Where Is the Risk in the COVID Economy? A look at shadow banking

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By Janet Roitman and Andrew Moon

We are witnessing a public bailout of the private sector that dwarfs the bailout response to the 2007­–2008 Great Recession. Compared to the $700 billion Troubled Asset Relief Program (TARP) implemented in 2008, today’s mobilization of public funds through the Coronavirus Aid, Relief, and Economic Security (CARES) Act amounts to a whopping $2.3 trillion, thus far.

As we know from media coverage of the CARES Act, today’s relief programs are intended to support payrolls, corporate operations, and small business overhead. What we don’t hear from the mainstream media is news on how these relief programs serve, once again, to privatize profits and socialize losses.

Unfortunately, few people are training their sights on that process — that is, on the actual mechanisms by which public funds are being used to underwrite not payrolls or job creation, but rather new sites of capital accumulation.

Just where are these new sites?

These new frontiers of accumulation aren’t confined to the marble halls of Wall Street. In order to observe them, we need to shed light on the non-bank financial sector, or “shadow banking.” This sector is central to the machinery of our contemporary economy. It has a role to play in our efforts to recover from the pandemic economy — and hence in the future of our wellbeing.

“Non-bank financial sector” sounds like an oxymoron. And it is.

It consists of a broad array of financial institutions and intermediaries that conduct “bank like” services. The economist Paul McCulley, who coined the term “shadow bank,” defines it as “the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures.”

Shadow banking sounds secretive, but it includes everyday activities: securities lending, market brokering, wealth management, and risk pooling. These services are conducted by credit hedge funds, money market mutual funds, private equity funds, insurance companies, and payday lenders, amongst others.

What holds them together — and makes them “non-bank” — is that they generally don’t fund themselves with insured deposits, as commercial banks do, and they don’t hold full banking licenses. That means, at least in theory, that these services are conducted without access to official central bank liquidity and public credit guarantees. They therefore function on the periphery of conventional economic regulation — or in the shadows of federal oversight.

In the wake of the 2008 Great Recession, the 2010 Dodd-Frank Act was implemented to regulate systemic risk in our banking institutions. But tougher regulation of the formal banking sector only led to the migration of risk-taking strategies into the shadows. In the end, despite regulatory legislation, the non-bank financial sector survived, and is now prospering.

These earlier interventions, which included the Federal Reserve buying Treasury bonds to increase the money supply, produced an era of very low interest rates, which provoked, in response, a “search for yield.” Pension funds, endowments, and insurance companies sought higher returns. As a result, private debt funds, which raise money from these long-term institutional investors, benefitted from a massive influx of capital.

The titans of this private debt industry are private equity funds, like Blackstone, Apollo, and KKR. We generally think of them as “buyout funds” because they pursue short-term resale strategies: they buy distressed public companies, which they deem “undervalued,” through highly leveraged deals — that is, using other people’s money. They then restructure and resell these companies, yielding profits for themselves and their investors.

More recently, these short-term strategies have been supplanted by more enduring activities, such as “permanent capital” investments in life and retirement insurance companies. Through these newer pursuits, private equity firms are displacing conventional banks as the primary source of credit for corporate America.

In April 2020, private equity funds were shut out of the Small Business Administration’s $659 billion Paycheck Protection Program (PPP). The reason, as stated in the Federal Register, is that “hedge funds and private equity firms are primarily engaged in investment or speculation,” and are therefore ineligible for relief funding for payroll and operations. Their portfolio companies were also subject to the “affiliation test,” which requires that businesses and affiliated entities of private equity funds be assessed according to the aggregate number of employees and annual revenue. These eligibility criteria firmly closed the door to federal emergency funding for all large private equity firms. In July, these rules were carried over to the $600 billion Main Street Lending Program, which, again, put all large private equity firms beyond the threshold to access loans.

But just how far beyond the threshold for Federal support are private equity funds?

At first glance, it looks like the rules were applied and the government kept these wealthy giants at bay. And yet, while they have not received access to Federal funding, because they are increasingly the main source of credit for corporate America, they benefit indirectly from the interventions of the Federal Reserve. How does that work?

Among other interventions to support the economy, the Federal Reserve has purchased corporate bonds, Treasury securities, as well as residential and commercial mortgage-backed securities. The Fed’s holding of these bonds and other assets now totals an unprecedented $7 trillion. One consequence of its guarantee is that the value of these holdings becomes inflated. But this is an intended outcome, since, through these purchases, the Fed ensures liquidity in the capital markets, which means that people are still willing to trade and lend, despite radical uncertainty.

The Fed also sought to avert corporate bankruptcies, which would impact the commercial real estate sector, the labor market, and so forth — a cascade of consequences. To do so, on March 23, it announced that it would underwrite and purchase investment grade bonds.

Only a few days later, this program was extended to include bonds that are — or have become — high-risk, or junk bonds. This move was not widely discussed in the media — but it is nevertheless momentous. In effect, the U.S. Federal Reserve is essentially guaranteeing the value of junk-rated assets, largely owned by private equity funds.

