Calibrating the Credit Crunch

November 24, 2009 By Richard Berner New York Credit headwinds to growth abating. The credit crunch is not completely over; far from it. This most severe financial crisis since the Great Depression likely will leave lasting scars on risk appetite and a legacy of impaired balance sheets that will take time to repair. Indeed, with housing activity turning lackluster and home prices starting to decline again, consumer sentiment declining, and commercial real estate fraught, it might appear that those scars are resurfacing in weaker activity. But in our view, courtesy in part of aggressive monetary, credit and quantitative easing, the credit headwinds to growth are subsiding. That abatement is evident broadly in funding markets, credit spreads and risky asset prices - indeed, in most indicators except in net credit creation itself. Moreover, we believe that what was a vicious circle of credit losses, tightening lending standards and economic recession is starting to turn virtuous and will gather strength in 2010. The ongoing improvement in financial conditions supports our call for a moderate and bumpy but sustainable recovery, and Fed moves away from an ultra-accommodative monetary policy next year. Two-tier improvement in financial conditions. Despite this improvement, there is a sharp dichotomy in financial conditions that not only makes calibration difficult, but also casts doubt on the basic thesis. Access to and functioning of many parts of the capital markets have improved dramatically. But banks remain relatively reluctant to lend. Consequently, credit availability for households and small businesses still seems to be impaired. But is it really? There's no mistaking the improvement in money and capital markets. Start with the cornerstone for funding and transacting, namely short-term money markets. Thanks to the ongoing effects of strong government backstops for financial institutions, the Fed's and other central banks' liquidity and funding facilities, as well as an unprecedented flood of liquidity, short-term money market spreads are back to pre-crisis levels. Suppliers of term (up to 90-day) unsecured and secured funding are now willing to assume counterparty risk for a few basis points, the ‘basis curve' has normalized to a more traditional upward slope, and haircuts have settled at economically viable levels. Despite the prospect of synchronized fiscal year-ends for both new bank holding companies and their customers, Libor-OIS forwards evince little pressure over the turn of the year. That reflects reduced systemic tail risk in the banking system, conditional commitments by officials to keep policy rates low, and the extension of liquidity facilities through February. But it also reflects genuine improvement in perceived counterparty risk, with higher capital buffers, lower leverage and thus greatly reduced idiosyncratic tail risk. As a result, the use of Fed facilities that carry a penalty rate has steadily dwindled and the Fed this week trimmed the provision of term funding at the discount window, reverting from 90 days to the pre-crisis 28-day repo maximum. Capital markets revival. This funding improvement, coupled with the Fed's securitization facilities and the Treasury's Public-Private Investment Program (PPIP), has revived parts of the capital markets, providing borrowers - including some consumers - with greatly improved access to credit. The Fed's Term Asset-Backed Securities Loan Facility (TALF) has breathed life into the asset-backed securities (ABS) market that is critical for financing consumer loan portfolios. To be sure, the government lifeline remains a huge source of support for markets and institutions. Yet so much has the market improved that the utilization of TALF financing has clearly waned. Since the TALF's inception in March, about US$90 billion of securities have come to market. In addition, there is a growing list of non-TALF consumer ABS issuance. My colleague Vishwanath Tiruppatur notes that after months of anticipation, and thanks in part to TALF, we have finally seen new issuance in the commercial mortgage-backed securities (CMBS) market with the Developers Diversified Realty Corp (DDR) transaction (US$400 million of bonds backed by 28 shopping centers in 19 states). The enthusiastic response to the DDR CMBS transaction set a positive tone to the CMBS market, which had been bereft of new issuance for well over a year-and-a-half. The TALF program for legacy CMBS, which has not had as much traction as the consumer ABS version, has nonetheless contributed to increasing liquidity in the secondary markets. Likewise, the so-called public-private investment funds (PPIF) launched under the PPIP umbrella, while still in their initial stage, have resulted in a buying capacity of over US$15 billion and helped buoy secondary markets in non-agency RMBS and CMBS. More traditional corporate borrowers, including many who lacked access to markets a few months ago, have also benefitted from this improvement, as investors flocked back to credit markets. Both the investment grade and high yield debt markets have provided a significantly higher volume of funding this year. Investment grade issuance has reached US$440.6 billion year-to-date versus US$289.8 billion in 2008. And monthly average high yield issuance has nearly quadruped since March to US$19.6 billion. Contracting bank credit: Weak demand. In contrast with these improvements, bank lending is contracting, partly because credit demand is weak. There is strong evidence for weak demand: Businesses are in the time-honored, early-cycle process of deleveraging, as cash flows are far outstripping declining inventories and capex, implying scant need for external funds. Since commercial and industrial (C&I) loans are mainly used to finance working capital and inventories, it should hardly be surprising that C&I loan originations are nil and outstandings are contracting. That is not an impediment to growth, and we expect that loan demand will increase with financing needs next year. Critically, moreover, CFOs are paying down credit lines drawn at the height of the crisis and are ‘terming' out loans by issuing longer-term debt in the capital markets. So businesses are liquidating C&I loans originated months ago. To quote the Fed's October Senior Loan Officer Survey: "In response to a special question on the sources of the decline in C&I lending this year, the two sources domestic banks cited most often as being ‘very' important were decreased originations of term loans and decreased draws on revolving credit lines." That willingness and ability to substitute borrowing in markets for bank loans is healthy and important, because it indicates that larger businesses are confident enough to issue longer-term debt and have the flexibility to fund their needs even when bank lending standards are tight. For their part, consumers are also deleveraging in a process that is proceeding rapidly, but likely has another 12-18 months to run. Repairing consumer balance sheets is a difficult, but ultimately constructive development. Looking more closely, some of the demand-driven deleveraging is voluntary and prudent, reflecting wealth losses and recession-induced uncertainty. But some of the change is involuntary and immediate, as defaults, the