Several weeks ago, Janet Yellen boldly declared “I don’t believe we will see another crisis in our lifetime.” For the rest of us who live in reality there is little doubt that the latest Fed-fueled credit bubble will eventually burst in epic fashion and once again lay waste to the personal balance sheets of millions of Americans. And while the timing of market collapses can never be predicted, UBS strategist Matthew Mish says there is one thing that is certain about the next credit unwind, it will be unlike anything we’ve seen before.
To summarize, Mish notes that unlike previous credit expansion cycles, this current one has been dominated not by traditional banks but rather by non-bank lending entities and government backed loans, especially in riskier subprime residential, auto and student loans. Moreover, unlike traditional lenders, Government debt tends to be much slower to react to things like rising delinquency rates…you know, because it’s just taxpayer money so who cares.
First, non-bank lending (as a share of net loan growth) has accounted for about two thirds of the total expansion, akin to prior cycles. However, the non-bank share has been elevated in residential real estate (at 101%), but depressed in commercial real estate (30%) versus history. Second, the role of federal credit support has been very material, with a significant 45% of net loan growth this cycle coming from government (or government guaranteed) loans. In particular, government backed loans (as a share of the debt stock) now comprise a record 63% of residential and 29% of consumer loans, respectively, up 9% and 18% from 2010. In nominal terms, non-government related net debt growth has been negative for retail loans in aggregate. Third, while the share of non-bank lending has held steady, their share of higher risk debt has increased substantially across many loan categories. Non-banks account for 58% of outstanding adversely rated (leveraged loan) commitments, roughly 75% of recently originated FHA mortgage loans, and over 85% of subprime student and auto loans.
With some exceptions (think auto and student loans), Mish notes that overall non-financial debt growth has roughly mirrored past credit cycles.
First, while US private non-financial debt growth has been weak in nominal terms vs. historical standards, debt expansion relative to economic growth has been more normal – akin to the 1990s. Anything materially better, absent stronger growth, would look more like the last cycle. In particular, the rate of corporate and consumer debt growth has exceeded that of US nominal GDP, consistent with our prior work highlighting the elevated leverage across corporations and millennial consumers.
That said, non-bank and government backed loans have taken on a much more substantial share of ‘riskier’ loan pools like residential and consumer debt.
Second, there has been a material increase in federal credit support to the private sector, particularly in student and residential lending. Government debt pricing tends to be non-risk based, slower to react, and subject to political (vs. economic) interests. Investors should monitor changes in credit policy closely, but expect changes in loan standards to lag delinquencies as it will likely take material losses to trigger changes in federal support. And third, ceteris paribus the better early warning signals this cycle will be those indicators that can calibrate shifts in non-bank lending standards (which will pick up higher risk loans) and in credit markets with limited government intervention (where lenders will respond to changes in risk). In our view, these include indicators like our non-bank liquidity index, high-yield credit spreads, and auto and credit card loan performance.
So what signs should you be on the look out for?
And third, ceteris paribus the better early warning signals this cycle will be those indicators that can calibrate shifts in non-bank lending standards (which will pick up higher risk loans) and in credit markets with limited government intervention (where lenders will respond to changes in risk). In our view, these include indicators like our non-bank liquidity index, high-yield credit spreads, and auto and credit card loan performance.
In summary, the next collapse in credit may come a little slower, since governments are far better than traditional lenders at burying their heads in the sand, but you shouldn’t be too quick to buy into Yellen’s delusions that “there will never be another crisis in our lifetime.”
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