August 28, 2023 | For several years now going back almost a decade, we’ve pondered the net, net impact of artificially increased asset prices on the volatility of credit. This is not the volatility measured by the VIX, mind you. The Chicago Board Options Exchange's CBOE Volatility Index is a measure of the stock market's expectation of volatility based on S&P 500 index options. But this is not the volatility that worries us.
The Oxford Dictionary defines volatility as the "liability to change rapidly and unpredictably, especially for the worse." The volatility that concerns us is the after-effects of a decade of market manipulation by the Fed and other central banks, which lowered visible rates of credit default by temporarily boosting asset values. One of the more frightening revelations in this regard came in the past week from Fed Chairman Jerome Powell during the annual meeting at Jackson Hole, WY:
“As is often the case, we are navigating by the stars under cloudy skies. At upcoming meetings, we will assess our progress based on the totality of the data and the evolving outlook and risks. Based on this assessment, we will proceed carefully as we decide whether to tighten further or, instead, to hold the policy rate constant and await further data.”
The statement above by Powell about stars and clouds is scary. First, it suggests that the FOMC adjusts policy based upon the relative assessments of short-term changes in data and risk – a recipe for a repeat of the December 2018 disaster. This is the equivalent of the pilot of an Airbus A321 telling the passengers that the radar and automated landing system are unnecessary on a foggy evening. Somehow promising to "be careful" while navigating by the stars does not quite cut it.
Second, this remarkable confession clearly reflects Powell’s worry about past missteps and the impact of those decisions on the Fed LT as an independent institution within the Executive Branch.
Third, it confirms that Powell and other FOMC members have no idea how to measure or benchmark changes in interest rate targets vs bond sales, much less unwind the Fed’s $8 trillion balance sheet. Given the huge increase in the now $33 trillion federal debt under first President Donald Trump and now President Joe Biden, the Fed may never be able to significantly reduce the size of its balance sheet. The chart below compares the Fed's balance sheet, including system open market account (SOMA), with the US banking system.
As we’ve noted previously, the FOMC’s decision to “go big” in 2019-2021 ties the Fed’s hands today in terms of fighting inflation. If the FOMC was selling $50-100 billion per month in mortgage backed securities, then mortgage coupon rates would be over 8%, home prices would be falling slowly, liquidity would be reduced and there would be no need for further short-term interest rate hikes. And BTW, the markets could easily absorb the SOMA assets. But a chastened Chair Powell is not selling.
Nick Timiraos of the Wall Street Journal precisely summarizes the fact that central bankers cannot quantify any of the key benchmarks of current monetary policy beyond metaphors about stars and clouds. The chart below shows the inversion of the Treasury two-year and ten year notes from FRED.
When the VIX measures future expectations of market volatility, it captures the worries of a marketplace that is pathologically bullish and rightfully so given the true underlying inflation rate in dollars. The reason that Buy Side managers seek 20% annual returns or more on alternative strategies is that public equity and debt markets barely offer real returns. But the VIX does not measure the increased volatility observed in economic and financial variables due to QE.
No, the volatility we worry about is also impacted by inflation, but goes to the issue of loss given default (LGD) on credit. Readers of The IRA are familiar with our Basel I era measures of post default loss we calculate for banks. Charge-offs less recoveries gives you a measure of loss severity (and management efficacy) that is very valuable when assessing a bank, for example.
The wider measure of LGD across the spectrum of secured lending, however, provides a striking measure of the equity left in a given distressed asset or portfolio. The chart below showing LGD (aka "net loss") on $12.2 trillion in bank loans illustrates the profound impact of Powell's decision to "go big" with QE on realized losses.
Source: FDIC/WGA LLC
Goodman and Zhu (2015) note that outside of the world of mortgages, there are few studies on loss severity (the percentage lost in the event of default) because of limited data. Gathering the actual losses post default on bonds or privately held commercial real estate, for example, is difficult and expensive because of the cost of acquiring and aligning the data. Yet anecdotal evidence suggests that LGD on leveraged buyouts are rising and surprising event veteran participants.
“In previous default cycles, leveraged-loan providers would expect to get 70% to 80% of their cash back from failing companies,” writes Lisa Lee of Bloomberg News regarding a leveraged loan loss by KKR & Co (KKR). “Those days are over.”
GenesisCare was an international cancer treatment company backed by the private equity firms KKR and China Resources Group. Earlier this year Genesis Care filed for bankruptcy under Chapter 11, with reorganization plans to sell its 130 U.S.-based practices.
Lee reports that KKR could take as much as 80% loss on debt to GenesisCare. This is a far higher loss severity that experienced a decade ago, suggesting that there is significantly less equity under later vintage deals. Through a 2020 merger with 21st Century Oncology, which had filed for bankruptcy in 2017, GenesisCare took on debt, as well as outdated technology and equipment, according to the bankruptcy filing.
“It’s yet another financial weak spot exposed by the end of the easy-money era, as tighter credit pushes over indebted businesses toward the brink,” writes Lee. “While some investment banks hope for a softer economic landing than feared, the crash in leveraged-loan recoveries is ominous for lenders.”
In a major study on LGD for corporate exposures of failed banks conducted by the FDIC, Shibut & Singer (2015) place the loss as a percentage of total exposure at default (EAD) around 40% and the percentage of the total loss closer to 80% for commercial and industrial loans (C&I) and construction and development loans (C&D). Our proprietary measures for LGD for these two bank asset classes are below. Notice that LGD for C&I loans has normalized, but C&D loans were still below average net loss at 50% in Q1 2023.
Source: FDIC/WGA LLC
Source: FDIC/WGA LLC
According to Equifax (EFX), 90+ day delinquent auto loans nationally are back at pre-COVID levels, but interest rates are far higher than they were in 2019. If the historical connection between employment, interest rates and consumer loan defaults is still valid, then we should expect to see default rates on auto loans and consumer loans move higher.
More to the point, most credit exposures other than 1-4 family loans are likely to see above-average loss rates as the US economy slows. If we assume that Chairman Powell is ready to sacrifice a quick victory over inflation in favor of hiding past mistakes through deliberate inaction (aka "caution"), then we may see loss rates start to approach 2008 levels in some asset classes. The volatility of changes in credit loss rates is perhaps among the most pressing question facing the FOMC and the one you can be pretty sure has not been discussed around the big table.
"Major U.S. department stores including Macy's (M) and Nordstrom (JWN) are flagging delays in store credit card repayments, another risk to revenues as consumers pull back from discretionary spending ahead of the crucial holiday shopping season," Reuters reports.
Macy's disclosed last week that rising delinquencies cut credit card revenues to $120 million in the second quarter, down $84 million from the previous quarter. Nordstrom's credit card revenues rose 10% in the first half of this year, but the company executives that delinquencies are now above pre-pandemic levels and could "result in higher credit losses in the second half and into 2024."
Below is the chart from The IRA Bank Book showing LGD for bank-owner credit card receipts through Q1 2023. The FDIC should release the Q2 data and peer group information this week. Notice how the Fed's market intervention pulled down net losses and the 40-year average loss rate. So here's the question: How much higher will these numbers go? Could we go back to 2009 levels of net loss? Yes we can.
Source: FDIC/WGA LLC
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