As the Fed Tightens, Where Will the Credit Crunch Pinch First?

Josh Rosner of Graham Fisher has graciously allowed us to republish their latest report on the outlook for banks and credit. Rosner was the first to warn of the dangers of allowing widespread mortgage lending with low down payments in his 2001 article: A Home Without Equity is Just a Rental With Debt. Rosner was the co-author with Gretchen Morgenson of Reckless Endangerment and describes himself as a “recovering GSE analyst.” From his analysis; the full document is embedded at the end of this post:

This report is the first in an ongoing series in anticipation of the likely recession of Q3 2019

History Sucks

Memories are short and recent lessons are quickly unlearned. Market participants have so quickly forgotten that the financial crisis did not descend upon us out of nowhere. It was the result of seven-years of artificially low interest rates. It was the result of herding behaviors that reduced consideration of credit and liquidity risks coupled with demands, by investors, for instruments with higher yields than could be gotten on an unlevered basis. As a result, issuers benefitted from an ability to originate riskier loans and sell much of those volumes to charter constrained investors who forgot that “risk is the price you never thought you would have to pay”.

The Federal Reserve began raising rates in the third quarter of 2004 and, within 24 months banks had withdrawn liquidity to third party mortgage originators and had tightened underwriting standards. As liquidity reversed and homeowners lost their ability to refinance (on an economic basis) investors began to wake up to the withdrawal of liquidity and the risks of rising credit losses which then reinforced the negative feedback loop that claimed homeowners, investors, financial institutions and Main Street.

As investor appetite for securitized mortgage assets collapsed, and banks were neither able or willing to hold loans they once had either been able to package into MBS, or as the non-investment grade tranches of MBS packaged into CDOs, we then saw bank loan growth – long supported by mortgage origination and refinancing – collapse.

Now, ten-years later, as the Fed has begun to drain liquidity from the system, investors are ignoring structural changes in bank lending markets that have occurred during this economic expansion. If the Fed is successful in reshaping the yield-curve we will again be faced with new and expressible opportunities in many banks, private equity firms, business development corporations (BDCs) and underlying commercial credits. Assuming the Fed continues on its stated path we are approaching the prelude to one of the most significant distressed and restructuring cycles in modern history. As shown in the chart above, the lag between Federal Reserve rate hikes and their impacts on the real economy is usually 12-24 months. As a result, it is time to begin identifying the resulting current and future opportunities. We have begun to drill down into the specific exposures of the publicly traded BDCs and those banks which have been most reliant to C&I originations.

Rather than accepting utility-like returns, over the past decade, the banks sought new markets to exploit. Subprime auto loans and student lending, expense reductions and reserve release could provide some support of growth, but they would not support market expected top-line returns. But there was an asset class that could – commercial and industrial lending. On a ten-year basis, C&I has become the largest portfolio asset for the banking industry. (21.07% vs 20.73% for 1-4 family first liens)

Flight to Quality or Higher Short-Term Rates – the “E” of P/E may be at Risk

It is unfair to speak of “the banks” in monolithic terms, and we can identify specific banks that will buck the trends and prosper due to the uniqueness of their businesses. Broadly speaking, the reality is that bank loan growth is near its cyclical peak and expense cutting appears to be past its cyclical peak. As the Fed raises rates banks will continue to be forced to choose between paying more for deposits or losing those depositors – these pressures are already mounting. Cost cutting and reserve releases that helped the banks earlier in the cycle will become less accretive to earnings.

Caveat: It is worth noting that if one believes that the Fed is likely to change course out of concern for the domestic economy, or as a result of global instabilities, then the concerns stated here are premature and investors should be focused on a different set of risks to financial markets and financial institutions that were taught by the 1997 Russian Debt Crisis. As a result of the Russian Debt Crisis global capital flew to safety and flowed into the United States. The result was downward pressure on rates. This pressure had negative impacts on the gain on sale assumptions of thinly capitalized independent mortgage lenders and on bank MSRs. Given the consolidation of these businesses and changes to gain on sale accounting requirements these risks are diminished but, for a few of the largest banks, the impact on MSRs should be felt in downward revisions to earnings estimates.

GF&Co - Banks, BDCs, C&I and the Yield Curve
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  1. markodochartaigh

    Maybe every cloud has a silver lining. I’m an RN so I obviously only have a lay person’s financial opinion, but I think that the silver lining on the hurricane that is Trump and the tRümpenproletariat is that at the end of the current extremely long economic expansion the “animal spirits” pumped adrenaline into the aged expansion (the opposite of a capital strike) which has allowed the Fed to ease up interest rates further than they would have been able to otherwise. Higher interest rates will obviously give the Fed more ability to bounce the economy when it inevitably takes a downturn. It’s not much of a silver lining, kind of like roasting marshmallows over the cinders of one’s home that has been burned down by an arsonist who lives in the mansion across the swamp.

    1. tegnost

      the flaw in your argument is that no one was making bernanke or yellen keep rates low, and we are not/were not in an economic expansion, we were in a massive bail out for the same rich people who claim there’s no inflation while they raise their rents 10% a year based on the QE bubble which helped only one class of individuals and created “the hurricane that is Trump and the tRümpenproletariat”… I really don’t think, and the author seems to agree in principle because of the caveat at the end, that the wonder years of geithner/bernanke/paulson/yellen/greenspan/obama can be exited simply by raising rates now because their policies effectively weakened the greater economy and rate increases will create a giant mess which the Fed may well decide to kick down the road, until there’s no road left.

