A few weeks ago, Mike Farrell, head of Annaly Capital, a New-York based, non-bank finance firm, wrote a letter to his investors that pointed out that “in times of chaos ... those that survive aren’t necessarily the biggest or the bravest.”
Instead, “the survivors are those that are smart, nimble and, yes, lucky enough to avoid the pitfalls of uncertainty,” he declared.
“Large banks may be restricted in the types of risk they can take and the businesses they can be in, but ... we are building a company that is prepared to perform through these tumultuous times.” Just a bit of New York marketing spin? Perhaps.
But Mr Farrell’s letter reveals a much bigger Wall Street trend: namely the degree to which non-bank finance companies, such as Annaly, are now spreading their wings with a new sense of confidence – and entrepreneurial hunger.
For notwithstanding the fact that the recent financial crisis largely started in the non-bank sector – or “shadow-bank” world – thus far, at least, Western regulators have focused most of their reform efforts on the regulated banks.
More specifically, while the new rules linked to Basel and Dodd Frank are significantly tightening capital standards for regulated banks, they largely spare non-banks, such as investment vehicles, hedge funds and interbank brokers.
Regulators say this simply reflects the fact that regulated banks play a bigger role in the mainstream economy than shadow banks, and have a more devastating impact when they fail.
They also promise that the rules for non-banks will be tightened, once they have put in place the new regime for regulated banks.
“This is a question of sequencing,” one senior Western financial regulator says.
Some regulators also argue that the state of the non-bank sector poses less of a problem, since the sector has shrunk in size.
When Timothy Geithner, US Treasury secretary, recently spoke with senior bankers at a conference in Atlanta, for example, he pointed out that the shadow banking world had been cut in half since 2007.
But on Wall Street, at least, there is little sense right now that the shadow banking sector is in decline: on the contrary, as rules on the banks tighten, activity and personnel are shifting into the shadow world at an accelerating rate.
Or as the head of one Wall Street private equity group says, “We are heading towards the golden age of [non-bank] finance companies ... and that is largely because of what regulators are doing with the banks.”.
Annaly is a case in point. The group was founded just over a decade ago, originally as a mid-sized real estate investment trust.
However, in the past three years – or since the financial crisis erupted – its assets have grown to more than $110 billion, comparable to that of America’s small banks.
That is partly because the REIT business has boomed, as the securitisation market has suffered in the past three years.
However, Annaly has also started moving into sectors which used to be dominated by banks, partly because it can often operate more profitably in some areas because as a non-bank it is regulated by the Securities and Exchange Commission – and thus does not need to meet banking rules on, say, capital adequacy.
Thus Annaly is gobbling up loans being shed by the large banks. It is also providing finance to mortgage companies.
Next it hopes to start purchasing the assets currently held by state entities, when these are sold in the coming years.
And it is far from alone: a host of Annaly-style funds are now also applying for licences with the SEC, to pursue similar activities.
The private equity group TPG is now moving into the business of middle-tier corporate lending.
And Fortress, another large private equity firm cum hedge fund, is chasing similar opportunities, along with some hedge funds. This trend leaves some observers fretting about new systemic risks.
“It is crazy what is going on – business is being pushed out of the regulated banks into parts of the system that regulators cannot see,” complains one of Wall Street’s most senior lawyers.
But Annaly, for its part, denies this: they argue that because they are answerable to hands-on investors, rather than distant regulators, make them more – not less – prudent in managing credit risk.
It is impossible right now to tell whether this is true; the real test may not come for several years.
But the one thing that is clear is that this trend is unlikely to end anytime soon.
Investors and regulators had better hope, in other words, that this new breed of shadow banks does turn out to be better run than before.
If not, historians may yet view this period as (yet another) lesson in the unintended consequences of regulatory reform.