James Saft
Reuters Columnist
…interest rates start to rise?
Yes, I know you have heard this joke before, and yes, I know it is not funny.
The Bank for International Settlement’s quarterly review of financial conditions is an exercise in nightmarish deja vu: familiar to those who watched the last crisis but just different enough to be plausible.
Not only are credit markets so loose that comparison with pre-Lehman Brothers days are fair, but this is happening within a context in which investors, on the whole, don’t really have faith in the strength of banks.
Little wonder – if you look at ‘stand-alone’ ratings of banks from Moody’s and Fitch, which measure default probability given no external government help, you will find that both ratings agencies consider banks to be worse risks now than in mid-2007, before the financial crisis.
This implies that if interest rates start to rise, and recent data and rumblings from central banks indicate they may, a reckoning of some kind will be at hand.
So how loose is credit?
“What is happening in corporate markets is unusual. It is as if the typical relationship with the macroeconomy has taken a holiday,” Claudio Borio of the BIS said at a press conference.
While spreads, the premium investors demand to take extra risk, are very low, so are default rates, with only 2.5% of US high-yield debt defaulting in the past year. That’s just a bit more than defaulted in the go-go years before the crisis, when growth was much stronger and when memories had not been seared by a mini-depression.
Look no further for evidence of very easy conditions in lending markets than the renewed vogue for payment-in-kind notes, a kind of bond which gives borrowers the ability to pay interest to lenders with – get this – yet more debt.
Borrowers have issued record amounts of these securities so far this year, despite the fact that about one in three borrowers who sold similar securities before the crisis defaulted between 2008 and mid-2013.
The syndicated loan market, in which groups of banks band together to make loans, is also showing signs of overheating. About 40% of new loans signed between July and November were “leveraged”, the riskiest class, a higher number than during 2005-2007.
These easy conditions and low default rates are self-sustaining. Who defaults when they can just issue more debt?
Whither the banks
We know, of course, what is driving this – quantitative easing. By buying safe securities using new cash, central banks engaging in quantitative easing hope to force investors to take on more risk. The idea is that, faced with cash to invest and very low rates in government bonds, investors will climb a bit further out the risk-reward branch. Do that long enough and taking more bonds in lieu of interest begins to sound not just reasonable but a smart play.
While banks traditionally had been able to fund themselves with spreads 20-30% lower than their non-financial peers, that funding advantage disappeared during the crisis.
After all, if a bank can’t borrow more cheaply how can it lend?
While no longer paying the 100-150% more that banks were forced to in 2011, they still find themselves globally at a disadvantage. US banks pay about the same as non-financials, euro area banks 10% more and UK banks 40% more.
That’s a tacit admission by investors that they still worry about bank creditworthiness, or perhaps about the level of commitment on the part of governments to backstopping their banking systems.
Little wonder – if you look at ‘stand-alone’ ratings of banks from Moody’s and Fitch, which measure default probability given no external government help, you will find that both ratings agencies consider banks to be worse risks now than in mid-2007, before the financial crisis.
The difficulty will begin when interest rates rise. Investors will be less willing to take risk, making credit conditions tighter and causing marginal borrowers to default. Rinse and repeat process. Public markets move with remarkable speed, remember, and if they turn cold to borrowers, questions will then begin to be asked of banks.
Traditionally in credit tightening cycles banks did clamp down but at least enjoyed a funding and safety advantage to their non-financial peers. If banks are deemed to be worse risks now, it is very hard to see that changing when times get tough.
Demand for bank loans will go way up, but the people who lend money to the banks will likely back away, demanding more compensation for funding. It will also put pressure on governments to take the politically difficult decision to make their backstopping of banks all the more explicit.
It is all so predictable we won’t know whether to laugh or cry.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)