One of the biggest quandaries of this cycle for the US economy has been the amount and growth of commercial bank loans. Virtually non-existent for the first three years of the centrally-planned new normal, something changed in 2012 at which point US bank loans, led by Commercial and Industrial or C&I lending growing at a double-digit pop, started to rise at an impressive pace, asking many to wonder: maybe the biggest driver for a sustainable economic recovery is in fact present, because where there is loan demand, there is velocity of money.
A few years later, as the loan growth persisted with virtually no flow through to GDP growth, we - and others - wondered: we know there is a "source of funds", but what about the "use of funds" - how can banks be creating tens of billions in loans if virtually nothing was ending up in the broader economy?
The first flashing red flag appeared last July, when we reported that companies were using secured bank debt to repurchase stock: a stunning, foolhardy development, comparable to taking out a mortgage on one's house and using the proceeds to buy deep out of the money calls on the S&P 500. This is what the FT said at the time:
For the top 25 US commercial banks by assets, C & I lending grew by 10.5 per cent in the quarter to June 25 from the previous quarter, according to annualised weekly data from the Federal Reserve.
This type of lending is an important source of business for the largest US banks, representing about a fifth of all loans made by the likes of Bank of America, JPMorgan Chase and Wells Fargo, according to Citigroup research. While low interest rates have made business lending less lucrative, the relationships it forges open doors for the banks to sell other services such as treasury management, hedging and leasing.
A second corporate banking executive at a large regional lender said: “The larger part of the usage in the market right now are loan refinancings where companies are paying dividends back out.” He added: "They’re requesting increased loans or usage under a lien in order to pay a dividend or equity holders of a company. Traditionally banks have been very cautious of that."
After scratching our heads for a few weeks afterward, we let the subject go: after all there is no way banks would be lending companies secured loans to use the proceeds to cash out existing stakeholders, in the process asset-stripping the corporation. This would mean that the loan officers at these banks are either criminally stupid, or corrupt and have been bribed by the borrower to close their eyes when signing the dotted line and wiring the funds.
But then, in mid-October it all came back with a bang when CLSA's Chris Wood spotted something very dramatic when looking at the several most recent loan officer surveys:
... American banks, in terms of the quite impressive pickup seen in commercial and industrial (C&I) loan growth (see Figure 10), have been financing financial engineering, be it M&A or share buybacks, not capex. Thus, C&I loans rose by 10.7% YoY in September. Yet in the Fed’s July Senior Loan Officer Survey, 26% and 18% respectively of US banks reporting stronger C&I loan demand stated that the ‘very important’ reason for stronger loan demand over the past three months were financing needs for M&A and debt refinancing, compared with only 6% for capital investment (see Figure 11). Meanwhile, the lack of healthy creative destruction associated with zero rates has long been associated with the Japanese experience of so-called zombie borrowers.
With this data in hand, the circle was almost closed, however one major question remained unanswered: how are banks so eager to lend out billions not for asset-backed growth projects but for the worst possible form of financial engineering: uncollateralized cashing out of existing investors, either through prefunding buybacks, or M&A? In other words, banks were the de facto sponsors of management teams and shareholders.
And more importantly, now with the credit cycle rolling over and the default cycle about to see a spike higher, when would banks wake up to the huge threat that their loans would end up being wiped out as a result of funding such terrible investments as the Bed Bath and Beyond stock buybacks, which as we showed recently, has resulted in a -27% return over the past 5 years.
Now we have the final answer, because according to the latest "Survey of Terms of Business Lending", the banks have finally woken up to the risk their billions in C&I loans issued to fund "financial engineering" are exposed to.
The reaction: an unprecedented surge in loan collateralization demands - as the chart below shows, the percent of total loans secured by collateral has soared by nearly 50% in the past quarter to a record 55.9% from 37.9%, the highest ever, surpassing even the loan collateralization demands hit after the financial crisis, which peaked at 52.3%.
Where does this sudden demand for collateral come from? While one can see a surge in collateral requirements across virtually every product, particularly at large domestic banks, where this ratio soared from 39.2% to 64.4% (small domestic banks have traditionally been prudent and here the collateralization ratio rose only from 86.6% to 88.9%), where the sudden risk appreciation was most obvious, was in "Commercial and industrial loans made under participation or syndication." Here, the ratio of collateralization of C&I loans made by large domestic banks has tripled from 23.8% to 74.9%, leading to an almost as dramatic jump across all domestic banks, where it soared from 26.5% to 75.7%.
What is the explanation? Since syndication involves bank balance sheet risk, and since loan funds have been recently slammed with near record outflows...
... leading to a historic plunge in the price of the leveraged loan index as all of a sudden nobody wants any loan exposure and is selling anything that is not nailed down ...
... suddenly banks don't want any risk from residual loan exposure which they can't sell to downstream investors, and as a result are demanding companies pledge assets and otherwise collateralize whatever loans they issue (via bank syndication), just in case...
Said simply, the credit crunch is back.
And the kicker: all this took place when ZIRP was still around. Now that both LIBOR and Prime have jumped following the Fed's rate hike, and now that financial conditions are far tighter than they were even back in October, expect collateralization demands to approach 100%, as a result of which C&A loan issuance will fall off a cliff as corporations, delighted to issue loans when collateral demands were at 25%, suddenly realize they have an all too real risk of seeing their assets "repoed" if and when the cash flow to satisfy interest payments suddenly dries up.