Here Are the Signs of a Slow-Moving Credit Crunch

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1:26Hello, and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway. And I'm Joe Weisenthal. So, Joe, we are recording this on April 19th, and we are firmly in the middle of bank earnings season. And so far, it seems pretty good. You always know it's going to be a good one when we have to state the date up front. That's a sign. It's like, okay, we're right in the thick of it. That stuff is happening. We're talking about news. It's going on right now. This is not some big theoretical thing where we're going to be talking about some ancient economic theory from 100 years ago. This is right now.

2:01That's right. So, you know, obviously we had the banking crisis in March and we have seen some signs of distress in the financial system start to fade since then. So things like borrowing from the discount window that has gone down from the peak that we saw at the end of last month. And then, of course, if you'd been listening to all thoughts before then, you would have known that discount lending was ticking up for months even before March. But the point is that if you look behind some of these headlines, headlines about bank earnings, headlines about, you know, discount borrowing starting to come down, some signs of strain beginning to evaporate, if you actually look into the guts of the financial system, there are still some issues and some maybe suggestions that there are more problems to come.

2:54Right. I think that's a really good summary. Early March with the Silicon Valley Bank implosion and some other concerns, that was like fears of financial crisis. And it faded pretty quickly, like those acute fears. But then there are the other questions is like, OK, well, it's like, all right, the banking system maybe is still chugging along. But what does it mean for credit and how much of a mark will it leave on the sort of broader economy in general that we had this moment and that all these sort of banks saw what can happen if they get on the wrong side of certain trends? Totally. And banks are obviously big players in a lot of different markets, but a big one would have to be bonds, all sorts of different types of bonds.

3:38So everything from treasuries to T-bills to commercial mortgage-backed securities to residential mortgage-backed securities. And so the question is, if there's more regulatory scrutiny on all of these things, if there's more concern about interest rate risk and duration exposure, is the appetite, the bank appetite for those assets still going to be there? And even though we've seen some of the crisis headlines fade away, we know that use of the Fed's reverse repo facility, for instance, the RRP, is still pretty high, which means a lot of money is still moving out of banks into money market funds, and they're parking that at the Fed.

4:15So the major disaster headlines may be gone, but there is still this evidence of strains in the background, worries about a credit crunch, a possible collateral crunch. Of course, those two things are interrelated. So we need to talk about all this. We need to get deep into the guts of the financial system and talk about what's going on. And I'm very pleased to say we have the perfect guest. We are going to be speaking with Ben Emmons. He is a portfolio manager over at New Edge Wealth. And before that, for a long time, he was a portfolio manager at PIMCO. I believe it sat fairly close to Bill Gross at the time, which must have been an interesting experience, to put it mildly.

4:54but someone who can talk to us about, you know, what is going on in this market? What do banks actually mean for bonds? Are we seeing signs of an unfolding credit crunch and collateral issues? So Ben, thank you so much for coming on All Thoughts. Hi, Tracey. Hi, Joe. It's great to be here. Thank you. And I'm glad we could finally get you on. One thing I was wondering, just as I was sort of doing some of the prep for this episode, how do we actually measure credit in the banking system? And what do we look at for signs of strains? I'm aware, for instance, that suddenly everyone has woken up to the Fed's H8 data, which hasn't gotten a lot of attention for a long time.

5:32But what are we looking at here? Yeah, the H8 data, the arcane data, if you think about it, right? It's like, you know, you wouldn't really pay attention to it unless you were in the 1980s at Trader Den and standing at the Xerox fax machine, eagerly seeing the money supply numbers coming off. and then making an assessment, okay, the Fed is doing this or the Fed is doing that. And that's a little bit what we're dealing with today too, though. You would say that that data now is important because this term called bank credit that's in there, there's 17 trillion or a change currently, that accounts for all the loans and securities that the banks have on their books.

6:11And that's ultimately how they extend credit or contract it. So if you look at that number and the change in that, which happened over the last month or so, it was kind of a few hundred billion that changed it. Now that's what people look at. That's a credit change. Right. So every Friday, the Fed releases this table called the H8 data, assets and liabilities of commercial banks in the United States. And it's interesting to get this historical perspective because back in the day, 40 years ago, whatever, the Fed didn't give much in the way of communication about its policy. It just had some sort of money supply target.

6:45And so people would look at this data to see how it was doing. Now, though, it's, you know, we get all this communication, but it gives us some additional information about the growth and contraction of credit. Yeah, indeed. And I think even so, that you could think of that as you listen to fat speakers and they point to this data, they seem to be quite confident that there isn't really anything materially going on. Sure. But everybody paying attention to it means like, you know, I'm going to try to extract the signal from this. Because, you know, if it does show more material decline in bank credit in this case, then the Fed would react to this.

