Credit cockroaches

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Good morning. Yesterday would have brought the CPI inflation report, were the US federal government open for business. But the shutdown drags on, so we have to settle for anecdata — such as Walmart US CEO John Furner saying on Wednesday that consumers are resilient and that “this is a very strong economy we’re operating in”. Send us your own observations, whether you run a huge company or not: [email protected].

Credit cockroaches: idiosyncratic or systemic? 

JPMorgan Chase took a $170mn charge-off stemming from the bankruptcy of the subprime auto lender Tricolor in the second quarter. “We make mistakes”, CEO Jamie Dimon noted earlier this week. But he predicted he and his bank would not be alone for long. “My antenna goes up when things like that happen. And I probably shouldn’t say this, but when you see one cockroach, there are probably more . . . everyone should be forewarned on this one.”

The cockroach metaphor was already familiar, but it became the cliché of the moment when Dimon used it.

Tricolor and the car parts supplier First Brands were the first two bugs. And just as Dimon predicted, two more nasties have scurried out from under the refrigerator. On Wednesday afternoon, Zions Bancorp disclosed in a regulatory filing that it “recently became aware of . . . apparent misrepresentations and contractual defaults” by two corporate borrowers that did not respond to the bank’s subsequent inquiries, and would take a $50mn writedown on the loans.

And on Thursday another mid-sized bank, Western Alliance, disclosed that back in August it had initiated a fraud lawsuit against one of its commercial real estate borrowers. The bank said that it believed the collateral covered the loan, but the market wasn’t waiting around to see a realtor’s report. Both Zion and Western alliance sold off hard yesterday.

The wider market responded, too. Not only did bank stocks sell off, dragging the wider market with them, but the two-year Treasury yield fell sharply and the dollar index weakened. All of this suggests that the market is pricing in some possibility that the cockroaches signal a wider problem, either in the financial system or the economy — a problem the Federal Reserve might have to respond to by cutting rates faster than expected (The jitters may not all be down to credit bugs, we should note. On Thursday a bank, or banks, tapped the Fed’s standing repo facility for the second day in a row, a rare-ish occurrence suggesting illiquidity in the money markets, which could have added to the nervy atmosphere).

A financial pundit who predicts that a systemic crisis is not imminent is a special sort of sadist. If you get it wrong, it’s the kind of mistake people remember, whereas dire prognostications are forgotten the instant they are falsified. But we try to follow the evidence at Unhedged and, so far, the evidence suggests that the recent crack-ups are more or less idiosyncratic casualties of a hot credit market, rather than symptoms of a deeper systemic or economic issue. To extend the entomological metaphor: there will be more cockroach sightings, but termites don’t appear to have chewed through the foundation.

For one thing, both the collapses of Tricolor and First Brands and the bad loans at Zion and Western Alliance are all linked with alleged fraud, and fraud is not necessarily or even usually systemic. “In the past few years, we have had a material tightening of credit spreads and too much money chasing too few assets, and that has led to lazy underwriting,” says Kyra Fecteau, a fixed income portfolio manager at Wellington Management. Similarly, Marc Rowan of Apollo recently told the FT that such “late-cycle accidents” result from a rush of money chasing borrowers: “It’s a desire to win in a competitive market that sometimes leads to shortcuts.”

Of course fraud can be a symptom of larger problems, or even cause them. Borrowers might resort to fraud because they are under economic pressure. And a bad enough fraud — something on the scale of Enron, say — might lead to an asset market correction big enough to drag down the economy. But as of today, there is little evidence of a larger problem. Default rates for leveraged loans and high-yield bonds have been falling, not rising, according to Moody’s:

And despite the recent accidents, overall provisions and write-offs in banks’ third-quarter reports have been lower than in the second quarter, and lower than analysts expected. After it disclosed its borrower lawsuit, Western Alliance confirmed that its “criticised” (impaired/under review) assets are now lower than at the end of the second quarter. Outside of specific sectors such as housing, the economy looks solid enough, if you accept that low job creation is an artefact of immigration policy and demographics. Yes, the consumer economy is K-shaped, and buoyed by the rich. But that is an old story.

Absent more evidence of wider systemic issues or an economic slowdown, Unhedged is not going to scream at the sight of a bug or two. But we remain vigilant.

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