Meanwhile Behind The Scenes: Banks Quietly Slash Loans As They Prepare For The Next Recession

Reading through the Fed's latest Senior Loan Officer Opinion Survey (SLOOS), revealed absolutely nothing to be concerned about when it comes to loan demand and loan standards (aside from a warning that a yield curve inversion would, predictably, result in substantially tighter financial conditions): as we noted one month ago, the net percentage of banks reporting easier standards on loans to large- and medium-sized firms stayed flat at 16%, while standards for small firms were basically unchanged on net. At the same time, terms on C&I loans eased somewhat for large- and medium-sized firms, as 27% of banks surveyed (in net terms) reportedly narrowed spreads of loan rates over the cost of funds; other terms, such as premiums charged for riskier loans, loan covenants, and collateralization requirements, all eased somewhat.

There is just one problem with the above: none of it is true.

In fact according to a Reuters investigation, when looking behind headline numbers showing healthy loan books, "problems appear to be cropping up in areas such as home-equity lines of credit, commercial real estate and credit cards" according to federal data reviewed by the wire service and interviews with bank execs.

Worse, banks are also starting to aggressively cut relationships with customers who seem too risky, which in a time when 3M USD Libor just hit a fresh decade high despite a flattening in short-term TSY yields, is to be expected: after all financial conditions in the real economy, and not the markets, are getting ever tighter and the result will be a wave of defaults sooner or later.

Quoted by Reuters, Andy Schornack, CEO of Flagship Bank Minnesota, told Reuters that "we are in somewhat of a goldilocks period of banking" as "interest rates are high enough that you can make good money and credit quality is at high enough levels where it’s pretty hard to lose money.”

It won't last.

Bank executives admit that the U.S. economy is probably in the final stages of a long recovery from the 2007-09 global financial crisis, Reuters warns, but they say that until credit metrics start to deteriorate meaningfully, there is no reason to boost reserves or slash customer financing.

"There is a big disconnect at this point in time between the market technicals and what we’re really seeing on the ground, said Citi CFO John Gerspach at an industry event last week. "The fundamentals still look very good" he added optimistically, with his banking peers echoing his comments, including Bank of America CEO Brian Moynihan, Wells Fargo CEO Tim Sloan, and JPMorgan Jamie Dimon.

And yet, despite this alleged "goldilocks" environment, and despite bank reports disclosing delinquency and default rates which remain near historic lows, as do industry reserves and charge-offs for bad debt, banks have started to pull back.

Here are the all too clear signs that banks are starting to prepare for the next recession by slashing and/or limiting risky loan exposure:

  • First, nearly half of the applications from customers with low credit scores were rejected in the four months ending in October, compared with 43 percent in the year-ago period, according to a survey released by the Federal Reserve Bank of New York.
  • Second, banks shuttered 7 percent of existing accounts, particularly among subprime borrowers, the highest rate since the Fed started conducting surveys in 2013.
  • Third, home-equity lines of credit declined 8 percent across the industry, with growth slowing in areas such as credit cards and commercial-and-industrial loans, the survey showed.

Then there are the bank-specific signs, starting with Capital One - one of the biggest U.S. card lenders - which is restricting how much it lends to each customer even as it aggressively recruits new ones, CEO Richard Fairbank said last week.

"We have been more cautious in the extension of credit, initial credit lines, the broad-based credit line increase programs," he said. "At this point in the cycle, we’re going to hold back on that option a bit."

Also, contrary to what the SLOOS reported, regional banks have become more cautious lately as well, as they avoid financing riskier projects like early-stage construction loans and properties without pre-lease agreements (here traders vividly recall the OZK commercial real estate repricing fiasco that sent the stock crashing).

New Jersey’s OceanFirst Bank has also pulled back on refinancing transactions that let customers cash out on their debt, and has started reducing exposure to industrial loans, CEO Chris Maher told Reuters.

“In a downturn, industrial property is extremely illiquid,” he said. “If you don’t want it and it’s not needed it could be almost valueless.”

The banks' cautiousness has backfired on their own stocks, because between collapsing loan issuance - amid concerns of an imminent recession - combined with the looming threat of an inverted yield curve, have sent bank stocks down more than 13 percent since the first trading day of the month, according to the KBW Nasdaq Bank Index .BKX.

What happens next? While a recession is now guaranteed, especially as it becomes a self-fulfilling prophecy with banks slashing loans resulting in even slower economic growth, resulting in even fewer loans, and so on, with the only question whether it is a 2019 or 2020 event, bankers and analysts remain optimistic that the next recession will look much more like the 2001 tech bubble bursting than the 2007-09 global financial crisis.

We wonder why they are so confident, and statements such as this one from Flagship Bank CFO Schornack will hardly instill confidence:

“I lived through the pain of the last recession. We are much more prudent today in how we underwrite deals.”

We disagree, and as evidence we present Exhibit A: the shock write down that Bank OZK took on its commercial real estate, which nobody in the market had expected. As for banks being more "solid", let's remove the $1.6 trillion buffer in excess reserves that provides an ocean of artificial liquidity, and see just how stable banks are then.