Analysts are losing sleep over what’s happening at US banks right now

UBS

The economy is all about cycles.

And to Matthew Mish, a credit strategist at UBS, there may be none more important than the credit cycle.

"We firmly believe in credit cycles: the expansion and contraction of access to credit, which foreshadow changes in credit spreads and shifts in business and asset prices," Mish wrote in a note Thursday.

Essentially, the access, or lack thereof, to loans presages major changes in the overall economy. And right now the credit cycle has things happening at US banks that remind Mish of what happened right before the financial crisis.

And he is losing sleep over it. 

Here's Mish (emphasis added):

"For this we turn to the Office of the Comptroller of the Currency's (OCC) 2015 Survey of Credit Underwriting Practices released in December, which assesses credit underwriting standards at 95 banks with assets of $3bn or more, on loans totaling $5.1tn (94% of total loans in the federal banking system) and covering 18 commercial and retail credit products. And the results, frankly, have kept us up some nights. 

The survey concludes underwriting standards eased at a significant number of banks for the three-year period from mid-2013 to mid-2015, broadly similar to that experienced from 2005 to 2007 before the financial crisis. Loan portfolios that experienced the most easing in underwriting standards included indirect consumer, credit cards, leveraged loans, other CRE loans, and CRE construction, and competition was the predominant reason for relaxing pricing and terms. With respect to the level of credit risk examiners focused primarily on commercial loan products, citing real estate lending products as the most frequent area of concern.

As a quick and simple reminder, the credit cycle typically goes through a period of expansion with banks lending to consumers and companies. Then standards get too lax, allowing unqualified borrowers to access debt. Then the bubble bursts, defaults rise, and fewer loans are issued. 

The big worry, said Mish, is that the current standards at banks are now low enough that credit issuance looks a bit bubbly.

The most worrying areas, said Mish, were commercial real estate, construction and indirect consumer loans.

And the overall thrust of Mish's note is that the most concerning signs are coming from non-bank lenders, which will likely presage broader stresses in credit markets that will eventually be felt by banks. 

As for what sort of pain the banking sector could eventually feel, Mish says there is more work to be done, but thinking back to the last cycle should make everyone think hard about what's going on in the economy right now. 

Mish again (emphasis ours):

In short, we believe non-bank lending is indeed the tip of the iceberg as it relates to this credit cycle. They comprise a majority of the lending to the US private nonfinancial sector, and their presence is important not only in corporate but also increasingly in household lending. In particular, they are heavily involved originating in the lower quality segments across products. And our evidence suggests if bank lending conditions were lax, then by extension non-bank lending standards were what we would define as dangerously loose this cycle ... And, while the banks are in a better position than they were last cycle to withstand a downturn, we think more work needs to be done to understand the interconnectedness between banks and non-banks before the next downturn.

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