7:20Right. And that's what happened to Martin. Just in terms of measuring credit. So this is volume. But then how do you incorporate surveys of businesses who are having a harder time getting a loan? That seems to be getting worse. Or the loan officer survey where they have been reporting some tightening. Or spreads. obviously we can look at junk spreads or CMBS spreads, et cetera. So is it one of those things where we're all blind and touching the side of the elephant and just trying to gather as much different pieces of it as possible? Yeah, the idea of a dashboard, right? You have all these different signals that come at you.

7:56Obviously, what you're summarizing, there are different parts of the credit markets because if you were to look at spreads and you look at, say, junk bonds, that's little to do with the bank credit itself unless there's underwriting from an investment bank in there. Even so, it's not really what we're looking at here today, commercial bank credit, which is really about mortgages, about consumer loans, about credit cards and things like that. But you're right. You have to look at a broader spectrum of measures about what credit is really doing in the economy because it gets extended in different ways, right?

8:28So I think if we take the H8 data and also the H4 data, I was going to mention that too, which is the Fed's balance sheet data every week, is the aggregate. The change in that does give us a sense where we are right now. Like we've risen rates a lot. It starts to affect the economy. People know that eventually banks will pull back and the earnings from banks show this too. They start to provision for loan losses as a sort of a precautionary measure. But I think what happened in March was a reaction to what ultimately happened where banks can extend credit through and that's deposits, right? And deposits have obviously declined.

9:01Well, this is exactly what I wanted to ask you. So let's step back for a second and talk about why a credit contraction could materialize. So what are the dynamics that are affecting banks at the moment? You know, I mentioned that if there's additional regulatory scrutiny on interest rate risk, then obviously that could affect appetite for certain types of bonds. But you also have a situation where banks may be nervous about the future, they may be increasing or hoarding their reserves, and that would also start to curtail on their lending. So walk us through how this materializes. Yeah, I was looking at the other day, Tracy, of thinking of different channels are currently showing some signs of that credit crunch stress.

9:44So one is then that leverage loans, which is now syndicated loans, that has declined quite a bit. And that has to do with that during the pandemic boom, a fair bit of financing took place because of all the hype, that bank sitting on a lot of like residual loans on that balance sheet and having a hard time getting rid of those loans. They have to be discounted low value and therefore they pull back from that syndicated loan market and push it into the private credit market, which although have been lending, are lending at higher rates, right? So it affects credit that way. Secondly, it's the commercial paper market, which is interesting.

10:19That was mentioned in the Fed Minutes too. That's frozen, so to speak, meaning there's very little issuance going on. I always get bad flashbacks to like 2008, 2009 when we start talking about commercial paper and that seizing up. Yeah, and that was happening in 2020 as well, right? And then that's in March of 2020, the market completely collapsed and the Fed actually did something about it. This time it seems to be driven by, yeah, little appetite to issue these commercial paper at this moment as one on a channel. Can you talk about, you know, different slices of the credit market or, you know, I think one of our longtime guests who we haven't had on a while ago, Chris White, you know, talked about these different slices of the credit market, essentially each being their own world, each being their own ecosystem.

11:06So when you talk about, okay, banks no longer being able to sell into the leveraged loan market and having to move into the private credit market, I don't know, like, what is the difference between these markets? Why do they have a different complexion? Why is the cost of funding of the latter higher? Well, two things there. So one, the private credit lenders, that's called special lending or direct lending. I mean, they use different terms. They don't act like a bank. You have to think of companies like Apollo or KKR or Blackstone. They lend to mid-size to smaller size companies that cannot go to a bank or find it harder to go to a bank, as in the lending centers are tighter at a bank than they are at a private lender.

11:50Yet the interest rate that they pay, which is typically a spread over the standard overnight funding rate, secured overnight funding rate, sorry, is wider, right? Private lender will ask for more compensation on taking risk of a company that generates say 50 million EBITDA, if you call it that way, per year. So on the other end, you have the syndicated loan market, which now is a bigger market, like there's bigger companies involved. I really think there was what the leverage buyout boom that happened briefly in 2020-21 contributed to the banks pulling back and now provisioning forward too. as in that's what showed up in this in the earnings data so far and that's actually the point that what you were asking about tracy is that you know where i really think where the crunch comes from is that if we're getting banks starting to accumulate more and more reserves lend out less or less incentivized to lend and then you're getting a really pressure on other markets other credit markets that have to then no longer having the access to banks because they ultimately to provide the liquidity and the credit for the system, right?

