Powell was right.
Banks continued tightening their lending standards to households and businesses in the second quarter. According to the Federal Reserve’s Senior Loan Officer Opinion Survey (SLOOS), 36% of banks tightened their standards for credit cards to consumers, an increase from 30% in the first quarter. On the demand side, 33% reported lower demand for residential mortgage loans, a considerable improvement from the 88% reporting weaker demand in the fourth quarter of 2022. Nevertheless, this is the eighth consecutive quarter in which residential mortgage loan demand has been weaker.
For businesses, 51% of banks tightened their lending standards for commercial and industrial (C&I) loans to large and middle market firms (e.g.; businesses with annual revenue of $50 million or more), up five percentage points from the first quarter. The comparable measure for C&I loans to small businesses (annual sales of under $50 million) was 49% in the second quarter. For commercial real estate loans, 68% of banks tightened standards, the same percentage in the first quarter.
The latest numbers have fallen into an area which would have been consistent with past recessions in the U.S. For example, the share of banks tightening standards for commercial and industrial loans to large and middle market firms was 32% in the first quarter of 2008 when the U.S. economy entered a recession and before that, 51% in the first quarter of 2001.
While the U.S. economy continues to exhibit resiliency and the so-called soft landing looks more achievable now, certain segments and sectors of the economy will continue to be squeezed by the higher interest rate environment and the increased underwriting scrutiny that lending institutions are imposing on both current and prospective borrowers.
Last week, Fed Chair Jay Powell hinted that the upcoming survey would reveal tighter conditions. “The economy is facing headwinds from tighter credit conditions for households and businesses which are likely to weigh on economic activity,” Powell said during the post-meeting press conference.
A special question in the survey asked about banks' expectations for changes in lending standards over the second half of 2023. In response, banks reported that they expected to “further tighten standards on all loan categories [our emphasis]. Banks most frequently cited a less favorable or more uncertain economic outlook and expected deterioration in collateral values and the credit quality of loans as reasons for expecting to tighten lending standards further over the remainder of 2023.”
Banks have been progressively tightening lending standards for well over a year. For those with a heavy debt load, the cost to refinance in the current interest rate environment threatens some firms as going concerns. This week, a major U.S. trucking company ceased operations after nearly 100 years in business.
Corporate bankruptcies (firms with liabilities of $50 million or more) are rising. Bloomberg reports that 126 companies have declared bankruptcies for this year to date, the highest since 2020’s pandemic-induced bankruptcies of 244 firms. During the global financial crisis, nearly 300 companies declared bankruptcy in 2009. Among market groupings, 23% of bankruptcies for 2023 have occurred in consumer discretionary businesses, 14% in health care, 11% for industrials and 9% in communications with the bulk in the latter sector occurring for media and advertising firms. The decline in discretionary spending has had a cascading effect, impacting advertising and social media campaigns.
Another concern is junk-rate companies and the leveraged loan market, which typically have floating coupons and make borrowers vulnerable to rising interest rates. Downgrades for high-yield companies in 2023 are running well ahead of the pace of 2022 and will likely be the highest since 2020. Moody’s has downgraded 297 companies in the high-yield space this year so far versus 362 in 2022 and 819 in 2020. S&P has downgraded 334 firms in 2023, which will likely surpass 2022’s 383 downgrades and become the highest since 2020’s 1,165.
Broadly speaking, financial market liquidity conditions have improved. The Chicago Fed’s weekly measure of national financial conditions at -0.4 shows conditions are easier. However, when you look at the index by its three constituents—risk, credit and leverage—they are not all pointing in the same direction. Risk is -0.5, credit 0.01 and leverage 1.09 for the week ended July 21, 2023. The tighter leverage and marginally tighter credit are consistent with the Fed’s latest SLOOS. [Note: The index and its subindexes are constructed to have an average value of zero and a standard deviation of one.]
Based on the answers to the special question in the SLOOS survey, the expectation for additional tightening of lending standards over the balance of 2023 could mean that July’s Fed rate hike could be the last in the current tightening cycle. The reason being that the cumulative restraint in lending activity will continue to slow economic activity into 2024, substituting the need for additional rate increases. KPMG Economics forecasts real GDP growth to be 1.2% in 2024, down substantially from a projected 2.1% in 2023. And how would you look at Powell’s comments from last week?
“The SLOOS has been telling us more than a year that banking conditions are tightening. I think we have to take a step back. I think basically we're just looking at the overall picture. Which is one of tightening credit conditions. And that's going to restrain economic activity. And it is restraining economic activity. That's how I would look at it,” said Powell.
Any company that has to refinance maturing debt in the next year or so will face sticker shock.
While prospects for a soft-landing for the economy look more achievable, certain sectors of the economy will have difficulty navigating the higher-for-longer interest rate environment which means market participants will need to be mindful of potential tail risks. In the previous three recessions, it’s always been leverage that rose above one standard deviation first before the economy succumbed to a downturn. Although recession risk is now lower, there is another r word for some firms to be concerned about and that’s rollover risk. Any company that has to refinance maturing debt in the next year or so will face sticker shock and a longer duration for business conditions to improve to offset materially higher interest expense.