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Tuesday, March 27, 2007

GUH Part 2

The question of the day: "Commercial debt, wherefore art thou different and distinguishable from consumer debt?"

Well, in a lot of cases commercial really isn't. Consumer debt turns into purchases from commercial operations, and both production and consumer credit may be funded by commercial paper. In the last five years commercial asset-backed securities have increased in a similar pattern to consumer ABS. Commercial debt is used for trading on margins, etc, in the same way consumer debt is.

If you consider two of the largest uses of commercial credit, you can understand how intertwined consumer and commercial credit are. Most mortgages are funded with warehouse lines of credit made to originators, which are then repaid when these loans are securitized and sold to investors. Most construction is funded with commercial lines of credit which are repaid when the project is finished and sold. Commercial construction may be sold to commercial RE investors, and then rented, and consumer construction is generally sold to the end-user (in which case the commercial paper is repaid by consumer mortgages) or to RE investors who get another commercial mortgage.

A great deal of small business credit originates either from credit cards or from RE-backed lines of credit. Banks have regulatory limits on how much unsecured lending they can do. If collateralization on a loan or line of credit is considered lacking, the bank is constrained by regulation to offset that risk by investing in extremely safe and extremely low-return investments. These investments generally return less than than the interest the bank must pay on deposits, which sharply cuts into the expected profits from the loan.

So while small business credit is profitable for banks, it requires careful management and generally is issued backed somehow by both consumer assets and by demand clauses so that the bank can limit its losses. Pricing on commercial debt should reflect the risk involved, including the risk of reserves required to carry the debt. Whenever you get into a situation in which the only real way to cover risk is to call the debt, you run the risk of inducing a secondary credit-caused downturn on top of a soft patch in the economy.

The Federal Reserve puts out a weekly summary of Commercial Paper:Rates and Outstanding which gives an interesting outlook on short-term costs and trends in commercial credit. This chart shows outstanding:

You can see how much asset-backed commercial debt has grown since 2001. Only the blue line (non-financial) is scaled to the left. If you will look at the right of the graph, you will see that all three categories have taken a turn down recently. It is early days yet, but it looks like a contractionary signal.

What has happened is that more commercial paper has been acquired by non-bank lenders. For the commercial entities borrowing, the cost is generally less due to the fact that the marketplace does not have the same regulatory requirement to compensate for risk (see the previous paragraph). However, the logical corollary is that in an economic downturn, these lenders will refuse to renew at similar terms in order to compensate for risk! The competition from the general marketplace has generally induced looser commercial credit terms at banks as well, and in the beginning of last year several banks I truly respect had largely backed off pursuing commercial credit because of the relatively low rate of return it offered in relation to the degree of risk.

To summarize, the same trends we have seen in consumer ABS (asset backed securities) have governed commercial debt. For example, one of the dictates in the C&D issued against Fremont was that they could no longer renew commercial loans by rolling into the new principal amount unpaid interest from the previous debt. Nor are they the only bank which has been C&D'd for this practice or for undercolllateralization and ALLL deficiencies.

The trend, then, in commercial credit has been similar to the trends governing consumer credit. Loan terms were easy, risk-based pricing has been an almost forgotten concept, and the prevailing belief was that if a loan became a problem one could always refinance out of it. Whether the borrower could actually repay even the interest on the principal borrowed became of relatively little concern, because the theory was that there would always be another refi to prevent the present lender from having to recognize any loss.

See, for example, the discount rate spread chart from the Fed release:

As you can see, the spread (difference between interest rates charged between risky and safe credit) has been steadily diminishing for years. Unlike consumer credit, the spread has not yet begun to be restored. However, delinquencies are rising and it looks as if the economic slump will accelerate that trend. When that happens, businesses will have to spend more of their profits paying off debt, and it is likely that this will occur when their profits are tending to shrink anyway.

I cannot look at such information and believe that we are not facing a situation in which both business and consumer spending will not be constrained by the need to pay off or keep up with huge extensions of credit over the last half a decade. Until the fourth quarter of 2006, consumers were essentially repaying debt with more debt, generally in the form of home equity loans. Now that is reversing itself, and the results can already be seen in retail sales.