12:58So I think this is where the real issue is. And people, if you rethink back of history, as you often do on the show, you think of Friedman and Swartz studies about money supply. What they really looked at was like what banks in the 30s did too. They started to really accumulate reserves quite significantly and it led to this huge contraction of credit in the economy. Now we're not there here today yet because it's not like that at that time. But we have had instances of this. 2018-19 was an example where it turned out as the Fed kept reducing its balance sheet, the banks, in the meantime, were worried about the economy and started pulling back and started accumulating reserves.

13:38Not every bank has access to the Fed reserves, by the way. So there's another aspect of that too. So I think if you summarize it, the different aspects of the credit markets, The private lending is really different from bank lending, clearly driven by different, I think, covenants and underwriting standards and lending standards. But then the banks themselves are, I think, in a very precautionary mode currently. And therefore, there is that possible risk of this, you know, further pressure on lending in the economy.

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16:12Complete disclosures available at public.com slash disclosures. So one of the interesting things that we've seen, and again, this is sort of in the background and I haven't seen it discussed that much, but I think risk premiums on things that tend to be dominated by bank buyers. So, you know, mostly securitized products like residential mortgage-backed securities or commercial mortgage-backed securities, RMBS and CMBS, which I mentioned in the intro, So risk premiums on those are higher than a lot of unsecured stuff. And I would guess the assumption is because people are thinking that banks may be less incentivized in the future to buy those types of assets, given what we just saw and the additional regulatory scrutiny or caution that we're expecting now.

16:59Talk to us about those markets and what sort of impact you see there. Yeah, we think about the agency mortgage-backed securities market in particular. You know, that's an asset class that, you know, there's still government guarantee, by the way. Right. So you're not worried about credit risk, just the rate risk. Just purely the rate risk. And, you know, a simple math of mortgages is that if rates go up, the prepayment speed of mortgages goes down and it actually extends the maturity of a mortgage-backed security. But banks buy those because they're yielding a bit higher than treasuries. They are liquid.

17:34There's a big market. And the Fed is involved. And that's been part of the reason. Now, as the Fed is reducing its balance sheet and pulling away from that market, the banks are left with buying more. Now, what's happened during this latest episode was that banks discovered that the duration of a deposit is actually a lot shorter than what has been estimated. There's been real estimates out on this that this could be as long as seven years. That's basically the idea of like the three of us have a bank account at XYZ Bank. We have our deposit in there. We trust that bank. We've stayed there for many years.

18:08and we never really pull our money out unless we absolutely have to. Now what happened in March was obviously people got really worried and pulled their money out really quick. In other words, it's not seven years, it's probably seven hours, right? So if you think of that, the deposit side, the duration much shorter and you're having a lot of mortgage-backed securities on your balance sheet that can extend the maturity as rates go up, you have this duration mismatch. And that I think is the issue here now for banks to have to reassess that gap. and there will be regulatory scrutiny, as you say, coming in here, meaning there's going to be a re-evaluation of banks' risk management in the wake of Silicon Valley, obviously.

18:47I think what then happens is that you could expect that banks will either decide to sell more mortgage-backed securities or let them run off, so to speak, just what the Fed did. Either way, more of that supply, quote, comes on the secondary market in mortgages and it has to be repriced at a higher spread. Indeed, nothing to do with the credit risk underlying, it's the government, but much more to do with, I think, the liquidity risk and the bank duration risk. Yeah, super reminiscent of the conversation we had late last year about the sort of broken mortgage market and how banks, you know, they didn't really want to hold a lot of MBS as rates were going up last year.

19:27And I can imagine this year they're even less incentivized to do it. On the mortgage front specifically, I mean, would that show up in sort of a straightforward higher spreads relative to treasuries? I mean, all things equal in terms of like, okay, banks want to reduce their duration risk. They all saw what happened with Silicon Valley Bank. The regulators come in. Would this be expected to feed through in a sort of straightforward way to cost their mortgages? In some way, it does, right? Because it's a market functioning. Okay, it's a very liquid market, so people will price in this, quote, unquote, higher supply that comes naturally on the market, so to speak.

20:06Because there's continuous mortgage origination that are packaged in these securities. Then you have to think about what happens also with other investors in this space. So the mutual funds and ETFs and foreign investors, either foreign mutual funds or foreign central banks even, or foreign pension funds, what they do, how they respond. Now, the analysis that's out there, there's an expectation that their demand will pick up as that spread implicitly widens. Yeah. You know, there will be money managers that will find it attractive. But I do think, let's say, on average, it should become a wider spread, really because banks in the United States have been the purchaser of these securities.

