The sequel to Jaw has the tag line, “Just when you thought it was safe…”
They’re back. Yep. Subprime loans are back and more prevalent than ever. If you thought Bush, Obama, and “too big to fail” were relics of history, you’d be as clueless as the 90-Day Guy or the naïve written about by other bloggers on this site. The truth is that subprime lending and non-traditional (non-bank) loans are even more prevalent than ever. This is true for both corporate and consumer lending.
Below are some articles outlining the threat that subprime lending poses to the financial system.
Definition: Subprime Credit
Subprime credit is typically composed of subprime borrowers with low credit ratings, high debt levels, a record of delinquency, defaults or bankruptcy, no property or assets that can be used as a collateral. Lenders use a credit scoring system, like FICO scores, to classify subprime borrowers based on the probability of repayment. Different creditors use different rules for what constitutes a subprime loan, but FICO scores below 600 have typically been classified as subprime in the past.
Subprime credit is financed by repackaging subprime credit card debt, auto loans, business loans and mortgage into pools and selling them investors as asset-backed securities, like collateralized debt obligations and mortgage-backed securities.
During the housing boom in the early 2000s, lending standards on subprime mortgages were relaxed, with NINJA loans being made to borrowers with no income, no job and no assets. When the bubble burst in 2007, the quantity of subprime credit in the financial markets contributed to the subprime meltdown and the subprime crisis, which triggered the Great Recession.
Consumer advocates say subprime credit is a social good and provides finance to low-income households. Yet it increases the risk of credit booms and busts. In the U.S., banks tightened lending standards after the financial crisis. However, auto finance companies have since used low interest rates to fuel a boom in subprime auto loans. This helped the economy to recover. However, auto loan delinquencies hit crisis levels in 2017, even as subprime auto-lending continued to boom, leading to speculation that this another credit bubble that is set to burst.
Subprime Loans to Consumers
The article that I saw today has political as well as economic implications. Read these excerpts and then see if you agree with me.
Lower-income U.S. consumers are showing signs of weakness despite the strong market, and if the economy enters a recession, any possible credit crunch could be “material,” according to UBS.
Strategists led by Matthew Mish and Eric Wasserstrom wrote in a note Thursday that they’re worried about lower-income consumers who have seen little net worth improvement since the financial crisis. Debt burdens for many of those households have grown as credit card interest rates hit record highs and student loan borrowings surged. UBS expects that the consumer credit cycle can extend but a future downturn could be worse than the one seen in 2001 and 2002 thanks to subprime consumers’ growing debt loads, higher losses and the growth of “fragile” non-bank lenders.
A UBS survey found that households reporting credit problems like loan application rejections matched a survey high of 40%, up 4 percentage points from a year earlier. Consumers’ likelihood of missing a loan payment in the next year increased 1 percentage point to 13% …
Even though the Treasury rally has sent U.S. interest rates sinking, the strategists say many U.S. households are still seeing their interest burdens rise, similar to what occurred in the years before the crisis. The higher rates may come from a shift in what kind of debts consumers have: household debt was a record $13.7 trillion in the first three months of 2019, and most of the post-crisis growth in obligations has come from non-mortgage debts like student loans that carry higher interest rates.
UBS’s consumer credit analysts expect some deterioration in delinquency rates, but say positive wage growth should help most consumers stay current on their obligations. They’re more concerned about long-term trends because consumers’ finances aren’t recovering as well as their credit scores might indicate. They estimate some $2.6 trillion of U.S. household debt is subprime, and any future downturn would likely affect lower-tier U.S. consumers, instead of a more systemic problem like 2008-2009.Bottom 50% of Consumers Are Showing Signs of Weakness, UBS Says
The article seems to indicate that in the next economic downturn that the rich will do fine and the poor will get hammered. The poor are living on borrowed money and when the economy goes down, the credit tap will be shutoff while interest on existing debt will go up. This will cause poor folks to default on their debt and due to the amount of debt, it will send shockwaves thru the economy. In the end, the rich will stay rich and the poor will be even poorer.
This in turn, will feed into the socialist narrative that is being propagated by much of the Democrat Party. Poor folks will once again vote to relinquish their freedom for security, and as a bonus, they can hope to screw the fat cats in the process.
Another soft spot in the financial world is the rapid rise of non-bank lenders. These guys exist to make money via loans that traditional banks won’t touch. They loan to both businesses and individuals. Many of these loans would be viewed by traditional metrics as subprime. Please note in the articles quoted below that half of all mortgages are controlled by these non-bank entities. They are not subject to regulation by banking or securities laws. They exist… in the shadows.
