Even crunchier credit

From Markets Insider

The US banking sector is still recovering from the worst turmoil since the 2008 financial crisis, but its troubles may be far from over.

JPMorgan & Chase CEO Jamie Dimon has warned that the next jolt to the American banking system could come from commercial real-estate (CRE) loans.

Stress has been mounting for months in the commercial property industry, which is being buffeted by headwinds including high interest rates, tighter credit conditions, and work-from-home trends causing office vacancies. That's fueling concerns about potential loan defaults by the more vulnerable borrowers in the sector.

"There's always an off-sides," Dimon said during the bank's investor conference on Monday, per CNBC. "The off-sides in this case will probably be real estate. It'll be certain locations, certain office properties, certain construction loans. It could be very isolated; it won't be every bank," he added.

Additionally, banks - especially smaller ones - should also brace for the risk of benchmark interest rates rising even higher, possibly up to 6% or 7%, according to Dimon. The Federal Reserve has boosted its policy rate to more than 5% currently, from near-zero levels in the first quarter of 2022.

"I think everyone should be prepared for rates going higher from here," Dimon said, according to CNBC.

Small and mid-sized US regional lenders are highly exposed to the CRE industry - financing around 70% of all debt in the sector - and that's made investors anxious about the overall health of the US financial system given the risk of CRE loan defaults.

Dimon said the banking industry is already building capital for potential losses by squeezing its lending activity.

"You're already seeing credit tighten up because the easiest way for a bank to retain capital is not to make the next loan," he said.

Half of America's banks insolvent

From The Age

The twin crashes in US commercial real estate and the US bond market have collided with $US9 trillion ($13.5 trillion) uninsured deposits in the American banking system. Such deposits can vanish in an afternoon in the cyber age.

The second- and third-biggest bank failures in US history have followed in quick succession. The US Treasury and the Federal Reserve would like us to believe that they are “idiosyncratic”. That is a dangerous evasion.

Almost half of America’s 4800 banks have already burnt through their capital buffers and are running on negative equity. They may not have to mark all losses to market under US accounting rules, but that does not make them solvent. Somebody will take those losses.

“It’s spooky. Thousands of banks are underwater,” said Professor Amit Seru, a banking expert at Stanford University. “Let’s not pretend that this is just about Silicon Valley Bank and First Republic. A lot of the US banking system is potentially insolvent.”

The full shock of monetary tightening by the Fed has yet to hit. A great edifice of debt faces a refinancing cliff-edge over the next six quarters. Only then will we learn whether the US financial system can safely deflate the excess leverage induced by extreme monetary stimulus during the pandemic.

A Hoover Institution report by Professor Seru and a group of banking experts calculates that more than 2315 US banks are currently sitting on assets worth less than their liabilities. The market value of their loan portfolios is $US2 trillion lower than the stated book value.

These lenders include big beasts. One of the 10 most vulnerable banks is a globally systemic entity with assets of over $US1 trillion. Three others are large banks. “It is not just a problem for banks under $US250 billion that didn’t have to pass stress tests,” he said.

The US Treasury and the Federal Deposit Insurance Corporation (FDIC) thought they had stemmed the crisis by bailing out uninsured depositors of Silicon Valley Bank and Signature Bank with a “systemic risk exemption” after these lenders collapsed in March.

The White House baulked at a blanket guarantee for all deposits because that would look like social welfare for the rich. Besides, the FDIC has only $US127 billion of assets (and less very soon) and may ultimately require its own bailout.

The authorities preferred to leave the matter vague, hoping that depositors would discern an implicit guarantee. The gamble failed. Depositors fled First Republic Bank at a fast and furious pace last week despite an earlier infusion of $US30 billion from a group of big banks.

White knights probing a possible takeover of First Republic recoiled once they examined the books and discovered the scale of real estate damage. The FDIC had to seize the bank, wiping out both shareholders and bondholders. It took a $US13 billion subsidy along with $US50 billion of loans to entice JP Morgan to pick up the pieces.

“No buyer would take First Republic without a public subsidy,” said Krishna Guha from Evercore ISI. He warns that hundreds of small and mid-sized banks will batten down the hatches and curb lending to avoid the same fate. This is how a credit crunch begins.