20:48In fact, with all my notes I brought with me here today. Nice. Always love when guests bring data. Yeah. There's data out actually really specifically by entity which owns mortgage-backed securities. You have even credit unions involved, community banks, smaller regional banks. They all rely on these mortgage-backed securities in part because their loan book is largely FHA mortgages, not really non-agency mortgages. It's mostly government-backed loans. So I think there's that change potentially coming. How much it will be of spread winding is obviously a bit of a market functioning idea, as in, you know, who will really be the buyer here.

21:35I can imagine that my former colleagues, as I may listen now, hey, you know, you're right, Ben, this is interesting. We can, you know, mortgages are interesting to buy, but that's not going to fill entirely the void, in my sense, given what the Fed is doing too with their portfolio, which is large, right? That's a large portfolio of mortgages. So would it be fair to say, summing it all up, that, you know, Americans are in for higher mortgage rates thanks to a bunch of, I guess, venture capitalists who pulled their money out of Silicon Valley? Yeah, maybe on average. Who had their money, who had their portfolio companies' money in Silicon Valley Bank in part so they personally could get lower mortgages from the bank.

22:14I don't, you know, that seems to be part of the story. So thank you. And now we all have to pay higher mortgages. Just to layer onto the irony. Yeah, the interest-only mortgages that they have, right? They originate at low cost and all part of this idea of, yeah, bring all your money in and we'll do more business with you. That's probably going to change to an extent. Now, I do think pointing to the analysis that Bloomberg put out is really good, right? How mapping out where these interest-only mortgages were in California and on the East Coast. Fortunately, it's all high quality borrowers, right?

22:47People that can essentially pay off those loans without a problem. It's not subprime. But nonetheless, I think that market has changed. And that will add to, you know, rising cost of credit, I guess. Can we talk a little bit about what we're seeing in terms of collateral? Because, of course, you know, collateral, the availability of collateral will affect the availability of credit because it's the thing that's used to secure a bunch of loans. And we have seen some signs of like, I don't want to say necessarily problems, but maybe weirdness in that market. So I think I wrote about this in the All Lots newsletter.

23:24But for instance, the one month T-bill is yielding like 80 basis points below the effective Fed funds rate, for instance, which is something that you wouldn't expect to see unless there was a big scramble for T-bills at the moment. What is going on there? Yeah, there's, I think, three things happening. So, as you said earlier, the reverse repo facility of the Fed is very large. And that has been for a while now. And the main reason is that, and which are particularly money market funds that are in that facility, they cannot purchase enough T-bills out there. So, one, it's the Treasury that hasn't issued more T-bills because of the debt ceiling in there, account of the Fed and that dynamic.

24:08We can talk about it in a second. And secondly, I think there has been indeed somewhat of a hoarding of these T-bills. If it isn't by those money market funds, it's by other participants. And then it's about, I think, the way the foreign investors are involved in our markets. Because, you know, the latest data I looked up from the Fed tick data showed actually an increase of holdings of T-bills by foreign central banks or foreign investors, what they call it, which could be others. So if you take that together, there is a, I'd say, a limited supply of T-bills in the marketplace. Then the Treasury is not issuing enough of it, so to speak.

24:47By the way, the Fed owns about$300 billion of it too, which is not insignificant. So I think it gives you together a picture of that. And this is statistics, by the way, data on the notes. There's$4 trillion of T-bills outstanding. There's something like$2.2 trillion is pledged as collateral. That's data from the Fed. Anything in between is sitting somewhere. Someone's holding it. And so there could be all different entities. I think this is constrained to supply of T-bills. Why that yield is lower? The effect of that. Would you expect that premium to shrink a bit? I mean, I could see like, okay, if it's early March, and you're probably thinking two things.

25:27I don't want to take any duration risk because we just saw a bank get blown out by duration risk. And I don't want to take any credit risk because I just saw a bank collapse. But, you know, as we get, as that recedes in the past, we see some of these emergency functions start to recede again. Would you expect some of that to just sort of ease a little bit as people feel a little bit safe to hold something other than, you know, one month government securities or something ultra short? Yeah, and some way it's playing out as we speak, right? You know, the spread looks like where we are in 2008, but that's not the same idea, even though people link it to the bank stress, you know, and parallels to the bank stress are like, yeah, okay, 07, 08 showed somewhat similar events that we just went through.

26:09But there's a difference maybe that, one, the Fed is much more in position to do something about it very, really quickly. That's what we saw. And that has definitely diffused part of the crisis. And two, as you say, there are a lot of alternatives now in terms of T-bills, right, that people want to invest in, you know, given that where rates are on fixed income. So I think that spread will not be so inverted for a long time. but that it is a combination of the technicality of debil markets in terms of its supply and what the treasury is issuing and who's holding it and the dynamic of the treasury with the debt ceiling in its account at the Fed against just a general sense of flight to safety that is temporarily and has receded.

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