In what has emerged as most concerning "anti-recovery" narrative, last week we most recently showed that both total and C&I loan growth had been slowing down sharply in recent weeks, with commercial and industrial loans growing just 2.9% recently.
While there had been no definitive explanation for this sudden slowdown, which recently prompting the WSJ to inquire "who hit the brakes?" overnight Goldman analyst Spencer Hill ventured one explanation which appears plausible. In a note titled "The C&I Loan Growth Slowdown and the Credit Line Payback Story" the Goldman economist writes that the cognitive dissonance triggered by a sharp deceleration in C&I (commercial and industrial) loan growth amid generally encouraging growth data may be explained by energy sector contraction in 2015, 2016.
According to Goldman, the reason for the slowdown may come down to nothing more than a base effect as many commodities firms began drawing on credit lines in late 2015 as financial conditions tightened, and the debt issuance window closed. Then, after a brief acceleration in early 2016, bank loan growth waned in late 2016, early 2017, once capital markets reopened and banks renegotiated, restructured credit lines. As a result, the recent slowdown is merely a function of stable demand in 2017 relative to a burst in loan activity in early 2016.
Hill suggests that other possible explanations, like less investment demand or sudden tightening in credit conditions, seem at odds with recent growth, financial indicators, although there is no way to know definitively.
That said, Hill notes that C&I lending accelerated during financial dislocations of autumn 2008 as businesses drew on credit lines; after peaking in Oct. 2008 near the height of the crisis, C&I lending declined for 24 consecutive months, lagging broader economic recovery of 2H 2009 and 2010, as businesses gradually de-levered balance sheets and repaid (or defaulted on) bank loans. The Goldman economists sees a version of this narrative playing out again today, though on a smaller scale mostly within the energy and commodities sectors.
He caveats his assumption by saying he believes "reasonable estimates" based on available data suggest an impact of this magnitude; and lacks comprehensive data demonstrating commodities sector accounts for most C&I bank lending deceleration. In other words, while plausible, it is merely a theory.
Here is the report summary:
The C&I Loan Growth Slowdown and the Credit Line Payback Story
- The sharp deceleration in commercial and industrial loan growth has generated a sense of cognitive dissonance among market participants, who are otherwise confronting generally encouraging growth data. Candidate explanations such as a step-down in investment demand or a sudden tightening in credit conditions seem at odds with recent growth and financial indicators, including a strong start to the year for corporate debt issuance.
- An alternative explanation is that C&I bank loans represent yet another casualty of the energy sector contraction of 2015 and 2016. More specifically, we believe the current C&I slowdown reflects payback from credit facility usage by commodities firms, many of which began drawing upon credit lines in late 2015 as financial conditions tightened and the debt issuance window closed. Following a brief acceleration in C&I lending in early 2016, bank loan growth waned in late 2016 and early 2017 once capital markets reopened and banks renegotiated and restructured credit lines. Available loan data are consistent with the timing and sector-level incidence of these inflections, and in our view, the credit line payback story is the most likely explanation of the current C&I loan shortfall, which we peg at roughly $100bn.
And the details:
Following further improvement in US survey data and several encouraging real activity reports, our Current Activity Indicator (CAI) is now showing 4.0% for March, and our tracking estimate of Q1 GDP growth remains at an encouraging pace (+1.8%). Against this backdrop of fairly broad-based improvement, one notable laggard has been commercial and industrial (C&I) bank lending, which has exhibited an outright decline over the past six months. As Exhibit 1 illustrates, the magnitude of the slowdown is large, and we estimate the shortfall relative to the previous trend at roughly $100bn.
Source: Federal Reserve System, Goldman Sachs Global Investment Research
While C&I lending generally declines during and after recessions, its relationship with the business cycle is inconsistent, sometimes exhibiting counterintuitive behavior. For example, C&I bank loan growth accelerated during the financial dislocations of autumn 2008 as businesses drew upon credit lines in the wake of the credit crunch. After peaking in October 2008 near the height of the crisis, C&I lending declined for 24 consecutive months – lagging the broader economic recovery of 2H09 and 2010 – as businesses gradually de-levered balance sheets and repaid (or defaulted on) bank loans. We believe a version of this narrative is playing out again today, yet on a smaller scale within the energy and commodities sectors.
Debt markets seized up in late 2015 as oil prices fell into the mid-40s – below the break-even cost of production for many US shale producers – and the high-yield issuance window closed for roughly ten months (August 2015 – April 2016). Lacking access to capital markets and with internal cash generation impaired by lower commodity prices, many exposed firms were incentivized to draw upon pre-existing credit facilities. Overall C&I lending accelerated during this period, as visible in Exhibit 1.
