Banks might not have long to cheer for reg relief

It has been a decade since Bear Stearns imploded, and bankers are ready to stock up on champagne for the passage of significant legislative changes to the Dodd-Frank Act.

But before they uncork those bottles, they should be put on notice that credit signals are not good.

Recent data shows that commercial and industrial loans extended are at the highest point they have ever been since the Federal Reserve started tracking the data in the 1940s. Since 2009, corporate debt has been growing faster than consumer debt.

And there are additional worrying signs: The leveraged loan market has, for example, doubled in just five years to $1 trillion. This growth comes despite new guidance about better risk management requirements for leveraged loans released by the Fed and the Office of the Comptroller of the Currency in 2013. In April 2018, covenant-lite, first-lien institutional loans outstanding hit a record high of 77% of that market. Covenant-lite loans typically come with fewer periodic financial performance obligations for the borrower that other loans require. This is a significant rise from 2007 when these types of loans represented about 20% of outstanding leveraged loans in the U.S.

When an economic downturn begins, these covenant-lite loans are at higher risk of default than other similar loans because lenders have fewer protections. Not only are banks at risk when they hold these loans on their balance sheets, but so are a wide array of global investors in collateralized loan obligations, which are disproportionately backed by leveraged loans. Unsurprisingly, banks are big investors in CLOs. Additionally, since a court ruled in April that CLOs are exempt from the risk retention rule, which required CLO issuers to retain 5% of the risk on its books, there has been a glut of CLO issuance. Even before this court decision, CLO issuance by the end of 2017 was already at record levels with $120 billion in outstanding CLO issues, higher even than in 2006.

On the consumer loan side, the rapidly growing student loan market is of greatest concern. College loan balances now stand at almost $1.5 trillion. The Brookings Institution calculated that by 2023 the default rate could reach 40%. Even if the default rate turns out to be half of that, that would still amount to billions of dollars in losses. Like with other loans, banks are exposed to student debt because they are packaged into securitizations.

Another trouble spot is in the auto loan market. While the big lenders in this market are auto financing companies, banks have been entering this market. Moreover, banks invest in auto loan asset-backed securities, in which issuances have been rising. Lenders in the U.S. $1.2T auto loan market are extending terms to borrowers for as long as eight years — 10 years ago the average auto loan maturity was five years. This increases the probability that defaults will rise and that loan recoveries will decrease. Already, auto loan subprime borrowers are defaulting at a higher rate than in 2007.

Credit card debt and exposure to it through credit card asset-backed securities should also be monitored carefully by bank risk managers as well as bank supervisors and rating agencies. The number of credit card accounts and credit card debt per borrower has been rising. Serious credit card delinquency rates rose to 1.78% in the first quarter of 2018, up from 1.69% a year earlier. Given that the level of credit card debt is rising, what seem like small losses actually represent millions of dollars.

The mortgage market is the only bright spot across all forms of consumer debt. For over a year and a half, mortgage delinquencies have been declining. Delinquencies have also been declining among subprime mortgages. Yet given the high likelihood that the Fed will continue to raise interest rates this year, anyone with a floating-rate mortgage or credit card will start to feel the pinch of higher borrowing costs.

I fear that legislators are choosing a terrible moment to lighten up regulations on big banks. No one should think for a moment that the changes to Dodd-Frank are just for well-deserving community banks across the country. Given the current level of corporate and consumer indebtedness, allowing banks to take on more risk could be detrimental to Main Street precisely when employment and GDP levels are finally improving. Historically, what we see every time we reach growing levels of GDP, banks pursue fewer regulations to reduce their auditing, reporting and compliance costs. This frees up cash for banks to engage in riskier lending and capital markets transactions. In order to compete with other banks that are trying to capture more market share, banks let go of their due diligence standards in the chase for higher profits.

While the macro economic data are positive, the yield curve, an important market signal, is flatter than it has been in over a decade. Despite slowly improving GDP, there has been a rise in purchases of Treasurys, which has brought down the yield. This is happening because the market is being weighed down by policy uncertainty in terms of a number of government initiatives such as trade tariffs, the direction of the North American Free Trade Agreement and what the true effects of tax reform will be on economic growth. If the yield flattens more or even inverts, this will give rise to concerns that we are starting to get into a recessionary part of the credit cycle.

As a result of these market signs, I would encourage bankers to consider buying “cheap and cheerful” bottles of champagne rather than vintage ones. Trouble could be bubbling up just around the corner.