The share price of PacWest, the next on the sick list, fell as much as 60 per cent in after-hours trading on Wednesday. That will be the bellwether of what happens next.

The US authorities can contain the immediate liquidity crisis by guaranteeing all deposits temporarily. But that does not address the greater solvency crisis.

The Treasury and the FDIC are still in the denial phase. They blame the failures on reckless lending, bad management, and over-reliance on footloose uninsured depositors by a handful of banks. This has a familiar ring. “They said the same thing when Bear Stearns went down in 2008. Everything was going to be all right,” said Seru.

First Republic lends to technology start-ups, but it chiefly came unstuck on commercial real estate. It will not be the last on that score. Office blocks and industrial property are in the early stage of a deep slump.

“Where we stand today is a nearly perfect storm,” said Jeff Fine, real estate guru at Goldman Sachs.

“Rates have gone up 400 to 500 basis points in a year, and financing markets have almost completely shut down. We estimate there’s four to five trillion [US] dollars of debt in the commercial (property) sectors, of which about a trillion is maturing in the next 12 to 18 months,” he said.

Packages of commercial property loans (CMBS) are typically on short maturities and have to be refinanced every two to three years. Borrowing exploded during the pandemic when the Fed flooded the system with liquidity. That debt comes due in late 2023 and 2024.

Could the losses be as bad as the subprime crisis? Probably not. Capital Economics says the investment bubble in US residential property peaked at 6.5 per cent of GDP in 2007. The comparable figure for commercial property today is 2.6 per cent.

But the threat is not trivial either. US commercial property prices have so far fallen by just 4 per cento 5 per cent. Capital Economics expects a peak to trough decline of 22 per cent. This will wreak further havoc on the loan portfolios of the regional banks that account for 70 per cent of all commercial property financing.

“In a worst-case scenario, it could create a ‘doom loop’ which accelerates a real estate downturn that then feeds back into the banking system,” said Neil Shearing, the group’s chief economist.

Silicon Valley Bank’s travails were different. Its sin was to park excess deposits in what is supposed to be the safest financial asset in the world: US treasuries. It was encouraged to do so under the risk-weighting rules of the Basel regulators.

Some of these debt securities have lost 20 per cent on long maturities – a theoretical paper loss only until you have to sell them to cover deposit flight.

The US authorities say the bank should have hedged this Treasury debt with interest rate derivatives. But as the Hoover paper makes clear, hedging merely transfers losses from one bank to another bank. The counterparty that underwrites the hedge contract takes the hit instead.

The root cause of this bond and banking crisis lies in the erratic behaviour and perverse incentives created by the Fed and the US Treasury over many years, culminating in the violent lurch from ultra-easy money to ultra-tight money now under way. They first created “interest rate risk” on a galactic scale: now they are detonating the delayed timebomb of their own creation.

Chris Whalen from Institutional Risk Analyst said we should be wary of a false narrative that pins all blame on miscreant banks. “The Fed’s excessive open market intervention from 2019 through 2022 was the primary cause of the failure of First Republic as well as Silicon Valley Bank,” he said.

Mr Whalen said US banks and bond investors (ie pension funds and insurance companies) are “holding the bag” on $US5 trillion of implicit losses left by the final blow-off phase of the Fed’s QE experiment.

“Since US banks only have about $US2 trillion in tangible equity capital, we have a problem,” he said.

He predicts that the banking crisis will keep moving up the food chain from the original outliers to mainstream banks until the Fed backs off and slashes rates by 100 basis points.

The Fed has no intention of backing off. [It raised rates further this week to the highest level in 16 years, and chair Jerome Powell warned not to expect any rate cuts this year]. It continues to shrink the US money supply at a record pace, with $US9 billion of quantitative tightening each month.

The horrible truth is that the world’s superpower central bank has made such a mess of affairs that it has to pick between two poisons: either it capitulates on inflation, or it lets a banking crisis reach systemic proportions. It has chosen a banking crisis.

 

The rise in the US discount rate from 1% in 2004 to 5.3% in 2006
led to the GFC.  The rise this cycle has been even larger.

