When Wall Street Innovates, Beware: Office of Financial Research Report
The Senate Intelligence Committee report on CIA’s detention and interrogation program has dominated the news cycle in the last twenty-four hours, and rightfully so. While I was reading the Senate report, and small news item flashed across my computer screen. (The Internet is constantly distracting me in different directions). All of a sudden, I was carefully reading “Threats to Financial Stability”, which is the second chapter of the annual report produced by the Department of Treasury’s Office of Financial Research.
Much of the OFR’s concern centers on the amount of risk-taking that has occurred in recent years, and the potential consequences as the Fed’s program of quantitative easing comes to an end and short-term interest rates eventually rise. These aren’t new concerns, and the OFR expressed them in last year’s report. As the report details, Wall Street is manufacturing an enormous amount of high yield bonds and leveraged loans. Moreover, companies are being allowed to increase their leverage, while simultaneously offering investors fewer protections (known as covenant-lite). Within seven short years we’re returned to the terms and conditions of 2007. This is not to say that we have a brewing financial crisis because the mortgage market and other financial sectors have not re-inflated like corporate debt.
However, and this is where the report gets interesting, the risk derived from corporate borrowing has shifted. Take a look at the chart below. In 1998, banks held about two-thirds of all highly leverage loans, and non-banks (institutional and retail investors) held the remainder. Today, banks hold about 10% of that paper and nonbanks hold the rest.
From the perspective of banks and bank regulators, this is good news. When the credit cycle inevitably turns downward, the banking system will probably be okay. However, pension plans, mutual funds, and ETFs will take the hit. The OFR report provides plenty of additional evidence for this shift.
As the OFR reports explains, this shift is no accident:
Product innovation has also increased in corporate credit markets, a hallmark of late-stage credit cycles. Recent issues have provided broader, cheaper access to credit such as exchange-traded, high-yield, and leveraged loan funds; total return swaps on leveraged loans; and synthetic collateralized debt obligations (italics added).
In other words, as corporate debt has become more and more risky, Wall Street has, once again found ways to package it up and sell it off to third parties. I italicized the word “product innovation” because I think it captures Wall Street’s fundamental disease. In any other industry, product innovation represents an improvement that is supposed to benefit customers. On Wall Street product innovation almost always means that damaged goods are being disguised or fees are being hidden so they can be passed along to customers. As the OFR reports points out, Wall Street’s innovation machine cranks up when it is late in the game. When the quality of residential mortgages began to deteriorate, Wall Street came up with imaginative packaging (e.g., CMOs) to make damaged goods look good. They are at it again with corporate securities. After all the investigations and new regulations, nothing has changed.