A Growing Share of Banks Are Tightening C&I and CRE Credit
The Fed released its 2Q16 Senior Loan Officer Survey yesterday afternoon. The survey was conducted between March 29 and April 12 and covers lending standards and loan demand across business and consumer loan categories.
In the previous survey (1Q16), we flagged that two of three C&I measures and CRE standards were tightening, on balance. Not only are those measures still tightening, an even higher percentage of banks are now tightening C&I and CRE standards.
A small silver lining is that consumer lending remains largely benign; a net positive percentage of banks continued to report easing of consumer lending standards.
The primary takeaway this quarter:
1. A net percentage of banks tightened C&I lending standards for the third quarter in a row, and that percentage was even higher than in 2Q16 than in 1Q16. Moreover, demand for C&I loans was net negative for the second quarter in a row. 12% of banks tightened C&I standards for large and medium firms (6% for small firms), up from 8% (4%) in 1Q16. Additionally, 9% of banks reported less demand for C&I loans from large and medium firms (3% from small firms) in 2Q16.
Why this matters: We've gone back historically and looked at the Senior Loan Officer Survey many different ways in an effort to discern its usefulness as a forward indicator. After much trial and error, our biggest takeaway is that when two of the three C&I questions have turned negative historically, it has portended a recession in the near future. This isn't coincident; it's causal. Banks tightening the screws, increasing the price of money or reporting reduced demand for money all portend a slowing of economic activity. The problem is that the cyclical activity tends to autocorrelate, or self-reinforce. In other words, banks tighten credit => consumption/investment decline => workers are laid off => delinquencies rise => banks further tighten credit => and so on and so forth. Below is a chart showing the three questions in the C&I survey back to 1990. To be clear, we've inverted the primary y-axis and we've also reversed the demand question so that all three categories are directionally consistent, i.e. when credit is constricting/price is rising/demand is falling, the survey measures on this chart fall, and vice versa.
Perhaps of equal interest is the fact that the Fed has historically had an enormous policy cushion in response to recessions. The table below shows that since 1969, the Fed has eased by an average of 750 bps in response to every recession. The last two cycles have seen the Fed ease by 560 bps and 520 bps. The challenge this time around is that the Fed's current policy cushion is 36 bps.
To summarize, credit conditions are tightening, which has historically ushered in a recession, and the Fed is short by around 5 percentage points on its ability to soften the blow.
The Data: As the chart below illustrates, the percentage of banks tightening C&I lending standards for large and medium firms increased to 11.6% in 2Q16, up from 8.2% in 1Q16 and 7.4% in 4Q15.
The secondary takeaway this quarter:
2. More banks are tightening CRE standards. Commercial real estate lending also saw continued and heightened tightening this quarter across all three categories: Construction & Development (C&D), Nonfarm Nonresidential, and Multifamily. Unfortunately, the survey format changed with the 4Q13 survey when the Fed replaced the single category of CRE loans with the three aforementioned subcategories. As such, it's not possible to compare apples to apples historically. That said, in the 11 quarters since the new format began, this marks the fourth (and fourth consecutive) quarter in which standards have tightened on C&D loans. It marks the third (and third consecutive) quarter in which Nonfarm Nonresidential loans have seen standards tighten. The Multifamily category has been bouncing between easing and tightening over the last two years, but it has never reached as high as the 36.2% of banks tightening this quarter.
The tertiary takeaway this quarter:
3. More banks expect pain from O&G loans than they did in 1Q15. One year after asking survey participants what they expect in the O&G space, the survey again included this line of questioning, and, not suprisingly, sentiment is worse this time around. As the first chart below shows, a net 63% of banks now expect delinquencies and charge-offs to deteriorate for their existing loans to firms in the oil and natural gas drilling/extraction sector over the remainder of 2016. That is up from 57% in 2015.
The one positive here is that banks are decreasing their O&G exposure. The second chart below shows that 87% of banks are now keeping their O&G loans under 10% of their book, up from 82% in 2Q15.
Given the persistence of and increasingly negative responses in the C&I and CRE lending categories, we appear to have reached the inflection point signaling that credit expansion is past peak. The chart below looks at the historical C&I lending standards (LHS) juxtaposed against the S&P 500 Financials Index (RHS). C&I lending standards have historically begun tightening coincident with or ahead of peaks in Financial equity prices. We've highlighted in green the periods during which Financials stocks have risen. In the 1990s it was clear that lending standards were tightening by late 1999, suggesting the roll was near. In the 2003-2007 period standards began to tighten in 2007.
A Review of the Senior Loan Officer Survey by Category:
C&I: Canary Carcasses Everywhere
C&I loans have signaled the credit cycle peak with standards tightening for three quarters in a row now. The net percentage of banks tightening standards for loans to large firms moved from +8.2% in 1Q16 to 11.6% in 2Q16. Additionally, +5.8% of banks tightened standards for C&I loans to small firms.
* Standards are tightening
* Demand is falling
* Spreads are not yet increasing, but the net percentage of banks easing is converging towards zero as the third chart below shows
CRE: Tightening Across the Board
Banks tightened standards for all three CRE categories in 2Q16. Additionally, the percentage tightening standards for multifamily loans, which had previously swung back and forth from negative (good) to positive (bad), saw a marked tightening (+36.2%) in 2Q16.
Meanwhile, although demand for CRE loans again increased in the second quarter, the rate of change is clearly decelerating, as the second chart below shows.
Residential Mortgage: Mostly Easing
Starting in 1Q15, the Federal Reserve broke the survey's residential Prime and Nontraditional categories into six new categories and kept the Subprime category for a total of seven different categories. The six new categories include: (GSE-Eligible, Government, QM non-jumbo/non-GSE eligible, QM jumbo, Non-QM jumbo, and Non-QM/non-jumbo).
The categories we're most interested in are the GSE-Eligible (Fannie/Freddie) and Government categories (FHA/VA) since these two categories account for ~90% of all origination volume. The GSE-Eligible category showed 11.3% of banks, net, eased standards Q/Q in 2Q16. Government standards were unchanged. While subprime responses were too few to be shown, all four other categories eased.
We pay little attention to the demand component of the Fed's Survey because it reflects shifting refi demand and isn't a good barometer for purchase activity. Nevertheless, we include both charts below.
Consumer Loans: Easing
Standards for credit cards, auto loans, and consumer loans ex-cards and autos all eased in the second quarter.
Joshua Steiner, CFA
Jonathan Casteleyn, CFA, CMT