Quarterly Strategy Report: Credit Crunch

April 03, 2023
By Steven Vannelli, CFA in Economy, Markets, News

As banks back away from credit creation, we think certain assets could reassert their leadership. In our Quarterly Strategy Report, we analyze the Credit Crunch.

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1. Summary

  • -The recent banking crisis, with several banks being taken over by the FDIC, has brought the banking system into focus for investors. Investors are still unclear how deposits will be treated in any subsequent bank closure.
  • -Recent academic research suggests there are significant unrealized losses in the banking system, jeopardizing the thin equity cushion on which banks operate and this may be a systemic crisis. It seems likely that banks will have to raise capital, possibly curtail dividends and deal with new regulations. With this backdrop, we think it is likely banks may curtail credit creation for a period, leading to a credit crunch.
  • -Banks have been suffering deposit outflows as money market funds and ETFs offer significantly higher yields to investors. To compete, banks will likely have to raise deposit rates, raising their costs and potentially negatively impacting their earnings.
  • -Lending standards already have been tightening on a range of loan types, from business loans to consumer loans. Greater difficulty getting credit and a diminished demand for credit can be modeled to suggest lower levels of economic growth, employment and inflation.
  • -Since the NASDAQ peak in 2000, M2 velocity (MV=PQ) has been in structural decline. The decline in velocity has been associated with lower interest rates—especially through the term premium channel—alongside gold’s rise. In the stock market, growth stocks outperformed value during this period too. If velocity turns down again, as banks back away from credit creation, we think these assets could reassert their leadership.


2. FOMC Statement March 22, 2023

“The U.S. banking system is sound and resilient. Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation. The extent of these effects is uncertain. The Committee remains highly attentive to inflation risks.”

Source: Federal Reserve, https://www.federalreserve.gov/newsevents/pressreleases/monetary20230322a.htm  


3. Market value of banking system is $2 trillion less when marked-to-market.

“To assess the financial stability of U.S. banks, we use bank call report data capturing asset and liability composition of all US banks (over 4,800 institutions) combined with market-level prices of long-duration assets.3 Our analysis proceeds in multiple stages. Firstly, we examine losses on banks’ assets including their loan portfolios held to maturity, which have not been marked-to-market, as well as securities linked to real estate (such as mortgage-backed securities (MBS), commercial mortgage-backed securities (CMBS)), US Treasuries, and other asset-backed securities (ABS)). These assets comprise more than half of bank assets (72% of $24 trillion dollars)…The market value of U.S. banking system assets is $2 trillion lower than suggested by their book value.”

Source: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4387676 


4. This chart from the FDIC quantifies only the unrealized losses on securities in bank portfolios, which are substantial.

Source: Daily Shot 


5. Is the current banking crisis systemic?

Source: NBER: w31066.pdf (nber.org) 

“In March 2023, policymakers opted for a specific mix of interventions into the U.S. and European banking sectors – designed to support different areas of bank balance sheets in the context of a sudden bout of financial distress. A comprehensive new database documenting and classifying 8 banking-crisis policy interventions over centuries now allows a granular contextualization of current events across a variety of operational dimensions. By combining “lending”, “guarantee”, and “restructuring” interventions, authorities expanded on a long pattern of such actions during distress episodes. But only 57 bank distress episodes over time have seen such a particular mix, and only three have witnessed them combined with relevant private-sector bail-ins. Several of the recent interventions already constitute sizable interventions in long-run context, thereby continuing a secular trend of ever greater policy interventions as measured relative to economic output: but past evidence suggests that these interventions may yet grow substantially further in size and could reach new all-time records. Importantly, conditioning banking crises types on the policy intervention mix suggests that a substantial share of distress events over time showing the presently unfolding intervention pattern eventually assumed “systemic” crisis dimensions, an outcome associated with meaningfully higher financial and real economic costs and dislocations.”


6. Commercial Bank Balance Sheets December 2022

Source: Factset

We’ll refer back to this table in subsequent charts. Equity in the commercial banking system is roughly $2.1 trillion. On the left is a breakdown of aggregate commercial bank balance sheet assets. Above are liabilities and equity.


7. In 2008, the banking system had about $1.2 trillion in equity capital and suffered a $1 trillion drop in the value of their assets. This prompted government interventions, injecting capital into banks.


8. Commercial banks usually get in trouble making bad loans. But this go around, their huge securities portfolios are the issue.


