With the manufacturing side of the economy now openly in recession (based not only on earnings call confessions, regional Fed surveys, but an inventory-to-sales spread that has never been greater and is screaming liquidation, as well as an energy sector that has been in freefall for the past year), and the US consumer - that 70% component of US GDP - slamming into a wall following not only three months of disappointing payrolls, non-existent wage growth, plunging retail sales, a high-end consumer that has stopped spending, and the lowest consumer confidence measured by Gallup in 2015, not to mention GDP itself, there were just two pillars of the so-called recovery that had not yet been crushed: housing and loan growth.
Then yesterday, courtesy of the largest US mortgage lender, Wells Fargo, we learned that housing (all housing, not the tiny subset that is the all-cash "market" for ultra-luxury duplexes in NYC or San Fran which is only a function of how much laundered money Chinese oligarchs can park into the new "Swiss bank account" that U.S. real estate has become) was also rolling over after the worst quarter for mortgage applications in since the abysmal 2014.
Which left commercial bank loans as the last remaining pillar of any so-called "recovery."
It was here, that after posing virtually no growth for over two years, starting in 2012, US bank lending, led by Commercial and Industrial or C&I lending growing at a double-digit pop, started to rise at an impressive pace, asking many to wonder: maybe the biggest driver for a sustainable economic recovery is in fact present, because where there is loan demand, there is velocity of money.
Then a few years later, as the loan growth persisted with virtually no above-trend GDP growth to show for it, some - such as us - wondered: we know there is a "source of funds", but what about the "use of funds."
The first flashing red flag appeared last July, when we reported that companies were using secured bank debt to repurchase stock: a stunning, foolhardy development, comparable to taking out a mortgage on one's house and using the proceeds to buy deep out of the money calls on the S&P 500.
This is what the FT said at the time:
For the top 25 US commercial banks by assets, C & I lending grew by 10.5 per cent in the quarter to June 25 from the previous quarter, according to annualised weekly data from the Federal Reserve.
This type of lending is an important source of business for the largest US banks, representing about a fifth of all loans made by the likes of Bank of America, JPMorgan Chase and Wells Fargo, according to Citigroup research. While low interest rates have made business lending less lucrative, the relationships it forges open doors for the banks to sell other services such as treasury management, hedging and leasing.
A second corporate banking executive at a large regional lender said: “The larger part of the usage in the market right now are loan refinancings where companies are paying dividends back out.” He added: "They’re requesting increased loans or usage under a lien in order to pay a dividend or equity holders of a company. Traditionally banks have been very cautious of that."
Incidentally we explained all of this back in April of 2012 when we laid out why there simply can not be capital spending-fueled growth, when corporate shareholders can make far greater and faster profits using funds to splurge on buybacks, dividends and M&A - uses of capital that generate little or zero actual revenue growth.
After scratching our heads for a few weeks afterward, we let the subject go: after all there is no way banks would be lending companies secured loans to use the proceeds to cash out existing stakeholders, in the process asset-stripping the corporation. This would mean that the loan officers at these banks are either criminally stupid, or corrupt and have been bribed by the borrower to close their eyes when signing the dotted line and wiring the funds.
We promptly forgot this bizarre tangent into the "use of loan funds"... Until today when we found that it was, indeed, all a lie and that the banks themselves had become complicit in perpetuating not only the worst possible capital misallocation, but being an accessory to the US stagnation, soon to be replaced with full-blown recession.
This is what CLSA's Chris Wood found when looking at the several most recent loan officer surveys:
... from the standpoint of the corporate sector, zero rates tend to encourage financial engineering over capital spending while also allowing non-competitive businesses to survive for longer. The financial engineering incentive provided by such policies has been most evident in America where share buybacks and M&A activity have surged even as capital spending has continued to disappoint. Thus, the latest data shows that S&P500 share buybacks and dividends rose by 6.6% YoY to a record US$923bn in the year to June, while total reported earnings declined by 8.4% YoY to US$841bn over the same period.
And here is the punchline:
Similarly American banks, in terms of the quite impressive pickup seen in commercial and industrial (C&I) loan growth (see Figure 10), have been financing financial engineering, be it M&A or share buybacks, not capex. Thus, C&I loans rose by 10.7% YoY in September. Yet in the Fed’s July Senior Loan Officer Survey, 26% and 18% respectively of US banks reporting stronger C&I loan demand stated that the ‘very important’ reason for stronger loan demand over the past three months were financing needs for M&A and debt refinancing, compared with only 6% for capital investment (see Figure 11). Meanwhile, the lack of healthy creative destruction associated with zero rates has long been associated with the Japanese experience of so-called zombie borrowers.
There is the explanation of the paradox of surging C&I (and overall) loan growth, which took place even as overall economic growth and capital spending never followed. The reason? All that secured C&I debt was going not toward growth capital spending, or even maintenance/replacement CapEx, but simply into financial engineering: M&A and debt refis, the first to cash out the CEO of the acquiring or target company (with the generous blessings of the lender bank), the second to lower the cost of debt so more cash could be retained however not to grow the business but simply to fund the equity portion of said M&A.
Meanwhile the loan demand associated with actual economic growth: a paltry 6% of the total!
And while we are delighted to close the loop on this last "leg" of the recovery stool, one which stuck our like a sore thumb against a rapidly deteriorating economic landscape, confirming that we are indeed facing a recession and a very ugly one at that since the Fed can no longer cut rates even as the "economic-impact" credibility of QE is gone, what is more important is that this should be a lesson to everyone to remember that when money is transferred or when a loan is made there are always two sides to the equation: a sources of funds, and a use of funds. Because while everyone was focusing on the former, nobody remember to look at the letter.
It is the latter that has made all the difference to the US recovery, or complete lack thereof.