even for sub-investment grade corporate debt, or “junk”-rated debt, have pushed their premium relative to risk-free Treasurys down to 5.35 percentage points, from a March peak of 11.38 percentage points.
Issuance of junk-rated and investment-grade corporate bonds in the U.S. stood at $1.94 trillion in the first nine months of 2020, 70% more than the comparable period last year.
That’s been a lifeline for businesses facing dismal earnings during the worst of the pandemic slowdown.
“This time the capital markets have continued to function relatively well and, coupled with government support, that is helping many companies maintain liquidity and manage their resources to get to the other side of the crisis,” said Ted Swimmer, head of corporate finance and capital markets at Citizens Bank, in emailed comments.
Lending in the shadows
Even as lending outside of regulated big banks has flourished, some say comparisons between the pandemic and the post-2008 backdrop don’t hold up.
“If you recall during the GFC [global financial crisis], that was a liquidity squeeze. This is a demand shock,” said Leland Hart, co-chief investment officer at Alcentra, in an interview.
In the past decade, nonbank lenders like Alcentra were busy raising capital with the goal of finding distressed businesses in need of cash. That’s why Hart expects this down cycle of stress to play out with plenty of funds to go around, unlike in the immediate aftermath of the 2008 crisis.
“If you speak to banks, some are growing their origination power in direct lending,” Hart said, referring to a type of lending where investors make loans to companies without having to go through a middleman who charges fees to place debt with investors.
Read: Bankers work hard to extend leeway for junk-rated loan borrowers
Still, concerns that banks might concede too much of the lending landscape due to COVID-19 could draw scrutiny from financial regulators wary of the growing heft of money managers, insurance companies and pension funds who aren’t supervised as closely.
“Regulators are not worried about potential losses arising from nonbanks, but they’re concerned about the interconnectivity of those institutions,” said Steven Oh, global head of credit and fixed income for PineBridge Investments, in an interview.
Earlier this month, the Securities and Exchange Commission issued a report on the growing presence of nonbank players in corporate debt markets, ahead of Quarles’ speech at a financial conference in Washington, D.C. to explore the economic shocks sparked by COVID-19 and the web of ties across markets and market participants that it exposed.
The regulator cited the close connections between junk-rated loans and banks, which may not hold the debt on their books but extended lines of credit to highly leveraged corporations, that could also drag banks into the morass of a credit crisis.
Starting in March, large corporations began to fully use these credit facilities, amid fears that if they weren’t first to borrow the funds other cash-strapped businesses would beat them to the punch.
That frenzy of borrowing briefly put pressure on major banks that had to lend out valuable capital during a time of financial stress. But companies also began paying down those credit lines after the Fed stepped in with slate of emergency lending facilities, including its first stab ever at buying up corporate debt.
“They aren’t going away,” said Hart of banks.