When the dotcom bubble burst, Chuck Doyle smelt an opportunity — arranging loans for companies shunned by big banks and too small to tap the bond market. It proved very fertile ground.
His company, San Francisco-based Business Capital, says it has since helped hundreds of smaller companies raise money to keep afloat, finance their inventory or expand. But Mr Doyle, an avuncular former fibre-optic salesman, says conditions in the non-bank, non-bond “private debt” market have never been more frenzied.
“We’ve been through a few cycles, but this one is crazy,” he says. “We’ve seen unbelievably explosive growth. We’ve seen deals that banks wouldn’t have done even before the financial crisis.”
The post-crisis explosion of the US corporate bond market, and more recently the leveraged loans industry, have hogged the attention of analysts, investors and regulators. But it is arguably the underbelly of the American debt market that has seen most change in recent years.
“It’s a wild west space, where everyone competes for every deal,” says Oleg Melentyev, head of high-yield credit strategy at Bank of America Merrill Lynch. “The whole thing has exploded in size, and everyone is getting into it.”
There is no clear definition for so-called private debt, which is often also called direct lending or mid-market lending. It broadly consists of bespoke loans made by specialised lenders such as fund managers, insurers and tax-advantaged vehicles known as “business development companies.”
Borrowers can range from sizeable international groups to small companies seeking money for a new store — or just a shot of cash to keep trading for another quarter. Unlike leveraged loans, private debt is typically not widely traded, and unlike bonds, the market is largely unregulated and opaque.
“Direct lending has been the strategy du jour — when we see stresses we’ll probably see it there first,” says Jim Smigiel, head of portfolio strategies group at SEI Investments, near Philadelphia. He doubts the market is extensive enough to cause systemic problems, but “a lot of people will lose a lot of money”, he predicts.
Non-bank lenders thrive in the shadows
Private debt investors admit that the flood of money has dramatically eroded both standards and returns. KKR estimates that the average private debt yield has now fallen to about 6-8 per cent, down from the low teens a few years ago. That is only slightly higher than in the mainstream junk bond market, which is actively traded and far more transparent.
“What’s the biggest risk to the system right now? After listening to Fed Chief Jay Powell, who made a lot of sense today, I’d say it’s non-bank lending,” Cramer said Wednesday on “Mad Money.”
In the speech, Powell characterized non-bank lenders as imprudent and a potential problem for the credit markets and the broader financial system.
Even so, Cramer thought the rapid-fire rise of institutions like Quicken Loans, PennyMac and LoanDepot, three of the largest non-bank lenders, posed a near-term threat.
“There are many non-bank institutions making home loans that could collapse in value,” Cramer warned. “These companies came out of nowhere. They now control about half of the current mortgage market — that’s a trillion dollars’ worth of mortgages a year.”
Non-bank lenders like Quicken Loans are ‘the biggest risk to the system’ right now, Jim Cramer warns
Worse, if those lenders can skirt regulations meant for big banks with similar lines of business and make loans without enough documentation or money down, “that could be a serious problem,” the “Mad Money” host warned.
Parallels between leveraged loans and subprime
It’s not surprising that people are drawing parallels. The leveraged loan market is just shy of $1.3 trillion, the size of the subprime market at its peak. As did subprime, it has experienced rapid growth and even more rapid deterioration in underwriting standards, with the most highly leveraged companies accounting for a growing share of the market. Also like subprime, it relies on an “originate to distribute” model meaning the lender originating the loan does not retain major risk if the borrower defaults, but rather passes that risk on to investors, frequently by pooling them and selling securities backed by their cash flows in a “collateralized loan obligation (CLO).”
Like subprime, which catalyzed distress in the broader mortgage market, leveraged loans could also precipitate problems in the broader corporate debt market. Non-financial corporate debt as a percentage of GDP is at an all-time high. A record number of companies are rated just above junk and thus are exposed to system-wide downgrades to sub-investment grade status if the ratings agencies get spooked by a high profile default.
How regulators can stop leveraged lending from becoming the new subprime
And the risk of that happening is not inconsequential. Leveraged borrowers are not obscure companies but include such household names as American Airlines (AAL), Hilton Hotels (HLT), and Burger King (QSR), according to the trade association that represents leveraged loan lenders.
Folks, I hope reading this will cause you concern that everything is not peachy keen in the financial world. I think the availability of these alternative funding sources in a quest for higher returns, might be part of the reason that the 90-day cycle is so important. People want to know their risky investments are paying off or they might be tempted to cut their losses and pull their support.