credit crunch and income losses squeeze consumers and businesses. Of course, looking to loans outstanding does not help identify these cross-currents in credit; arithmetically, the change in outstandings reflects the sum of new originations, repayments and defaults (net charge-offs), each of which has demand and supply elements. But also supply restraint. We also have strong evidence that constrained supply, or reduced availability of credit, continues to play a role in the contraction of bank credit. Banks continue to tighten the terms on which they grant credit and the standards for most loan types. Collateral requirements or downpayments are higher, spreads over benchmark funding costs are wider, covenants are more stringent, and maturities are shorter. Small wonder: Credit losses in 2007 and 2008 eroded the capital base for leveraged lenders, promoting the credit crunch. In turn, an ‘adverse feedback loop' from the credit crunch to the economy and back to credit losses promoted a deleveraging of the financial system that pushed the US economy into recession. Despite the incipient economic recovery, delinquencies and charge-offs continue to rise, lagging behind the economy in time-honored cyclical fashion. Moreover, policy uncertainty is likely contributing to banker caution. As Fed Chairman Bernanke noted this week, cautious banks are holding much larger cash buffers than before the crisis. We suspect that uncertainty about capital and liquidity regulations is making lenders more conservative. And changes to accounting rules under FAS 166/167 will require banks to bring conduits, securitized credit card and other assets back onto their balance sheets at the start of 2010. Looking further ahead, commercial real estate developers face US$2.6 trillion in maturing debt that must either be rolled over or paid down over the next five years. Listening to loan officers: Pace matters. Although improvement in capital markets is an offset to bank credit restraint, the substitution is only partial. As a result, the ominous litany of bank credit headwinds at first sounds inconsistent with a moderate recovery. The key to reconciling the two is pace: For example, the Fed's Senior Loan Officer Survey indicates that banks were still tightening lending standards in October, but at a significantly slower pace. To quote the October Survey: In the October survey, domestic banks indicated that they continued to tighten standards and terms over the past three months on all major types of loans to businesses and households. However, the net percentages of banks that tightened standards and terms for most loan categories continued to decline from the peaks reached late last year. The cumulative tightening in standards affects the level of lending or activity, but it is pace (or the proportion of respondents tightening) that matters for growth. Correspondingly, tight lending standards are still depressing the level of lending and thus output relative to what they would otherwise be, but their effect on growth is abating. To be sure, the Senior Loan Officer Survey results are presented as a diffusion index, and readings greater than zero mean that more banks are tightening standards than easing. The survey is qualitative, not quantitative, so we don't know how to calibrate the difference between tightened ‘considerably' and ‘somewhat'. Thus, empirical work is needed to quantify the impact. Empirical evidence. Updating past empirical work by Fed researchers supports our conclusions: Given aggressive policy stimulus and the healing in capital markets, the recent slower pace of tightening bank lending standards is consistent with slower declines in bank lending and an improving economy. Two studies pioneered in examining the relationship between the proportion of lenders changing standards and loan and economic growth. They show that changes in loan standards have a strong correlation with loan volume and business activity: Tighter standards trigger events resembling credit crunch, easier standards promote recovery. Importantly, the proportion of lenders changing standards (the numerical level of the survey responses) influences growth in loans and output. Our replication and updating of these results revealed a striking development: The influence of changes in lending standards on loan growth increased over time and became much more statistically significant. In contrast, the influence of such changes on output or demand, while important, was relatively stable over time. For example, for the periods ending 1998 or 2000, the Fed and we estimate that a 10 percentage point change in standards, other things equal, allows a 0.6 percentage point change in business loan growth. Extending the results to 3Q09, we find that a 10-point drop in the proportion of banks tightening standards allows a one-point increase in business lending growth - nearly half again more sensitivity as in the earlier period. And the statistical precision of the estimate more than doubled. In contrast, our work and others' suggests that the effects of changes in lending standards on business activity are relatively stable over time. For example, other things equal, a six-point drop in the proportion of banks tightening mortgage lending standards will promote a one-percentage-point increase in housing demand. Estimates by Macroeconomic Advisers suggest that a 10-point increase in banks' willingness to lend would yield a 0.3 percentage point increase in PCE. These empirical results underscore three important developments. First, despite the steady disintermediation of banks and other depository institutions, the availability or supply of bank credit - proxied here by changes in bank credit standards - has an important effect on bank loan and economic growth. Second, the recent increased sensitivity of bank credit growth to changes in lending standards probably reflects the increased availability of credit through the capital markets through 2007. In other words, when banks tighten standards but markets are still functioning, borrowers may turn to other sources of credit, and banks lose market share. Third, however, systemic shocks that promote deleveraging across banks and capital markets will result in deep and lasting recessions. Positive but bumpy outlook. In our view, the reversal of those systemic shocks is now promoting recovery, and renewed gloom about the economy and concerns about an intensifying credit crunch are overdone. While uncertainty about the economy and policy are creating borrower and lender hesitation, we see a positive feedback loop developing from financial conditions to the economy that will promote a sustainable recovery in 2010 and 2011 (see Hiring Still Poised to Improve Early in 2010, November 9, 2009). In particular, we and our large-cap bank analyst Betsy Graseck believe that bank risk appetite will improve as uncertainty over capital and liquidity requirements dissipates; this uncertainty should lift when regulators release capital and liquidity proposals in early 2010. In addition, banks are currently holding excess liquidity in part to show the breadth of resources they have available to repay TARP loans. As growth in bank earnings accumulates, and banks repay those loans, the excess liquidity will likely translate into securities purchases and loan growth.