The Deteriorating Credit Cycle and Wall Street's Credit Risk Transfer Schemes
The Federal Reserve has reported a sharp rise in default rates across a range of household loans, reflecting the deterioration in the labor market. The New York Fed has also noted that rejection rates have soared to new highs this year, indicating that the credit cycle is just getting started.
This has put a spotlight on an arcane bit of Wall Street bank balance sheet engineering - a new spin on the old credit default swaps that has seen an explosion of popularity this year. As credit quality deteriorates, banks are increasingly demanding credit protection, and the market for providing this protection is booming.
The private, non-bank investors who are supplying this credit protection are the same ones who were caught flat-footed on macro risks back in early August. They now have a "soft landing fever," happily accepting lower and lower payments for guaranteeing losses, even as the risks of doing so are rising.
This creates a feedback loop where further setbacks in employment and incomes lead to worsening credit quality, which in turn raises the demand from banks for more credit protection. The private non-banks are currently happy to supply this protection, but once it goes too far, they may stop supplying it or demand too high a rate to keep it up.
At that point, banks will have to start rejecting a whole lot more loans, and the credit cycle will get a whole lot uglier as a result. There are also questions about who is actually funding these credit protection schemes, but those will be saved for a later time.
The Federal Reserve's Household Debt and Credit Report
The headline from the Federal Reserve's household debt and credit report for the third quarter of 2024 was that the total delinquent balance on all household debt shot up to 3.5%, up from 3.2% in the first and second quarters. The credit cycle began to shift in 2023, with the delinquency rate ticking up from around 2.5% in the fourth quarter of 2022 to 2.6% in the first half of 2023, and then accelerating in the second half of the year as unemployment began to rise.
The 90-day delinquency rate on credit cards shot up to 11.13%, the highest since the first quarter of 2012. Even for auto loans, the 90-day delinquency rate rose to 4.59%, similar to the late 2000s or 2010 levels, indicating that the later stages of the credit crisis are now being felt in the auto loan market.
There was some good news in the report, with new delinquencies or transitions into delinquencies actually down for credit cards in the third quarter compared to the second quarter. This is likely due to banks cutting back on the access to revolving credit, another cyclical indicator. However, auto loans are where a lot of the trouble is starting to really pop out.
The Federal Reserve's data showed that rejection rates for credit card applications, mortgage applications, auto loan applications, credit card limit extension applications, and even mortgage loan refinance applications all rose in 2024. The average rejection rate so far this year is 21%, up from 20.1% in 2023 and 17.6% in the pre-pandemic era.
For mortgages, the rejection rate soared to 20.7%, up 8.6 points and double the rate from 2019. Mortgage refinance rejections moved up to 25.6%, the highest in the series. Auto loan rejection rates went up to 11.4%, the highest since 2013.
This reflects the deterioration in the labor market, as lenders are looking at their prospective borrowers and demanding more documentation, seeing diminishing income prospects.
As banks tighten lending standards and reject more loans, they are also taking proactive measures to ensure their balance sheets as credit quality deteriorates further. One of these measures is the use of credit risk transfer (CRT) or significant risk transfer (SRT) schemes, which are essentially a new spin on the old credit default swaps.
These CRT/SRT schemes allow banks to offload credit risk to private, non-bank investors, who are often the same institutional investors that were caught flat-footed on macro risks earlier this year. These investors are now happily providing credit protection, as they believe in a "soft landing" scenario and are willing to accept lower and lower payments for guaranteeing losses.
The regulatory treatment of these CRT/SRT schemes was uncertain until last year, when the Federal Reserve clarified its stance. The Fed is now aware of these schemes and requires banks to seek approval before using them. However, the appetite to do CRT/SRT has gone way up this year, as banks seek credit protection and the private investors are willing to provide it.
Potential Procyclical Headwinds
The concern is that if the CRT/SRT market dries up, as the private investors realize that the risks they perceive as low are not actually low, banks will no longer be able to offload credit risk. This could lead to banks rejecting even more loans, further exacerbating the deteriorating credit cycle.
In essence, the CRT/SRT schemes, which are supposed to spread out risk more broadly, could end up making the system more rigid and procyclical. As the credit cycle continues to deteriorate, the potential rug pull from the CRT/SRT market could become a lot worse, adding further headwinds to an economy that is already facing significant challenges.
This is in addition to the other cyclical warnings, such as the movements in the US dollar exchange rates, which have also been signaling potential trouble ahead.