      1. markodochartaigh

        Sure, I’m not arguing that rates shouldn’t have been raised sooner or that the massive QE which went to banks to prop them up so that their owners could siphon off massive profits, prop up the stock market with stock buybacks, and reinflate the real estate market would not have been much better spent into the real economy helping the 99% to rebuild the country with a non-FIRE sector focus. I think that there has been an economic expansion, unfortunately not like the healthy growth of an economy providing for everyone but like a cancerous growth sapping the life from its host; but an economic expansion nonetheless.

    2. Harry

      I think an excellent take although I think its not much of a silver lining.

      Trump might subsequently be seen as having conned the Fed into over hiking. Seeing as how credit is seldom given where it is due, I will wait and see who has

  2. JCC

    I looked up C&I originations and from what I’ve read they have doubled since 2000 to now, $1T to $2.1T.

    I don’t see how this exposure, for either side of the transaction, could support market expected top-line returns, except very briefly. With rising interest rates wouldn’t these start to dry up? And wouldn’t the existing loans eventually be trouble for both the borrower and lender as an economy contracts?

  3. ocop

    During the GFC it was residential loans which brought down the financial system and collapsed the real-estate market, which in turn hit the “real” economy leading to widespread layoffs.

    If this time it’s the C&I market that directly implodes, do we just go from 0 to mass unemployment as increasing funding costs for junk bonds and leveraged loans directly lead to bankruptcies? Does the trigger here (residential vs. C&I) matter?

  4. Susan the other

    This was interesting. The road map to recession. It makes the banks look like victims. I believe they might be. At the mercy of “investor demand.” Haven’t really thought about demand as “investor demand.” Seems like a contradiction in terms. And Dodd-Frank intentionally left a loophole for “Business Development Corporations?” Hmmmm. Are BDCs just good old-fashioned corporate raiders? The sentence that says it all is, “Investor demand often leads banks to over-lend and throw risk to the wind.” The illogic of investor finance. It’s very Picketty. Investor demand seems like it is masquerading as demand but in reality it is supply blithely creating its own glut. …and we somehow plan to use this system to fight global warming and pollution??

  5. John DT

    Rosner is a sharp independent thinker, but his paying clients are influencing his narrative… The fortune makers who were driven by soulless greed ten years ago have exploited the unprecedented bail out to accumulate more wealth than they ever dreamed of. Nowadays, it is not only the vast majority of Americans who are exposed, nor is it ‘only’ the financial system, but also the fed, petro-dollar regime and political system that are fully exposed. Whether other major nations suffer first, or we experience pain onshore, the debt/financials/currencies/manipulations entanglement is already a given, and the repercussions will be on a global scale, if history is any indicator when dealing with unprecedented circumstances we have allowed to unravel.

    1. Harry

      I saw the hit piece on Bloomberg. I complained about the hit piece on Bloomberg. Josh and I have our differences of opinion but he has never displayed anything but the highest degrees of integrity. I would argue that his paying clients might prefer him to hype his views as much as possible but those are his views and they are usually well formed and held with a laudable degree of passion. I remember him arguing that the mortgage market was going to cause a housing collapse because of a collapse in lending standards in 2003 when we both smoked cigarettes – all the important conversations happen over fags don’t you know.

      He was early but his views were genuinely held and I think still are. Josh has always been an advocate for good governance and efficient fair markets. He believes in how the system is meant to work (its here we differ). I would also note that we are not close nor particularly friendly. If I advocate for him its not because he is a friend but because the suggestion is unfair.

      I would ask others on Naked Capitalism to feel free to write letters of support if they think the bloomberg piece is as unfair as I do. I already have.

  6. Jeremy Grimm

    I confess I could not understand the content of this report. The jargon is alien to me and many of the acronyms familiar to those in the business are difficult for me to remember or unknown to me if they are not explained in their first use. Given these limits of my understanding many questions came to me which though they may be stupid questions — I’ll ask anyway.

    The report cited C&I, commercial and industrial lending, as today’s equivalent of the residential real estate sector in the previous downturn. What is commercial and industrial lending — what does that category of lending include? How is C&I related to business development corporations (BDCs) — “key aggregators of main street risk”? Are business development corporations specialists in the high risk, low equity end of C&I? What purpose do our main street banks serve if they aren’t serving main street? What commercial and industrial investment is there? Where I live half the local businesses have closed their doors and I don’t notice much growth in local industrial activity. How much if any of the C&I is used by corporations to repurchase their own stocks?

    At the close of this report: “Add the possibilities that trade tensions remain unresolved and we have the makings of a recession in late 2019 and stagflation with a Fed that has limited tools.”

    I can see the possibilities for a recession — but stagflation? What areas of the economy are poised to continue inflating their prices in spite of a recession? — medical expenses, education, utilities, gasoline, diesel, … rents? what about assets like residential real estate? A lot of these expenses of living seem left out of the calculations for inflation and the cost of living. Does this usage of ‘stagflation’ assume a more honest calculation of inflation?

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