🪳Credit cockroaches

Hey hey, happy Monday! 

Didn’t ever think I’d have a cockroach emoji in the title of this post, but what can I say? Jamie Dimon made me do it.

There’s a slow and no-so-silent freakout on Wall Street (and in the stock market) over a handful of bad loans made from banks and other firms to private enterprises. I find it to be an interesting psychological redux of the financial crisis that rocked our world nearly two decades ago.

A 5-minute digest on what exactly is going on, what the data tells us, and why the biggest risk could lie in your own experiences.

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The global financial crisis is one of the freshest scars we collectively share.

Less than 20 years ago, the stock market dropped nearly 60% and the U.S. economy plunged into its longest recession in recent memory after banks loosened up their lending standards and Americans gorged on adjustable-rate mortgages and all kinds of exotic debt.

Then, the Fed started raising rates in late 2004, and debt-saddled homeowners discovered they couldn’t afford their debt payments. Banks’ balance sheets melted down, millions of Americans lost their houses, and one in 10 workers lost their jobs.

It was easily the worst credit crisis in history. Two decades later, we’re all working through some serious PTSD (I wrote about my own here).

So when inklings of credit and lending issues come up, Wall Street gets understandably jumpy.

The latest scare is unfolding right now. In September, First Brands – an auto parts dealer – filed for bankruptcy, and the world discovered that it owed $10 to $50 billion in liabilities due to murky off-balance sheet loans. Soon after that, banks such as UBS and Jeffries said they could lose hundreds of millions of dollars on soured First Brands loans. Last week, JPMorgan mentioned in its earnings call that it had to record $59 million in loan losses for one client. That client was supposedly Tricolor – a used car retailer/auto lender that also filed for bankruptcy last month.

A few other banks disclosed in earnings reports that they had been tied up in bad loans and corporate mortgages. But to Wall Street, the most striking moment was when JPMorgan CEO Jamie Dimon dropped this ominous quote:

"When you see one cockroach, there are probably more, and so everyone should be forewarned of this one."

Cockroaches – the nastiest bugs out there. Plus, an implication from one of Wall Street’s most powerful  (and loose-lipped) figures that there could be more pests living in these rotten walls. Instant credit crisis vibes for traumatized investors.

While the fallout hasn’t weighed too much on the broader stock market – the S&P 500 is within 2% of a record high, after all – it’s wreaked havoc on financial stocks. Shares of regional banks have dropped as much as 11% since the end of August, while business development companies (non-bank firms that lend to and invest money in other businesses) have slid as much as 15%.

Look – banking crises can be pernicious, and it’s fair if you’re still reeling from the memories of 2008. The financial crisis also started with anecdotes, after all.

But when we find ourselves going down rabbit holes, we anchor ourselves in the data. That’s the OptimistiCallie way.

The numbers should calm you down, at least on the bank side.

Banks mainly fail for two reasons: a dependence on bad loans, or an inability to keep funding through deposits and other money. Luckily, there are ways to measure both.

First, the gold standard: the loan-to-deposit ratio, a gauge of a bank’s ability to cover deposit withdrawals and loan losses. Loan balances at banks look historically low compared to the deposits they hold, which should tell you they have enough cushion to handle unpaid loans here and there.

Here, it’s important to also look at stats for big versus small/regional banks because the chasm between the two has been extra wide lately. Big banks have to operate under stricter rules, but they also have the luxury of depending on other businesses (brokerage, investment banking) for profits. They don’t necessarily need lending to boost their bottom lines, which has been a godsend after a decade of low rates. 

You can also decipher how much a bank is losing from bad loans through loan loss provisions. Industrywide, loan loss totals are rising (as a percent of total loans – this context matters!), but not at an alarming rate.

I’m sensing a pattern here. Yes, banks have made some silly loans, but overall, their lending standards aren’t as untethered as they were around the financial crisis. At least according to senior loan officials, who the Federal Reserve surveys quarterly.

BTW – can you believe the Fed watches over banks as well? What can’t our interest-rate superheroes do?

Seriously, though, there’s been a lot of bank reform since the wild days of the early 2000s. Too much reform, as some would argue. Stricter laws have required banks to keep a lot of cash on their books, make more stringent disclosures about their loans, and stress-test their books annually.

In a way, the pain of the financial crisis has somewhat inoculated us to future crises.

Things change, of course. The Silicon Valley Bank meltdown happened two and a half years ago. That event was different – banks’ ability to fund themselves was hampered because people cashed out deposits like mad, and the firms were sitting on huge investment losses after rate hikes pummeled Treasury prices. A long, but fascinating story you can read about here.

What strikes me about this particular situation is how little stress you can see, even in the hard data. With SVB, cracks were forming in bank data if you knew where to look. Here? Not so much, and bank data is fairly transparent.

Still, you have reasons to be anxious.

The health of business development companies – those non-bank businesses I mentioned earlier – and other opaque lenders that have thrived in popularity over the last decade.

Banks have obeyed the rules because they have their hands tied after their financial crisis misdeeds. Other firms? Not so much, and they’ve turned into de facto banks (shadow banking!) without the same oversight.

This is why Wall Street is worried. It’s hard to put your arms around just how entrenched – and risky – shadow banking channels have become.

This isn’t worth panicking about (yet), but it is a hard part of the financial system to monitor.

Also, in finance, perception can easily become reality.

The world is frictionless, and that allows us to change our minds at the drop of a hat. More opportunities, but more instability and unintended consequences.

If enough investors are worried about something, they can fan the flames enough to turn a small issue into a crisis. We’ve all heard about meme stocks, right? The same thing can happen with bank and financial stocks, especially in this era of social media and fast-moving information.

Bank runs are a thing, too. If enough customers are worried about the health of a financial institution, they can pull their money. And when deposits are a funding source for loans, the financial base can weaken quickly.

This is what made the SVB fiasco so frightening. Yes, SVB leaders made poor decisions and the bank’s customer base was uniquely concentrated in tech and venture capital, but we also saw how quickly America can turn its back on a company and drive it into ruin. Even the Fed got involved towards the end, opening up the agency’s pocketbook for distressed smaller banks impacted by huge deposit withdrawals. At points during SVB’s downfall, we saw the highest amount of deposit withdrawals from small banks since the beginning of the financial crisis.

That takes us back to the collective trauma we all share. People are quick to point fingers at bad headlines and call them a crisis in the making. Our lizard brains are wired to scan for familiar risks.

Yes, it makes sense if your spidey senses are going off extra loud about these headlines – even if the data shows the risk fairly benign.

Your scars are still fresh, and you’ve seen what lives behind these walls.

Today, your choice is how much you act on those instincts.

Thanks for reading!

Callie

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