Just a few weeks ago, we reported on a very worrying situation in the Eurozone as an official study of the European Central Bank showed the banks in the Eurozone were actually lowering their credit standards. This was clearly visible on some charts we provided as the most important reason of the Eurozone banks to expand their credit portfolio was based on fears for their competition to increase their market share rather than being based on improving quality of the borrowers.
This resulted in lowering the credit standards for prospective borrowers, just to make sure the banks were able to maintain a specific market share.
At first, this issue seemed to be contained to the Eurozone, but the Federal Reserve recently released a working paper wherein the impact of the low interest rates on the lending standards is being researched. In fact, the paper provides hard evidence on how the first and third round of the Quantitative Easing resulted in the banks lowering their credit standards in the USA as well!
It’s definitely nice to be able to get money for free (from the central bank) whilst you aren’t even responsible for how the money will be spent. After all, a subprime client will increase your net interest margins as his payments (and cost of debt) will be higher than the creditworthy clients. This isn’t a new technique, as this has been widely used in the Eurozone as well.
A few years ago, the European Central Bank refused to provide direct assistance to the Eurozone countries by buying their bonds to keep the interest rates (artificially) low. Instead, the ECB made money available for banks which subsequently bought those bonds. Or why do you think a certain Spanish bank received billions of Euro in cheap ECB funding, only to immediately reinvest that cash in Spanish government bonds?
But if we would now take a step back to get a better overview of how the US credit market works, it’s clear the ‘Spanish situation’ has been imitated. Have a look at the next paragraph, which we copied from the Fed working paper.
Source: Federal Reserve
Of course, words can be cheap, and we wanted to see numbers to back up these claims. A lending portfolio of a bank is obviously confidential, but the next chart shows you how the total size of the loans to the private sector have increased by in excess of 50% in the past five years. On top of that, the total size of the loan book to the private sector is now much, much higher than during the Global Financial Crisis.
And this worries us. Not only are the banks lending again to counterparties which are less creditworthy than before, the size of the loan book is getting worrisome. A larger loan book combined with a higher default rate (which is obviously directly correlated to the creditworthiness of the borrowers) is a really bad cocktail.
As the Federal Reserve will start to unwind the QE stimulus, natural interest rates will increase making loans more expensive. And it’s unlikely the subprime borrowers will all be able to meet these higher payment requests. After all, that’s why they belong to the SUB-prime category.
Read our Guide to Gold and be prepared for economic headwinds!