Credit is tightening

If credit is tightened, this ultimately leads to an economic downturn.  The chart below shows whether large and medium-sized banks are tightening lending.  Because when credit is tightened, the economy slows, and vice versa, it is plotted inversely, and because it only affects the economy with a lag, it has been plotted with a nine-month lag.  So, the rise in the number of banks tightening credit since Q3 last year will be reflected in a fall in economic activity in Q3 this year, and has been plotted accordingly.  The economy should start to decline from next month, and this should start showing up in more than just shorter-leading indicators like the ISM and PMI and regional Fed surveys, such as employment, GDP, retail sales, etc.

Note how an external (exogenous) event, the Covid pandemic, affected the lags.  

I don't use the credit tightening indicator in my US leading index, because it is quarterly, so it is an additional independent pointer towards an imminent recession.

Five factors pointing towards US recession

Money Supply

M1 is falling almost as fast as it during the Great Depression

The Yield Curve

The last time the yield curve (the gap between the 10-year bond yield and the "cash rate"/Fed Funds rate) was this negative was before the deep 1974 recession and the deep and long 1980-1983 recession.

The Fed Funds rate

The Fed Funds rate has risen as much as it did during the '74 and '80-'83 recessions.

Credit tightening

Banks' willingness to lend is collapsing, and banks are tightening credit standards.  This is not yet at levels seen in the GFC, but the data are quarterly, so we don't know what's happened in the most recent three months.

Commodity Prices

I wrote the piece I linked to above a year ago.  

The lag between a sharp rise in commodity prices and the subsequent economic downturn is quite long --- 24 months, though it has been as short as 12 months.  

All 5 Factors

If we combine all these indicators into one index, we get the chart below.  As an "average" of five indicators, it isn't as severe as some of its components.  On the other hand, it has not yet bottomed.

What seems clear enough is that there is likely to be a US recession.  How long and how deep it gets depends on whether there is a banking crisis, whether the Fed raises rates further, and whether the post-Covid rebound in services continues.  I'll keep you posted.

Note that where the 5 factor index appears to coincide with recessions, 
that's because it has been plotted with a 12-month lag.

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.