At the same time, the deterioration in commodity prices weighed on financial results and interest coverage ratios in that sector, resulting in deteriorating overall C&I credit quality (see left panel of Exhibit 2). Within the commodities sector in particular, financial institutions recorded over $150bn of bank loans as either “Classified” or “Special Mention” – two classifications indicating potential credit concerns – based on data from the Office of the Comptroller of the Currency (right panel of Exhibit 2).
Exhibit 2: Non-Performing Bank Loans Began to Increase in Late 2015, Largely Reflecting Deteriorating Credit Quality Among Commodities Firms
Source: Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, Goldman Sachs Global Investment Research
While the weekly bank lending data from the Federal Reserve System lacks industry-level granularity, quarterly data from company financial reports indeed suggest that some oil and gas firms significantly increased bank borrowing in early 2016, then subsequently drew down these balances over the remainder of the year. As shown in the left panel of Exhibit 3, publicly traded US energy firms reduced their balances of short-term borrowings by 35% (or $11bn) between 1Q16 and 4Q16, following a sharp rise during the previous 3 quarters (that itself coincided with commodities-related credit stress).
Additionally, US oil & gas bankruptcies over the last two years have totaled over $70bn in terms of cumulative liabilities (right panel, Exhibit 3). To the extent that some of these liabilities represent bank loans, any subsequent defaults or collections would also reduce the current level of C&I lending. The timing and sector-level incidence of these various inflections are consistent with a “credit line payback story,” in which temporary credit facility borrowings in early 2016 were gradually paid back, as capital markets reopened and as banks renegotiated and restructured some credit lines.
Exhibit 3: Publicly Traded Energy Firms Reduced Short-term Borrowing by 35% Since 1Q16; Liabilities Associated With Oil & Gas Bankruptcies Totaled Over $70bn Since 2014
Source: Bloomberg LP, Dow Jones, Goldman Sachs Global Investment Research
Annual data from the Shared National Credits Program (Office of the Comptroller of the Currency) offers valuable sector-level insights in terms of the sizes of these credit facilities, and the most recent report (1Q16) shows total bank loan commitments to commodities firms totaling $938bn. More general research by the San Francisco Fed suggests that firms draw upon roughly a third of their credit lines during periods of tight credit conditions (on average). Additionally, FDIC data show that most C&I loans are made under commitment (81% on average in 2016).
Based on these considerations, a decline in credit facility usage by commodities firms – driven by a combination of voluntary repayments, collections, and defaults – would arguably be large enough to explain the current shortfall in C&I loan growth. For example, assuming the commodities sector was borrowing a third of its available loan commitments as of quarter-end 1Q16, then a 35% reduction in this balance over the remainder of the year would result in a decline in bank lending of $108bn.
While we lack comprehensive data to demonstrate that the commodities sector accounts for the lion’s share of the deceleration in C&I bank lending, we believe reasonable estimates based on available data suggest an impact of this magnitude. Additionally, the alternative narrative of a sudden economy-wide credit crunch or investment bust seems at odds with the other information we have about the economy. Despite some softening over the last two weeks, investment grade issuance started the year at a record pace, and the high yield issuance window is now open, even for oil and gas companies. These trends are also reflected in other indicators of investment demand, credit supply, and financial conditions, as illustrated in Exhibit 4. Taken together, we see the “credit line payback” hypothesis as the most plausible explanation for the recent C&I lending weakness.
Exhibit 4: Broader Indicators of Credit Supply and Credit Demand Suggest Minimal Cause for Concern
Source: Bureau of Labor Statistics, Department of Commerce, Federal Reserve System, Bloomberg LP, Goldman Sachs Global Investment Research
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If Goldman is correct, expect C&I loan issuance to spike every time oil slides and E&P companies rush to either draw down fully on revolver capacity and/or refinance existing debt with more debt. Alternatively, if and when oil is higher and working capital funding needs decline, companies may reduce their revolving credit needs, pay down secured debt, and lead to a reduction in overall loan growth.
That said, it will be interesting to see E&P companies in fact do this: if the events of 2016 taught us something, it is that when oil prices tumble and the borrowing base declines, it is then that companies are most in need of excess funding. As such it is unlikely that they will seek to actively reduce revolver borrowings, unless of course Libor and/or PRIME rise to the point where paying for the excess "revolver" cash on the balance sheet becomes uneconomical.
In any case, within the next few weeks we should know whether Goldman's theory is right: if loan growth stabilizes as last year's burst in secured credit borrowing is anniversaried, it will indeed suggest that E&P companies were the marginal swing factor in C&I loan issuance. If demand however continue to decline, the more unpalatable answer will have to be considered.