Fed: Hedge Funds, Banks Sell Crappiest Debt To Small Investors (Before Credit Bubble Blows Up)

In its report on shadow banking, the New York Fed buried some nuggets: Hedge funds and banks are bailing out of the highest-risk “opaque” but now relatively low-yielding loans – low yielding thanks to the Fed’s repressive monetary policies – by selling them to small investors via harmless-sounding and conservative-appearing mutual funds and ETFs.

Shadow banking loans are estimated to have reached $15 trillion in the US. And among them is a particularly hot category: lending to highly leveraged companies with junk credit ratings. Sophisticated investors with a big appetite for risk who know how much yield to demand to compensate them for these risks might see these “leveraged loans” as an opportunity. But the NY Fed found that these loans are increasingly issued in a loosey-goosey manner, with low underwriting standards. And issuance has soared.

In 2007, issuance of these “leveraged loans” peaked at $680 billion but then totally collapsed in 2008. Since 2009, according to NY Fed, “it has rebounded very quickly, and is now at record levels of volume, projected to be larger than $1 trillion in 2013.”

Layered into these crappy and risky loans are the crappiest and riskiest of all loans, namely “covenant-lite” loans. Their covenants are so watered down and so full of holes that investors have few if any protections in case of default. If the Fed ever allows reality to set, and these companies stumble under their load of debt or can’t refinance it at ridiculously low rates, investors can kiss their money goodbye. In 2010, 0% of the leveraged loans issued were “covenant lite.” This year, they ballooned to 60% of the issuance, or about $600 billion.

“One area of concern,” is how the NY Fed called this phenomenon.

For sophisticated investors, it’s a gamble worth considering. In normal times, they’d demand yields deep into the double-digits before touching covenant-lite loans with their ten-foot pole. But these are not normal times. The Fed, with its QE and zero-interest-rate policies, has been immensely successful in annihilating any link between reality and financial assets. Now, no one is getting compensated for risk – neither at the low end, with many Treasuries yielding below the rate of inflation, nor at the high end, with junk “covenant-lite” debt yielding as little as FDIC-insured CDs did not that long ago.

But the Fed has systematically vaporized these CDs. Conservative retail investors, such as retirees and millions of others, watched their income streams get confiscated by the banks. To do something about their loss of income, they have embarked on an all-out search for yield elsewhere – and they have stumbled upon junk, including these “covenant-lite” leveraged loans. They’re doing exactly what Chairman Bernanke, out of the goodness of his heart, has wanted them to do for years: invest their life savings in super risky assets without being compensated for these risks. And they don’t even know it.

The NY Fed notes in its dry manner: These high-risk, loosely underwritten leveraged loans have come “hand-in-hand with an increased presence of retail investors in the leveraged loan market, through both CLOs [collateralized loan obligations] and prime funds, as relatively sophisticated investors, like banks and hedge funds, are exiting the asset class.”

It could be an indictment of Chairman Bernanke’s policies. But that would be wishful thinking. The NY Fed isn’t worried about small investors getting stuck with landmines that will later blow up in their portfolios. It’s worried about things like shadow credit intermediation: “The funding of long-term opaque and risky loans through mutual funds and exchange-traded funds, which engage in liquidity and maturity transformation, help to define this activity clearly as shadow credit intermediation.”

The Fed printed $3 trillion and handed it to banks and hedge funds. The top echelons became immensely wealthy in the process, but some of this wealth is now tied up in crummy overvalued financial assets – from these leveraged loans to stocks. To preserve their wealth, they have to dump these assets before the rest of the hot air hisses out of the biggest credit bubble in history. But they have to do so in a disciplined manner to avoid causing a sudden implosion of the credit bubble, which would end it all – or, more likely, produce another Fed bailout.

And small investors are lining up to buy this junk. Assets at mutual funds that deal in leveraged loans have doubled from two years ago to $145.7 billion, according to the Wall Street Journal. Without knowing what they’re buying – they’re just buying a fund symbol along with a vague description – these small investors have bought one-third of these leveraged loans in 2013 for an average yield of 5.3%.

That’s about what their five-year FDIC-insured CDs had yielded before the Fed killed them.

For the same yield, these desperate small investors, after having seen their income streams get confiscated by the banks, have unknowingly made a quantum leap in risk – allowing the smart money, which hears the hot air hissing from the credit bubble, to bail out. This must be one of the proudest moments in Chairman Bernanke’s glorious tenure.

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