This week, the American Bankruptcy Institute posted an article (which is reprinted below) identifying a growing trend that may impact a large sector of the economy: alternative lenders making risky loans. As many know, the 2008-2009 meltdown ensnared a lot of big and established financial institutions and if not for substantial government intervention the fallout would have been worse and perhaps longer-lasting.
For purposes of context, a Wikipedia report states that the “financial crisis of 2007–2008, also known as the global financial crisis and the 2008 financial crisis, is considered by many economists to have been the most serious financial crisis since the Great Depression of the 1930. It began in 2007 with a crisis in the subprime mortgage market in the United States, and developed into a full-blown international banking crisis with the collapse of the investment bank Lehman Brothers on September 15, 2008. Excessive risk-taking by banks such as Lehman Brothers helped to magnify the financial impact globally. Massive bail-outs of financial institutions and other palliative monetary and fiscal policies were employed to prevent a possible collapse of the world financial system. The crisis was nonetheless followed by a global economic downturn, the Great Recession. The European debt crisis, a crisis in the banking system of the European countries using the euro, followed later. In 2010, the Dodd–Frank Wall Street Reform and Consumer Protection Act was enacted in the US following the crisis to “promote the financial stability of the United States”. The Basel III capital and liquidity standards were adopted by countries around the world.”
If one juxtaposes the above summary of the 2008-2009 crisis with the ABI’s summary of the current high-risk lending environment (see below), there are notable parallels that should make insolvency professionals take note. Of particular relevance is the current tendency of less regulated institutions to engage in risky transactions (some of which are not unlike the subprime mortgages (see above) that helped precipitate the 2008-2009 meltdown).
According to the ABI:
“A decade after reckless home lending nearly destroyed the financial system, the business of making risky loans is back, the New York Times reported on Tuesday. This time, the money is bypassing the traditional, and heavily regulated, banking system and flowing through a growing network of businesses that have stepped in to provide loans to parts of the economy that banks abandoned after 2008. With almost $15 trillion in assets, the shadow-banking sector in the U.S. is roughly the same size as the entire banking system of Britain, the world’s fifth-largest economy. In certain areas — including mortgages, auto lending and some business loans — shadow banks have eclipsed traditional banks, which have spent much of the last decade pulling back on lending in the face of stricter regulatory standards aimed at keeping them out of trouble. But new problems arise when the industry depends on lenders that compete aggressively, operate with less of a cushion against losses and have fewer regulations to keep them from taking on too much risk. Recently, a chorus of industry officials and policymakers — including Federal Reserve Chair Jerome H. Powell — have started to signal that they’re watching the growth of riskier lending by these nonbanks. “We decided to regulate the banks, hoping for a more stable financial system, which doesn’t take as many risks,” said Amit Seru, a professor of finance at the Stanford Graduate School of Business. “Where the banks retreated, shadow banks stepped in.” Lately, that lending is coming from companies like Quicken Loans, loanDepot and Caliber Home Loans. Between 2009 and 2018, the share of mortgage loans made by these businesses and others like them soared from 9 percent to more than 52 percent, according to Inside Mortgage Finance. While they don’t have a nationwide regulator that ensures safety and soundness like banks do, non-banks say that they are monitored by a range of government entities, from the Consumer Financial Protection Bureau to state regulators.”
According to an article in the Business Insider, a key metric for the onset of a recession is leaning towards a downturn. In this case, the yield on 10-year US Treasury notes declined for a fifth consecutive week and is close to the yield on a 2-year Treasury. According to the article:
“Treasury yields don’t automatically trigger recessions, of course. But there has been a worrying historical correlation between the moment that the percentage yield on the two-year Treasury becomes greater than the yield on the 10-year note. That phenomenon is called a “yield curve inversion,” and it means that investors are so worried that they’re much less likely than normal to bet on short-term assets.When the opposite happens and investors signal that the short term feels riskier than the long term, something must be wrong. If investors say they have less idea of what’s going to happen in two years than in 10 years, then they must be very worried about the near term — and that is a pretty good signal of an impending recession.When the two-year exceeds the 10-year, recessions tend to follow in short order.”
There is one reason not to panic. The yield curve doesn’t say that a recession will come imminently. Just sometime soon. The Macquarie analyst Ric Deverell and his team told clients recently that even if the curve were inverted, a recession might not show up until 2019, based on the historical record.
“Indeed, each of the five most recent recessions were preceded within two years by an ‘inverted’ yield curve, with only one false signal (the yield curve very briefly dipped into negative territory in mid-1998, during the Russia crisis and the collapse of Long Term Capital Management, around 33 months before the cyclical peak).
“On average, the lag between yield curve inversion and the onset of a recession is around 15 months … Even if the current trend pace of flattening since 2014 were to persist, the curve would not invert until the middle of 2019.”
While the 10-year yield still exceeds the 2-year yield, the differential is small — 25 basis points on Monday, the flattest since 2007.
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