I started this post six days ago. But, I couldn’t get it sorted because of the holiday and my need to start the blog site up again. That blog site thing and some maintenance issues at home were a real time suck. So let me give you an abbreviated version of what I initially intended to write on Wednesday last week – this time with some hindsight.
This is a follow on from the post I wrote last Friday.
The near term picture is still bright
I was talking about how holiday sales would hold up on Friday. And from what I have seen, both Black Friday and Cyber Monday have gone pretty well. We still have to wait for the final numbers to come in. But, there’s no reason to think that sales fell off a cliff and that consumption growth is slowing dramatically.
The near-term picture is bright. But there is a fade to all of this. The layoffs at GM on Monday are the big signal that we are in a different part of the cycle. I told you on Friday that auto sales were the first chink in the armor for the end of the credit cycle. And now we’re seeing that translate into job losses via GM’s cuts.
Subprime is down
I caught a piece at Wolf Street on subprime that I thought was pretty good on how this credit cycle is starting to turn. It points to a swelling Q3 delinquency rate on credit cards at commercial banks outside of the top 100 in the US. That’s the next 4,705 small and medium-sized banks.
There, credit card delinquencies spiked to 6.2% in Q3. That’s higher than during the financial crisis, when the delinquency high for subprime hit 5.9%. Now, the scale is what matters here. It’s not going to cripple the banking industry by a long shot. But it’s the deterioration and what it means about consumer health that matters. Just as it does with autos. Right now, the charge-off rate of 7.4% has been above 7% level for five quarters on the trot. That’s longer than during the financial crisis (though not yet as high, because it peaked at 8.9% then).
Note the dichotomy here. Credit card delinquencies at the top 100 banks are just 2.48%. Wolf Street says it’s because smaller banks have less creditworthy customers i.e. more subprime. But the momentum to the rising delinquencies suggests that subprime consumers’ finances are foundering despite low unemployment and an expanding economy.”
Housing disappoints
Three data points here, very quickly
First, home builders’ stocks are getting creamed. See MarketWatch and the FT. The data there have been poor: month after month of flagging new home sales. I’ve talked about this before. So let’s move to point number two, the general market.
Ooops. US housing & real estate data have never disappointed this much before… (on data since January 2000) $USD pic.twitter.com/js3gaEjOTv
— Martin Enlund 🦆🚁 (@enlundm)
That’s downward momentum on the market as a whole.
And then point three: Home appraisals
Inflated home appraisals are fueling losses at the Federal Housing Administration, which said this week that it expects a $14.4 billion drain from its mortgage insurance fund in coming years.
The shortfall stems from the FHA’s portfolio of reverse-mortgage insurance, but the agency’s chief, Brian Montgomery, says he fears inflated appraisals may also be lurking in its much-larger portfolio of traditional mortgage insurance.
Sounds like there’s some fraud there. Just as during the housing bubble, we’re seeing fraud.
But remember: No boom no bust in US housing is the mantra for most. That means we can talk about boomlets but nothing like the mania over a decade ago. So, as with autos and subprime, these are smaller but still worrying deteriorating credit cycle signals.
Subprime, Housing are not the problem. Leveraged lending is.
And we’re not looking at Cassandras here. This comes straight from the establishment: the IMF. Look at what they’re saying:
We warned in the most recent
Global Financial Stability Report
that speculative excesses in some financial markets may be approaching a threatening level.
For evidence, look no further than the $1.3 trillion global market for so-called leverage loans, which has some analysts and academics sounding the alarm on a dangerous deterioration in lending standards. They have a point.
This growing segment of the financial world involves loans, usually arranged by a syndicate of banks, to companies that are heavily indebted or have weak credit ratings. These loans are called “leveraged” because the ratio of the borrower’s debt to assets or earnings significantly exceeds industry norms. Here’s the chart of the excess.
And note it’s not just the leverage but the likely recovery rates for investors because of covenant lite deals:
At this late stage of the credit cycle, with signs reminiscent of past episodes of excess, it’s vital to ask: How vulnerable is the leveraged-loan market to a sudden shift in investor risk appetite? If this market froze, what would be the economic impact? In a worst-cast scenario, could a breakdown threaten financial stability?
It is not only the sheer volume of debt that is causing concern. Underwriting standards and credit quality have deteriorated. In the United States, the most highly indebted speculative grade firms now account for a larger share of new issuance than before the crisis. New deals also include fewer investor protections, known as covenants, and lower loss-absorption capacity. This year, so-called covenant-lite loans account for up 80 percent of new loans arranged for nonbank lenders (so-called “institutional investors”), up from about 30 percent in 2007. Not only the number, but also the quality of covenants has deteriorated. And look at the chart.
Credit spreads are finally going up
It’s notable, then, that, in a world of recently decreasing Treasury yields, credit spreads are widening. That speaks again to end of credit cycle dynamics (or as in 2014, hopefully a mid-cycle pause, though I doubt it this time).
Here’s the Wall Street Journal from just over a week ago:
Signs of stress are mounting in the corporate-bond market, where rising interest rates and lackluster demand for new debt have investors questioning whether a long run of favorable
for U.S. companies is ending or merely hitting a rough patch.
The amount of extra yield, or spread, that investors demand to hold investment-grade U.S. corporate bonds instead of benchmark U.S. Treasurys in recent days reached its highest level in nearly two years, while spreads on junk-rated bonds hit a 19-month high.
The widening gap comes despite a relative dearth of new bond sales from U.S. companies, a sign that investors’ demand has slowed faster than supply. When businesses have sold debt recently, they have often struggled to attract much interest, giving investors more say over interest rates and other key terms.
One source of stress has come from a sharp drop in oil prices, which exert an especially strong influence on junk bonds because of the large amount of debt issued by speculative-grade energy companies. There have also been company-specific problems that have happened to befall particularly large debt issuers, such as General Electric Co. and PG&E Corp. And to make plain what they’re saying aout high yield, see here:
High yield spreads are finally playing catch up with the rest of credit land pic.twitter.com/KAmqXrXLJx
— The Long View ⚫️ (@HayekAndKeynes)
This was one in a series of tweets. Take a look at the spreads on the charts and you can see that the numbers are moving higher across markets.
My take
This was all evidence I collected a week ago before the Thanksgiving holiday of what has become a turning point in this credit cycle.
Again, I am willing to entertain the notion that this is just another mid-cycle pause because the Fed can engineer a soft landing. But previous history suggests that’s an unlikely outcome. Instead, we should be prepared for these numbers to get worse and to feed back negatively into a deteriorating real economy.
In my view, it’s still early days here. But there’s a wider and wider cross section of credit stress now visible. With the Fed still raising rates, this will likely get worse. For now, the real economy is looking pretty good. But, we will just have to take it month to month because I think we are going to see a slowdown.
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