Three months ago the Fed released its Fourth Quarter "Senior Loan Officer Opinion Survey on Bank Lending Practices", which revealed something ominous. It showed that in Q4, lending standards tightened for the second consecutive quarter. This was a problem because as Deutsche Bank pointed out at the time two consecutive quarters of tightening Commercial & Industrial loan standards "has never happened before without it signalling an eventual move into recession and a notable default cycle. Once we have 2 such quarters lending standards don't net loosen again until the start of the next cycle."
As of today, we now have three consecutive quarters of tightening lending standards. In fact, based on the latest survey, net lending standards tightened even more than during Q4 as shown in the chart below, and are now the tightest on net since the financial crisis. Needless to say, if a recession and a default cycle has always followed two quarters of tighter lending conditions, three quarters does not make it better.
This is what the Fed said:
On balance, a moderate net fraction of banks reported a tightening of lending standards for C&I loans to large and middle-market firms over the past three months. Meanwhile, only a modest net fraction of banks reported tightening lending standards for C&I loans to small firms. Banks reported that they tightened some C&I loan terms for large and middle-market firms: A moderate net fraction of banks reported that they had increased premiums charged on riskier loans, a modest net fraction of banks reported that loan covenants had tightened, and most other terms to such firms remained basically unchanged on net. Banks reported mixed responses regarding changes in loan terms for small firms. A majority of the domestic respondents that tightened either standards or terms on C&I loans over the past three months cited a less favorable or more uncertain economic outlook as well as a worsening of industry-specific problems affecting borrowers as important reasons. Meanwhile, a significant net fraction of foreign respondents reported a tightening of lending standards for C&I loans.
In other words, credit availability is bad and getting worse, and may explain why the ECB had no choice but to shock the credit pipeline into action when Draghi announced that the ECB would monetize corporate bonds (and soon enough, junk bonds).
And while our focus looking at this data is on the implied probability (based on historical precedented, now at 100%) of a recession, Bank of America's high yield strategist Michael Contopoulos is looking at the implications of continued lending tightness on the credit market, where he has been uncharacteristically gloomy for many moths. This is what he said:
Banks tightening their grip on lending
Today's Senior Loan Officer Opinion Survey on Bank Lending Practices confirmed several of our concerns from last year; that in the face of deteriorating corporate fundamentals, a weak economic outlook, industry specific woes in the commodity space and global markets that have been volatile, banks would pull back the reins on lending. Below we highlight some of the details of the report that we think are relevant when considering the durability of the post February 11th high yield rally.
- The two best predictors of the US default rate are C&I lending and the proportion of downgrades to upgrades within high yield. With both deteriorating over the last several quarters our model now suggests a default rate over the next 12 months of 5.4%. We note, however, that the model this time last year forecast a 2.7% default rate yet with the high degree of Energy defaults, we have actually realized a 5.3% rate as of April 30th. It stands to reason, then, that our model, usually highly accurate in its calculation, could be understating the actual default rate over the next 12 months. We think there is upside to our forecast of 5-6% this year, and caution investors that non-commodity defaults are also likely to rise absent a complete opening of capital markets.
- The survey noted that banks tightened their lending standards on C&I and commercial real estate loans while enforcing material adverse changes clauses or other covenants to limit draws on existing Energy credit lines. Late last year and earlier this year we wrote that one of our fears was that regional banks in areas hit hard by the energy rout would be less willing to lend than before the collapse in oil. Our theory has been that as banks set aside reserves for their Energy exposure, they will tighten lending standards in other areas. Sure enough, the survey noted that "on balance, banks indicated a spillover from the energy sector onto credit quality of loans made to businesses and households located in energy-sector-dependent regions." As these areas of the US experience further hardship, we expect the quality of borrower to deteriorate and lending standards further tighten in these regions. This likely means the one area of lending strength, the consumer, could begin to realize tightening later in the year.
- Demand also waned for C&I loans, as large and middle market firms in particular noted decreased investment in PPE and a decline in financing needs for M&A, accounts receivable and inventories. In our mind, a lack of demand could prove to be indicative of an economy that has not only stalled, but one in which corporate CEOs and CFOs lack confidence in. Additionally, with little capex to cut, deteriorating assets, a labor market that is both tight and unproductive, and a bank lending environment that is becoming harder to leverage, we wonder how long it will be before corporates begin to cut headcount.
The survey noted that a "majority of the domestic respondents that tightened either standards or terms on C&I loans over the past three months cited a less favorable or more uncertain economic outlook as well as a worsening of industry-specific problems affecting borrowers" as the reason for tightening. As we read this statement, our first thought is that the problems are not just an Energy story any longer.
What all of the above means is simple: either lending standards will ease or the Fed will have no choice but to do what the ECB has done, and jam the credit channel open by actively backstopping bond - and loan - issuance. Either that, or the central banks will have to engage in more coordinated commodity manipulation attempts, since at the very core of the deteriorating lending standards is the collapse in the oil price which in turn has forced banks to collapse revolver availability and halt future issuance until they have some visibility on where the price of oil stabilizes. Perhaps instead of monetizing loans, Yellen will covertly greenlight whoever is the global activist central bank du jour, with a mission to monetize enough oil to push it another $10-20 higher. At that point we will eagerly look forward to Saudi Arabia's response as crude above $50 will mean virtually the entire shale patch is back online.
On the other hand, if just like the BOJ last week the Fed does nothing , we have little reason to doubt the historical precedent in which case the countdown to the next recession can officially begin.