Part 1/8:
The Deteriorating Credit Cycle and Wall Street's Credit Risk Transfer Schemes
The Federal Reserve has reported a sharp rise in default rates across a range of household loans, reflecting the deterioration in the labor market. The New York Fed has also noted that rejection rates have soared to new highs this year, indicating that the credit cycle is just getting started.
This has put a spotlight on an arcane bit of Wall Street bank balance sheet engineering - a new spin on the old credit default swaps that has seen an explosion of popularity this year. As credit quality deteriorates, banks are increasingly demanding credit protection, and the market for providing this protection is booming.
Part 2/8:
The private, non-bank investors who are supplying this credit protection are the same ones who were caught flat-footed on macro risks back in early August. They now have a "soft landing fever," happily accepting lower and lower payments for guaranteeing losses, even as the risks of doing so are rising.
This creates a feedback loop where further setbacks in employment and incomes lead to worsening credit quality, which in turn raises the demand from banks for more credit protection. The private non-banks are currently happy to supply this protection, but once it goes too far, they may stop supplying it or demand too high a rate to keep it up.
Part 3/8:
At that point, banks will have to start rejecting a whole lot more loans, and the credit cycle will get a whole lot uglier as a result. There are also questions about who is actually funding these credit protection schemes, but those will be saved for a later time.
The Federal Reserve's Household Debt and Credit Report
The headline from the Federal Reserve's household debt and credit report for the third quarter of 2024 was that the total delinquent balance on all household debt shot up to 3.5%, up from 3.2% in the first and second quarters. The credit cycle began to shift in 2023, with the delinquency rate ticking up from around 2.5% in the fourth quarter of 2022 to 2.6% in the first half of 2023, and then accelerating in the second half of the year as unemployment began to rise.
Part 4/8:
The 90-day delinquency rate on credit cards shot up to 11.13%, the highest since the first quarter of 2012. Even for auto loans, the 90-day delinquency rate rose to 4.59%, similar to the late 2000s or 2010 levels, indicating that the later stages of the credit crisis are now being felt in the auto loan market.
There was some good news in the report, with new delinquencies or transitions into delinquencies actually down for credit cards in the third quarter compared to the second quarter. This is likely due to banks cutting back on the access to revolving credit, another cyclical indicator. However, auto loans are where a lot of the trouble is starting to really pop out.
Rejection Rates Soar Across Loan Types
Part 5/8:
The Federal Reserve's data showed that rejection rates for credit card applications, mortgage applications, auto loan applications, credit card limit extension applications, and even mortgage loan refinance applications all rose in 2024. The average rejection rate so far this year is 21%, up from 20.1% in 2023 and 17.6% in the pre-pandemic era.
For mortgages, the rejection rate soared to 20.7%, up 8.6 points and double the rate from 2019. Mortgage refinance rejections moved up to 25.6%, the highest in the series. Auto loan rejection rates went up to 11.4%, the highest since 2013.
This reflects the deterioration in the labor market, as lenders are looking at their prospective borrowers and demanding more documentation, seeing diminishing income prospects.
Part 6/8:
The Rise of Credit Risk Transfer Schemes
As banks tighten lending standards and reject more loans, they are also taking proactive measures to ensure their balance sheets as credit quality deteriorates further. One of these measures is the use of credit risk transfer (CRT) or significant risk transfer (SRT) schemes, which are essentially a new spin on the old credit default swaps.
These CRT/SRT schemes allow banks to offload credit risk to private, non-bank investors, who are often the same institutional investors that were caught flat-footed on macro risks earlier this year. These investors are now happily providing credit protection, as they believe in a "soft landing" scenario and are willing to accept lower and lower payments for guaranteeing losses.
Part 7/8:
The regulatory treatment of these CRT/SRT schemes was uncertain until last year, when the Federal Reserve clarified its stance. The Fed is now aware of these schemes and requires banks to seek approval before using them. However, the appetite to do CRT/SRT has gone way up this year, as banks seek credit protection and the private investors are willing to provide it.
Potential Procyclical Headwinds
The concern is that if the CRT/SRT market dries up, as the private investors realize that the risks they perceive as low are not actually low, banks will no longer be able to offload credit risk. This could lead to banks rejecting even more loans, further exacerbating the deteriorating credit cycle.
Part 8/8:
In essence, the CRT/SRT schemes, which are supposed to spread out risk more broadly, could end up making the system more rigid and procyclical. As the credit cycle continues to deteriorate, the potential rug pull from the CRT/SRT market could become a lot worse, adding further headwinds to an economy that is already facing significant challenges.
This is in addition to the other cyclical warnings, such as the movements in the US dollar exchange rates, which have also been signaling potential trouble ahead.