Fed

Chairs & Credit Bubbles

August 29, 2017

By: R. Christopher Whalen

New York | Fed Chair Janet Yellen’s defense of the benefits of regulation last week in
Jackson Hole probably killed her chances for reappointment, but the more pressing
reason to see Yellen return to the private sector is visible in the US real estate
market. Chair Yellen and her colleagues have created large bubbles in many assets
classes from residential homes to commercial real estate to construction lending. As
in the 2000s, this latest bout of asset price inflation will not end well for banks or
investors.

In this issue, The Institutional Risk Analyst looks at the most recent bank portfolio
data from the Federal Deposit Insurance Corp for Q2 2017 to see what it says about
asset prices and inflation. For some quarters now, the credit statistics for the $16
trillion asset banking system has been too good to be true, in some cases suggesting
that credit events have no cost. The last time that this circumstances existed was
the mid-2000s, when several large mortgage banks were reporting a negative cost –
that is, a profit – from default events.

The same real estate market dynamic that allows growing numbers of Americans to
take cash out of their homes is depressing the cost of loan defaults to half century
lows. Even faced with this rather striking situation, our faithful public servants on
the Federal Open Market Committee can actually stand up in public and say that
inflation is too low. The skews in the credit world are so large that some banks are
actually earning a profit on recoveries after a loan balance is repaid in full.

First let’s examine credit trends for 1-4 family mortgages, a $2.4 trillion asset class
for US banks. Loss given default (LGD), a fancy way of expressing net charge-offs,
shows the average loss for 1-4 family mortgages. At the end of Q2 2017, the LGD for
this asset class was just 24%, the lowest loss rate net of recoveries since at least
1990. Last quarter, the volume of defaults on 1-4s fell below $1 billion or less than
1/10th of one percent of total loans.

Source: FDIC

The chart above suggests that residential assets prices are quite high, as reflected by
the high recovery value – 76% – implied by the 24% LGD in Q2 '17. Since 1990 the
average loss rate after a default for 1-4 family loans is 67%, thus it seems reasonable
to ask when US home prices will adjust downward. How you feel about that
depends upon whether you view the extraordinary home price inflation seen since
2012 as being permanent and thus immune to mean reversion.

The situation in the world of construction lending is even more profound, with
LGD’s well into negative territory for the first time since the 1990s. In Q2 ’17,
LGD on those few construction loans that actually defaulted was negative
94%. Given that C&D loans tend to be mostly multifamily paper and have loan-to-
value ratios around 50%, when you see a bank reporting such unusual profits on
defaulted loans it suggests that the value of the real estate has basically doubled
since the loan was made by the bank. Note that the downward move in
LGD coincides with the end of quantitative easing by the FOMC.

Source: FDIC

Of note, home equity lines of credit are showing similar behavior to the 1st lien
mortgages, which typically stand in front of HELOCs in the credit stack. LGD for
HELOCs reached a mere 31% in Q2 ’17, implying that banks are recovering almost
70% of the value of a loan when a borrower default occurs. The 25-year average
LGD for HELOCs is 65%, illustrating that Chair Yellen and her colleagues on the
FOMC have literally turned the world of real estate credit on its head. As the chart
below suggests, the value of the collateral backing HELOCs has surged since 2012.

Source: FDIC

Next we move to the $780 billion in credit card loans held by US banks, an asset
class that has seen recent growth after years of flat to down portfolio levels. The
interesting thing about credit card loans is that they are totally unsecured. Thanks
to the generosity of Chair Yellen and the other members of the FOMC, credit card
loss rates have fallen dramatically since 2008. First let’s take a look at default and
non-current rates, which are both turning up after the years of irrational easing by
the FOMC.

Source: FDIC

Notice in the credit card chart that charge-off rates are above that for loans which
are non-current, the opposite of this relationship for most other loan types held by
US banks. This is due to the fact that, being unsecured, these credits tend to be
charged-off before they have an opportunity to be classified as non-current. The
next chart below shows LGDs for credit card loans, which at 83% is at the lowest
levels since the mid-2000s.

Source: FDIC

The real question that the previous two charts raise is much on the minds of bank
analysts, namely how much future default risk has been buried under the
comforting blanket of low interest rates. The average rate of net-charge offs for
credit cards is almost three quarters of a point above current levels, again begging
the question as to when we shall revert to the mean. The answer to that question
will have a significant impact on bank earnings and the ability of banks to return
excess capital to shareholders.Finally, let’s take a look at the $1.9 trillion portfolio of
commercial and industrial (C&I) loans, traditionally one of the most important
indicators of future US economic growth. Defaults and non-current rates are both
below the averages going back to the 1980s, while credit spreads are as compressed
as ever over that same time period. The chart below shows net defaults and non-
current rates for all bank-owned C&I loans. Notice that net charge-offs are below
non-current loans, which may end up being worked out or restructured short of a
formal default.

Source: FDIC

While the chart for net-charge offs for C&I loans looks relatively normal compared
to the real estate related asset types, loss rates measured by LGD have been
climbing since 2015. More important, new loan production rates (as well as sales)
are falling so that the portfolio of bank owned C&I loans is no longer growing very
much. This suggests that the US economy is slowing and demand for credit is
therefore on the wane. The chart below shows LGD for all C&1 loans.

Source: FDIC

It’s important to note that the charge-offs and recoveries reported in each period by
FDIC insured banks are disparate events. A recovery reported today might be
related to a loan charged off three years ago. But the key element of price is
reflected in the aggregate data reported by each bank, so that a rising recovery
rate/falling LGD strongly suggests that prices in the underlying market are quite
frothy. Just as in the 2000s and the 1990s, the Fed again has stoked an asset price
bubble in real estate that may lead to significant losses for banks and bond investors
should prices correct.Whoever gets the top job at the Fed, the FOMC must live with
the balance sheet and market conditions served up by Chair Yellen and her
predecessor, Ben Bernanke. While the Fed’s initial focus on narrowing credit
spreads was correct, the FOMC should have stopped after QE1 ended in
2010. Instead, concerned that banks were not lending, the Fed continued to buy
securities.The Fed has kept the pedal to the metal, repeating the errors of the 2000s
by fueling a credit driven bubble in residential real estate. This time around, the
bubble is more focused on affluent areas of the country, but the result is likely to be
more tears.BTW, we’re rooting for Kevin Warsh as the dark horse candidate for the
Fed job in the event that White House chief of staff Gary Cohn decides to stay
put. But the biggest challenge facing Yellen's successor as Fed Chair is having the
courage to admit that inflating asset bubbles does not create jobs or prosperity, just
future financial crises.