9. One can see the surge in securities purchases relative to loans issued after the COVID pandemic. It is these securities that have been the focus of recent bank failures.


10. Government securities are 80% of their securities portfolio.


11. To be sure, banks are sitting on a large inventory of securities that likely have unrealized losses.


12. Commercial banks have been growing all aspects of their loan books, but for how long?


13. Non-residential commercial real estate loans are a potential problem area for commercial banks. Trying to isolate on these loans, they actually are not at any record high.


14. Bank borrowing, which supplements deposits to fund operations, have been in a downtrend since the Great Financial Crisis (GFC). So, there is not a huge inventory of bank bonds outstanding, possibly helping to insulate contagion into the broader corporate bond market.


15. Encouragingly, banks deposit coverage ratio (cash assets/demand deposits) is at an elevated level. It is down from 2015, but it is still 3x higher than 2008.


16. But, commercial banks have been losing deposits in aggregate, down almost 3% in the last year.


17. The deposits are flowing to higher yielding vehicles like money market funds (MMFs).


18. Water runs downhill, and money moves to where it is treated best. US Treasury yields are well above bank deposit and CD rates, encouraging consumers to shift their money into MMFs and government bond ETFs.


19. Within the banking system, deposits are being withdrawn from small banks and partially placed with larger banks.


20. We’ll learn more in April, but credit conditions have already been tightening for a year. This chart and the next few refer specifically to commercial and industrial (C&I) loans to large and medium firms.


21. There are a variety of indicators of credit standards. Here I focus on the percent of banks that are increasing the cost of credit lines.


22. Banks are also increasing the premium on riskier loans, another form of credit tightening.


23. Banks also have been increasing loan covenants, tying down borrowers with more hoops to jump through.


24. Banks also have been reducing the max credit lines for C&I loans.


25. They also have been increasing collateral requirements for borrowers.


26. Lastly, referring to C&I loans, banks are increasing the cost of credit lines. This and the preceding charts would seem to telegraph a credit crunch coming.


27. Still focusing on corporate borrowers, banks have been severely increasing standards for construction and land development loans.


28. Turning to the consumer, banks have been steadily increasing standards on car loans, making it more difficult for consumers to finance auto purchases.


29. Credit card standards on credit card loans have been tightening on the consumer as well.


30. Piper Sandler performed an interesting analysis* shocking credit standards and demand for credit.

First, they shocked consumer demand for loans by -10%. Then they shocked C&I standards by +10% and Commercial Real Estate by +10%. The results suggest a drop in consumer spending, employment, non-residential fixed investment and inflation.

Source: Piper Sandler, 3/28/23 
*Estimated from impulse responses from vector autoregressions using data starting in 1985 (or later if history is limited) to 2019.


31. Money growth is down -2.4% on a 1-year basis. It is the first time in modern history—as far back as the data goes—M2 has declined year-over-year.


32. Ever since the NASDAQ peaked in 2000, commercial banks loan-to-deposit ratio has continuously fallen. It experienced a bump post-Pandemic, but it is still well below the level that existed pre-NASDAQ 2000 crash.


33. The structural drop in the loan-to-deposit ratio has led to the structural drop in the velocity of money. A credit crunch, reducing bank loan books further, would likely lead to another leg lower in M2 velocity.


34. 10-year US Treasury yields track velocity over time. If velocity does take a leg lower, while money is also declining, it seems likely that longer duration bonds could fall in yield.


35. Looking at the bond market in a different way, one can see how the drop in velocity has been highly correlated to a falling term premium. A leg lower in velocity would seem to suggest a renewed drop in the term premium.


36. Historically, growth stocks outperform value stocks when velocity declines. The short value rotation has been commensurate with the tick up in velocity. Another leg lower in velocity may reverse value leadership. The recent tick lower in value/growth may be telegraphing lower velocity.


37. Fitting with the value/growth dynamics is the relationship between velocity and valuations on the S&P 500. A leg lower in velocity could serve to increase the P/E of the equity market, which would be consistent with growth stocks re-asserting leadership.


38. Another beneficiary of a decline in velocity is gold. Gold’s attempt to break out above $2,000 would be consistent with a leg lower in velocity.


39. Commodities—broadly represented by the Bloomberg Commodity Index (BCOM)—don’t historically fare well when velocity is falling.


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The velocity of money is a measurement of the rate at which money is exchanged in an economy.

M2 is a measure of the money supply that includes cash, checking deposits, and non-cash assets that can easily be converted into cash.

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