By James Saft
Dec 10 What happens when credit conditions are
far too loose, the banking system is fragile and 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.
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 percent
of U.S. 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 percent of new loans signed between July and November
were "leveraged", the riskiest class, a higher number than
These easy conditions and low default rates are
self-sustaining. Who defaults when they can just issue more
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 percent 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
While no longer paying the 100-150 percent more that banks
were forced to in 2011, they still find themselves globally at a
disadvantage. U.S. banks pay about the same as non-financials,
euro area banks 10 percent more and UK banks 40 percent 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
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