A debt crunch is looming

 From Bloomberg

Just when it seemed the US regional banking strains were starting to ease, First Republic Bank has leaped back into headlines, reigniting concerns of rising pain in the lending system.

Banks increased emergency borrowing from the Federal Reserve for the second week in a row in a sign of the ongoing stress in the system. Last week, the New York Fed reported that financial conditions in its region had deteriorated sharply.

The trouble is rekindling concern that a credit crunch is underway. And it further complicates the plan for next week’s Fed policy meeting, where officials have to figure out how to balance the risks of tighter borrowing conditions against stubbornly high inflation.

Below are six charts that help explain why and how borrowing is getting harder in vast parts of the economy:

Lending Contraction

“Lending from U.S. banks is poised to contract over the next few quarters,” Amanda Lynam, head of macro credit research at BlackRock Financial Management wrote in a note on Thursday. Headwinds to profitability including higher deposit costs have seen bank spreads underperform relative to non-financials, she wrote.

Money Supply

The blow to credit availability comes as the money supply shrinks, a sign that the spike in interest rates by the Fed is causing money to exit the banking system, shrinking the availability of loans. That could slow the economy, with monetarist economists suggesting it could herald a crash and deflation.The Dallas Fed and the San Francisco Fed last week reported pressure on funding in their geographic regions, with projects being canceled and nonperforming loans expected to increase.

[See my piece about money supply, here]

Consumer Headwinds

Banks that posted quarterly results this month said they boosted provisions on bad consumer loans to levels not seen since the early days of the pandemic. For example, Capital One Financial Corp. increased its provision for credit card losses by more than 300% to $2.26 billion compared with a year earlier. The firms have generally said the rising provisions are just consumers returning to pre-pandemic norms.

Office Woes

Capital One also set aside more money to cover souring office loans, as vacancies rise and many workers choose to work from home. Morgan Stanley has previously estimated that office property valuations could fall as much as 40% from peak to trough, increasing the risk of defaults.

Another emerging source of stress in credit is the leveraged loan market as corporate borrowers with floating-rate debt struggle to keep pace with higher borrowing costs.

Higher Defaults

The amount of loans trading at distressed prices, defined as below 80% of face value, has jumped 26% to about $127 billion since the end of February, according to data compiled by Bloomberg. That compares with a 10% increase for bonds to about $488 billion.

“We believe the loan market, which has historically had a lower default rate than the high yield bond market, will record a higher rate during this cycle,” Armen Panossian and Danielle Poli, managing directors at Oaktree Capital Management LP, wrote in a memo last week. “This is due to the covenant-lite nature of most loans and the rising prevalence of loan-only capital structures.”

Credit Chatter

Company executives worldwide, meanwhile, are talking about credit on conference calls at the highest rate since the pandemic hit, according to data compiled by Bloomberg News. Some mentions include Evercore Inc.’s Chief Executive Officer John Weinberg noting an increase in restructuring and liability management business and Peabody Energy Corp. investor relations vice president Karla Kimrey saying the company has positioned itself to avoid uncertain credit markets.

Tightening credit confirms likelihood of US recession

 Credit is the lifeblood of economic activity.  But it normally takes a while to affect the economy.

In the US economy, banks have been tightening credit for months now.  Inevitably, that affects economic activity.  And there is no sign that banks have started t loosen credit.  The economy might have a little bump, but tightening credit will inevitably lead to recession. Especially if it continues to tighten.

 

Credit tightening points to 2023 recession

Here is an independent survey by the Fed of lending practices by US banks.  (Technically, "Net Percentage of Domestic Banks Tightening Standards for Commercial and Industrial Loans to Large and Middle-Market Firms", shortened in my data banks to "USCREDTIGHT".)

When credit standards are tightening, it tends to precede a recession, when they are improving, vice versa.  So in the chart below, tightening credit is plotted with a 3 quarter lag (the data are quarterly), and inverted, i.e., when credit is tightening, its line in the chart (cyan) is falling.

I don't use this series in my indicators because it is quarterly, rather than monthly, but it provides useful corroboration for my own leading indices (for which I will provide an update tomorrow, since it is quite late now here in Eastern Oz now).

(Note how the relationship goes out of phase, briefly, during the Covid Crash)

Credit tightening plotted with a 3 qtr lag