Whalen - Macro-Prudential Delusions: Bank Credit Outlook 2H 2017

by R. CHristopher Whalen
The Institutional Risk Analyst
May 29, 2017

In the mid 2000s, just before the financial crisis began, US banks were reporting credit metrics for all asset classes in loan portfolios that were quite literally too good to be true.  And they were.  The cost of bad credit decisions was hidden, for a time, by rising asset prices.

The same aggressive, low-rate environment used by the Fed to artificially stoke growth in the early 2000s has been repeated in the aftermath of the 2008 crisis, only to a greater extreme.  Today US banks report credit metrics in many loan categories that are not merely too good, but are entirely anomalous.  Negative default rates, for example, are a red flag.

A decade ago, the more aggressive lenders such as Wachovia, Countrywide and Washington Mutual were actually reporting negative net default rates, suggesting that extending credit had no cost – in large part because the value of the collateral behind the loans was rising in value. In those heady days of comfortable collective delusions, non-current rates for 1-4 family loans were below 1%, the lowest levels of delinquency since the early 1990s.

This situation changed rather dramatically by 2007, when several large west-coast non-bank mortgage lenders collapsed.  By the start of 2008, funding for banks, non-banks and even the GSEs was drying up and default rates were rising rapidly.  The cost of credit reappeared. Net-charge off rates for 1-4 family loans in particular went from 0.06% early in 2005 to 1.5% by the end of 2008 and peaked at 2.5% by the end of 2009.   

Today the irrational exuberance of the Federal Open Market Committee has created huge asset price bubbles in sectors such as residential and commercial real estate.  A combination of low rates, a dearth of home builders (down 40% from ~ 550k firms in 2008 to ~ 330k firms today) and even less construction & development (C&D) lending (down ~ 30-40%) has constrained the supply of homes.  But low rates sent prices for existing homes soaring multiples of annual GDP growth – both for single-family and multifamily properties.

Keep in mind that the folks on the Federal Reserve Board think that asset price inflation is helpful – thus the “wealth effect.”  Specifically, the FOMC believes that manipulating risk preferences, credit spreads and therefore asset prices helps the economy to generate more income and employment. Many analysts have debunked the notion of a “wealth effect,” but the FOMC persists in this thinking even today.  Mohamed E-Erian writing in Bloomberg has it right:

“Forced to use the 'asset channel' as the main vehicle for pursuing its macroeconomic growth and inflation objectives – that is, boosting asset prices to make consumers feel wealthier and spend more, and also to increase corporate investments by fueling animal spirits – the Fed has ended up providing exceptional multiyear support to financial markets using an experimental array of unconventional tools and forward policy guidance. Indeed, most investors and traders are now conditioned to expect soothing words from central bankers – and, if needed, policy actions – the minute markets hit a rough patch, virtually regardless of the reason.”

In an economic sense, the Federal Open Market Committee is the heart of the Administrative State. The use of the “asset channel” to pretend to boost economic activity is part of the larger delusion at the Fed known as “macro-prudential” policy.  The macro-prudential worldview sees the Fed as an all knowing, all-seeing global managerial agency that can somehow balance goosing economic growth using asset bubbles with preventing the associated systemic risks. Note that regulating whole industries and constraining growth is, in fact, a key part of the Fed’s macropru model.

Having maintained low interest rates and used trillions of dollars of bank reserves to fund open market purchases of Treasury bonds and agency mortgage paper, the FOMC now faces an asset market that has understated the cost of credit for over a decade.  From 2001 through 2007, and then 2009 through today, the FOMC has boosted asset prices – but without a commensurate and necessary increase in income.  The Fed has, to paraphrase El-Erian, decoupled prices from fundamentals and distorted asset allocation in markets and the economy.

SO the question that concerns The IRA is when will the credit cycle turn and how much of the apparently benign credit picture we see today is a function of the Fed’s social engineering?  If this latest round of Fed “ease” is more radical than that seen in the early 2000s, will we see an even sharper uptick in bank loan loss rates than we saw in 2007-2009?

So how does this all end?  In the short term, look for default rates on consumer exposures to continue rising.  But in asset classes like commercial real estate, residential homes and C&D lending, we suspect that the party may continue, at least in statistical terms, through at least the end of the year.


After that, however, we full expect to see loss rates and LGDs start to snap back to the middle of the proverbial distribution. As one well-placed bank CEO told The IRA over breakfast, “there are lots of sweaty palms” in the New York commercial real estate market.  Read this little missive in The New York Times about the Park Lane Hotel to get a sense of the level of exuberance in the commercial real estate market in Gotham.

Without a rather robust confirmation of asset prices with rising incomes, as El_Erian and many others have observed, current levels of assets prices are unlikely to be maintained.  In the event, look for bank default and recovery rates to normalize, with a sharp increase in credit costs for lenders and bond investors alike.

Trees do not grow to the sky, credit costs are never really negative, and last we looked, Fed chairs cannot fly through the air or spin straw into gold.  But they can manipulate asset prices and cause other mischief that, we suspect, represents a net cost to consumers and investors alike.  But this is hardly a novel state of affairs.

In that regard, we appreciate your comments about our earlier missive, “Buy Britain, Sell Europe.” Many of you challenged our idea that Britain is an enduring nation state, while the EU is merely a bad idea whose sell by date has passed.  

To address these comments, we refer to one of our favorite reads of late, “Playing Catch Up,” by Wolfgang Streeck. The emeritus director of the Max Planck Institute for the Study of Societies in Cologne, Streeck writes regularly for the London Review of Books. He is ready to suspend democratic processes to support “willing governments” that advance German-style reforms, but Streeck has a cogent view of the European political economy:

“Here, as so often in her long career, Merkel is anything but dogmatic, and certainly isn’t beholden to ordoliberal orthodoxy since what is at stake is Germany’s most precious historical achievement, secure access to foreign markets at a low and stable exchange rate.  For several years now, Berlin has allowed the European Central Bank under Draghi and the European Commission under Juncker to invent ever new ways of circumventing the Maastricht treaties, from financing government deficits to subsidising ailing banks. None of this has done anything to resolve the fundamental structural problems of the Eurozone. What it has done is what it was intended to do: buy time, from election to election, for European governments to carry out neoliberal reforms, and for Germany to enjoy yet another year of prosperity.”

Sound familiar?  In the US as well as Europe, what passes for fiscal and monetary policy are merely a series of short-term expedients meant to get us from one day to the next.  The nonsense of macro-prudential policy represents the apex of such thinking.  As we look out to credit conditions in the US banking sector in 2H 2017 and beyond, the one sure bet is that the cost of credit will not remain suppressed forever.