We have been writing about the totally crazy lending that has been taking place the past several years. It’s like 2007 on steroid, except that residential real estate is only involved on the fringes. That’s why it doesn’t get much attention. But there are lots of excesses in the types of commercial financial, junk bonds, “P-K (payment in kind) bonds, low covenant loans, etc.
In an environment of low and declining interest rates, that all works. But let rates rise, even a bit, and things start unraveling, especially because of the big role that derivatives play in the markets.
Wolf Richter had an excellent article about the peak in the credit bubble. It’s well worth reading:
The Credit Bubble Peak was Marked by “Totally Crazy Lending.”But the financial media doesn’t even mention this problem. When the CEO’s are interviewed, they only tell us how wonderful it is that now any person can get a loan. Well, we saw that in the last cycle, and many of these people couldn’t even pay the interest. The words, “responsible lending” are once again forgotten. Millions of innocent people who have nothing to do with this will once again pay the price, unless they are prepared.
Debt is good. More debt is better. Funding consumer spending with debt is even better – that’s what economists have been preaching – because the consumed goods and services are gone after having been added to GDP, while the debt, which GDP ignores, remains until it is paid off with future earnings, or until it blows up.
Corporations too have gone on a borrowing binge. Unlike consumers, they have no intention of paying off their debts. They issue new debt and use the proceeds to pay off maturing debts. Funding share-buybacks and dividends with debt is ideal. It’s called “unlocking value.”
Debt must always grow. For that purpose, the Fed has manipulated interest rates to rock bottom. Actually paying off and reducing debt has the dreadful moniker, bandied about during the Financial Crisis, “deleveraging.” It’s synonymous with “The End of the World.”
At the institutional level, “debt” is replaced with more politically correct “leverage.” More leverage is better. Particularly if you can borrow short-term at near zero cost and bet the proceeds on risky illiquid long-term assets, such as real estate, or on securities that become illiquid without notice.
Derivatives are part of this institutional equation. The notional value of derivatives in the US banking system is $190 trillion, according to the Office of the Comptroller of the Currency. Four banks hold over 90% of them: JP Morgan ($53 trillion), Citibank ($52 trillion), Goldman ($44 trillion), and Bank of America ($26 trillion).
Over 75% of those derivative contracts are interest rate products, such as swaps. With them, heavily leveraged institutional investors that borrow short-term to invest in illiquid long-term assets hedge against interest rate movements. But Treasury yields and mortgage rates have moved violently in recent weeks, and someone is out some big money.
These credit bubbles always unravel to the greatest surprise of those institutions and their economists. When they unravel, the above “End-of-the-World” scenario of orderly deleveraging turns into forced deleveraging, which can get messy. Assets that had previously been taken for granted are either repriced or just evaporate. But they’d been pledged as collateral. Suddenly, the collateral no longer exists….
On the way up, lots of money can be made on this debt, in myriad ways, including in interest and fees extracted from consumers directly, and in fees extracted by Wall Street, for example in repackaging risky consumer or corporate debt into highly rated asset-backed securities that are then spread to institutional investors who use proceeds from leverage to acquire them. But no problem; it’s just OPM (other people’s money).
Then there’s the peak. It’s marked by “totally crazy lending.” We’ve seen that peak. One sign: white-hot online peer-to-peer lenders, or rather “platforms” for risky consumer loans. They’re Silicon Valley inventions that were going to revolutionize lending and put banks out of business. They proudly operate with disregard for risks. They borrow from individual and institutional investors and extend unsecured personal loans to consumers. They also repackage consumer loans into bonds and sell them to over-eager institutional investors.
There are many of these platforms, including Lending Tree, CircleBack, LendingClub, LoanDepot, and Avant.
Avant makes unsecured personal loans up to $35,000, ranging from 2 to 5 years. It targets subprime borrowers with credit scores as low as 580 who wish to consolidate debt, i.e. flip their credit-card balances into a personal loan so that they have room to borrow more on their credit cards.
This is expensive debt. There are fees, including origination fees between 0.95% and 3.75% of the loan amount. According to Nerdwallet, which reviewed Avant’s loans, annual percentage rates range from 9.95% to 36%!
No one, least of all a struggling subprime borrower, is going to pay off a five-year loan with an annual interest rate of 36%. Or heck, even 26%. These usurious rates on unsecured personal loans practically guarantee that the borrower will have to default.
Yet, borrowers typically receive funds the same day, according to Nerdwallet, though it may take up to a week in some cases. And investors were eager to buy these loans, which is the definition of “totally crazy lending.” It marked the peak of the bubble.
Then it began to unravel. The amounts may be small in the multi-trillion dollar scheme. But they’re red flags that soothsayers are busily ignoring.
Citing unnamed sources “with knowledge of the matter,” Bloomberg reported that a slew of these subprime consumer-loan backed securities, which had been issued just last year, are already going bad:
Delinquencies and defaults are reaching key levels known as “triggers” for at least four different sets of bonds. Breaching those levels will force lenders or underwriters to start paying down the bonds early. Avant Inc. and its underwriters, for example, are going to have to begin to repay three of its asset-backed notes….
The four deals totaled over $500 million, nearly 20% of the $2.8 billion of online consumer-loan-backed securities sold in 2015. But the securitized loans are only a small portion of the loans arranged by online lending platforms, which in 2015, reached $36 billion. Bloomberg:
Online loans have shown other signs of weakening. LendingClub Corp. last month raised interest rates and tightened its standards for at least the second time this year after seeing higher delinquencies among its customers, especially those with the most debt.
Online lenders arranged only a small part of the $3.7 trillion in non-mortgage consumer debt outstanding, mostly student loans, auto loans, and credit card balances. While credit cards are still holding up, student loans have terrible delinquency rates, and subprime auto-loans delinquencies have jumped to the highest in six years.
LoanDepot began making unsecured online consumer loans last year. By September this year, according to Bloomberg, losses on its consumer-loan backed securities breached the ceilings set by its underwriters. Other online lenders are just trying to hang on:
Avant, based in Chicago, cut its monthly target for lending this summer by about 50%, and decided to shrink its workforce in line with that, while CircleBack Lending, based in Boca Raton, Florida, stopped making new loans earlier this year.
Given the amount of central-bank liquidity sloshing through the system, the unraveling of the credit bubble will likely be a slow drawn-out process starting in these sorts of pockets here and there.