We should remember: junk bonds are high-return financial instruments because they entail . . . high risk! High-risk, high-return. Therefore, as the ProPublicajournalist Jesse Eisinger notes, “the Fed bailout disproportionally helps not just the wealthy, but the wealthy who take the most risk.”

We are now in a world where the Fed (or the taxpayer) is guaranteeing the risk on these high-return financial instruments. Perhaps the returns will wither or disappear altogether. Nonetheless, we have not seen similar commitments — underwriting and guaranteeing debt and risk — made to hospitals, small businesses, and certainly not to working people.

So while many companies are suffocating under debt burdens, made worse by downgraded debt ratings, and waves of defaults and bankruptcies are in the offing, private equity is shadow banking. Officially shut out of the CARES Act, private equity funds have made their way to federal support through the back door.

Since the onset of the pandemic, private equity has invested heavily in the insurance industry. For instance, just this month, KKR, a private equity fund and early architect of short-term leveraged buyouts, announced the $4.4 billion acquisition of life insurer Global Atlantic. The controversy surrounding the deal centers on the massive management fees KKR will reap — upwards of US $200 million annually. But this misses the point. The acquisition led to the tripling of its portfolio of what’s known as “permanent capital.”

Private equity funds had already created and invested in non-bank financial institutions with vigor after the 2008–09 bailouts. Then, too, they took a particular interest in the insurance industry. Investment in insurance companies is seen as a way to access premiums as a source of capital. They also provide access to the increasing premium rates and favorable underwriting conditions that accompany industry-wide loss events, or catastrophic loss.

For private equity, this represents “permanent capital” because, unlike a bond that matures over ten years, annuities insurance (to take one example) extend into perpetuity. And for these firms, this represents a new model of value creation: “Private equity has [. . .] shifted to permanent capital by embracing an alternative business model: acting directly as an insurer over the long-run; rather than buying, overhauling, and exiting subsidiaries.”

Permanent capital is used to hedge risk. Private equity–backed insurance companies achieve this by reducing the risk that their investment activities will be constrained. For instance, during economic downturns, like the one we’re experiencing today, cautious investors redeem cash held in short-term private equity funds. In contrast, holdings in insurance companies give private equity the ability to reinvest premiums without the risk that they will be redeemed.

Private equity’s pitch is simple enough: insurers invest premiums to create value so as to fund future liabilities. Private equity says that it brings “capital efficiency” to that objective. But how does capital efficiency work?

It’s a two-pronged approach. Private equity firms substitute high-rated, low-return insurance assets for high-risk, high-return junk bonds to create value in the short term. And this is where the Fed’s backing comes into full effect. Remember: the Fed’s interventions put a floor under the value of private equity’s prized asset class — junk bonds. What is typically high-risk, is now backed as high-reward. And, remember: this leveraging occurs in perpetuity.

Private equity funds then engage in what’s known as “shadow reinsurance.” Shadow reinsurers are foreign affiliates set up by private equity holding companies and domiciled in places like Bermuda and other lightly regulated jurisdictions. Through these foreign affiliates, private equity funds reduce the tax burden on the premiums they receive.

But, perhaps more concerning, they also increase the range of investment activities that private equity–backed insurers can undertake with those premiums. This is because, in these jurisdictions, there are few or no capital requirements or regulations that dictate the amount of money a financial institution is required to keep on hand to meet its liabilities, which in the case of insurance is the payment of claims.

Private equity is diversifying into the wider credit system of the non-bank financial sector during a global pandemic. And these investments are hardly in the shadows. They are increasingly a primary source of credit for corporate America.

As such, they pose risks to working people and the uninsured.

We need to ask: Should the U.S. Federal Reserve support — with record amounts of public money — private equity’s “permanent” entry into the heart of conventional financial institutions? Should liabilities — that cover mortality and morbidity risk, for example — be parked (and not underwritten) in “shadow” companies as investment capital?

We can only answer these questions when the entire shadow banking system is subject to federal oversight — and to analysis by academic scholars.

On June 3, the U.S. Labor Department announced that employer-sponsored retirement accounts can now include private equity funds in their portfolios as an asset class.

This opens yet another door to private equity funds: access to a share of the $6.5 trillion 401 (k) market, from which private equity stands to gain up to $400 billion in new assets.

Presented as a “the holy grail for alternative managers,” this is the most recent example of the ongoing wealth transfer from citizen savings to private equity.

In that sense, the pandemic economy has not been a crisis that has brought finance to a standstill. To the contrary, it has opened up new opportunities for the extension and intensification of certain financial practices and private forms of debt.

We might want to believe that high-risk financial activities meet their day of reckoning when the markets go sour. “But perhaps,” as one observer notes, “ this is merely the end of the beginning of a new era of private capital, rather than the beginning of the end.”

Janet Roitman is a university professor at The New School

Andrew Moon is a PhD candidate in anthropology at The New School for Social Research.

This post was first published on Public Seminar. Photo by David Webrouck.

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