We've Been Looking for Credit Excesses in All the Wrong Places
Don't look at banks or the bond market to get a sense of when the credit cycle is turning or how bad the ensuing bust will be, according to UBS AG.
"There has been a significant and, in our view, structural contraction in supply for all borrowers aside from U.S. high grade entities," wrote Strategist Matthew Mish, pointing to the declines in gross issuance in Europe, emerging markets, and U.S. high yield corporate debt.
But whereas the end of the commodities supercycle has raised questions about banks' exposure to and underwriting standards in a specific segment—as well as whether indebted shale producers will be able to continue to tap the bond market for financing—Mish is worried about credit quality at non-bank lenders more broadly.
The combination of abundant liquidity and stricter regulation of banks following the financial crisis laid the groundwork for non-bank lenders, such as insurers and online platforms, to make gains in market share.
And they've done just that:
Since nearly two-thirds of lending to the private sector (ex-financial) isn't facilitated by banks, "This implies, similar to the last cycle, the tea leaves or canaries in the coalmine are more likely to appear in non-bank lending."
According to Mish, the headline figures belie the excesses that have cropped up amid a time of expanding credit.
These non-bank institutions tend to originate loans to households in riskier segments like auto or student debt, he said, and their share of Federal Housing Administration-insured mortgage loans has spiked to 70 percent from 30 percent in 2013.
If non-banks are gaining market share so rapidly, it stands to reason that their underwriting standards are looser than at banks, Mish theorizes.
The Office of the Comptroller of the Currency's (OCC) 2015 Survey of Credit Underwriting Practices suggests that underwriting standards "eased at a significant number of banks for the three-year period from mid-2013 to mid-2015, broadly similar to that experienced from 2005 to 2007 before the financial crisis."
"If underwriting standards overall were this loose at banks, one could reasonably conclude lending conditions became dangerously easy at non-banks," concludes Mish. "We believe this presents growing downside risks to growth when the non-bank credit cycle fully turns from boom to bust."
But questions linger, including:
- How broad and how loose has access to credit been—that is, is this a systemic issue?
- Are the financial products tied to these riskier segments of loans obviously mispriced?
The first query is likely something we won't have a decent handle on until the tide goes back out; on the second front, the answer appears to be no. While some hedge funds, for instance, want to bet against subprime auto loans as the next "Big Short," an analysis performed by New River Investments' Guillermo Roditi Dominguez suggests "the math just isn't there for that amazing trade."
But even if there may be no easy money to be made betting against specific products, it's undeniable that a broad-based restriction of credit would have adverse effects for financial markets and the real economy.
Banks might not be the first victims of any inflection point in credit nor the prime contributors to the excesses that developed, but Mish warns that they won't be immune from any softness that starts in the non-bank space. This is particularly concerning because the linkages between bank and non-bank lenders are currently not well understood.
"While the banks are in a better position than they were last cycle to withstand a downturn, we think more work needs to be done to understand the interconnectedness between banks and non-banks before the next downturn," the strategist writes.
That's because these non-bank lenders aren't just providing access—they've also been rapidly levering up themselves.
"Since 2013 loans to non-bank financial entities have increased more than 217 percent and are now the fourth largest commercial category (compared with the 11th three years prior)," he writes, drawing on data from the Office of the Comptroller of the Currency.
"These would include loans to REIT [real estate investment trusts] and mortgage originators, warehousers or servicers, holding companies of other banks, insurers, finance companies, federally sponsored lending agencies and loans to investment banks," he adds.