The top-off in the outstanding credit graph indicates that the same is beginning to occur in commercial credit. As with consumer credit, the moment the easy refi stops delinquencies are doomed to rise.

We are beginning to see the first signs of those delinquencies in yet another Fed release - the euphoniously named Charge-offs and Delinquency Rates on Loans and Leases at Commercial Banks. In the fourth quarter, seasonally adjusted delinquencies for commercial RE loans took a significant step up, even compared to consumer. Consumer RE loan delinquencies increased 17.9% from the fourth quarter 2005, but commercial RE loan delinquencies increased 23% from 4th Q 2005 to 4th Q 2006. If you look at the non-seasonally adjusted figures, it looks considerably worse! NSA consumer RE delinqencies increased 18.5% in one year, whereas commercial RE delinquencies increased 23.3%. Commercial is lagging consumer, but commercial delinquencies are increasing faster at banks.

Needless to say, commercial RE delinquencies are increasing more rapidly at small banks than at the 100 largest banks. On the other hand, consumer RE delinquencies are increasing more rapidly at the 100 largest banks than at small ones. Overall loan and loss delinquency rates in the fourth quarter were similar to those seen between the second and third quarters of 2004. Chargeoffs will follow.

Lender surveys did show some tightening in loan standards, and so all the data agrees - we have a commercial credit bubble of sorts, and the compensation process will exert some drag on the economy going forward. It's possible that the commercial credit bubble may turn out to be worse or approximately equivalent to the consumer bubble. Again, the first problems in commercial credit showed up in an expanding economy, so a slowing economy is expected to inflict a sharp exacerbation.

Margin credit for trading of equities, commodities and currencies has been running very high as well. At some point all of this is going to catch up with us. Everyone hopes that this will occur in the form of a slow and orderly tightening. That is the best case scenario.

Mama, this does not sound very good.
For the average person, what's your advise?

We are seeing a bunch of homes going up for sale all over The Woodlands, Texas but still new ones are being build everywhere.

Thanks for your posts. They are always very informative!
WOW! You are more than an analysis. You’re a great teacher. If you ever offer a course on line; please advise me. I’ve been perusing economic blogs for a long time; and, while I get a lot of facts (e.g. charts) I can never seem to get a picture of how the economy works. These last two postings of yours give me a real sense of the interrelatedness of facts posited.

By the way, I’m the fellow whom you kindly translated Cui Bono for over at CR. I posted a thank you in the comments section a couple of articles back. You may be interested, since you don’t go to movies, last night I saw the movie The Departed and one of the characters used the expression ‘cui bono’ and translated it as ‘who benefits.’ Obviously, he doesn’t know Latin, as you seem to do. How does a techie come to know Latin? I wonder if Tanta picked up the phrase in the movies.

At any rate, thanks again for the translation and steering me to your blog. It will be a daily read from now on.
Viola, I will try to post some practical advice soon. It's difficult, because there really are no "average persons". What works for one thirtyish person is not good for a late 40s person, and also it all depends on exposures.

I will try.
Tom - I took Latin in high school, because it is very helpful if you are scientifically inclined. Tanta went to Catholic school, so I'm sure she picked hers up there.

Thank you so much for the kind words.
I totally understand that. We are in our mid 40's but I know the age spectrum is large out there on the net. I always like practicle applications and you are so good at what you do. Just do it if you have time though.

Thanks so much. I really enjoy your posts!
We are seeing a bunch of homes going up for sale all over The Woodlands, Texas but still new ones are being build everywhere.

Those are called "roof farms". Las Vegas even has highrise condos where they stopped construction halfway through pouring the structural framework. Ran out of money as the buyers/suckers backed out. Just half-completed concrete frameworks sitting there. Empty & Unfinished.

I expect the same thing of the QUARTER-MILE RADIUS of bulldozed ground to the west of Anaheim Stadium with all the construction fences touting "LUXURY HIGHRISE CONDOS STARTING *CHEAP* AT 1 MILLION!!!"
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