Snakes and ladders

This article was written by Richard Horswill. All views and opinions expressed are strictly his own.

Recently, a well known banking CEO made a comment regarding a sizeable bankruptcy in the US. Tricolor Holdings, a sub-prime car/auto lender went bust leading to the commentary “you find one cockroach, and you’ll probably find more” to paraphrase. Almost simultaneously, First Brands Group, an auto parts manufacturer followed them into bankruptcy. Both companies were financed outside the traditional lending markets, through private credit, sometimes referred to as “shadow banks” or as they have been formally termed Non-Depository Financial Institutions. These institutions have opaque financing structures that are seemingly unregulated. Central bankers and regulators have taken particular note of these high profile events and prompted general concern in financial markets over potential systemic risk within the sub-prime lending market. Other notable events post ‘cockroach comment’ surrounding commercial lending risks led to big losses in Zions bank and also Western Alliance, sending their stock values plunging, and Primalend, an auto industry sub-prime lender, filed for bankruptcy. And finally, two hedge funds were shuttered recently by UBS due to the first having significant exposure to Tricolor and the second due to redemptions suggesting an escalation of concern by investors. One must ask if these events could lead to an escalation in concerns over private credit and whether the underlying collateral backing the lending has the credibility that is required.

The collateral issue noted in the Tricolor bankruptcy was an alleged fraud around pledging the collateral multiple times to different lenders, hence, due to the lack of transparency and the lackadaisical lending practices by some banking institutions, it may appear that regulators have been asleep at the wheel yet again. Banks appear to have been lending to private credit institutions without proper controls, seemingly oblivious to the underlying risks, particularly as economies have been stagnating since mid 2022 with the consumer having being unable to keep pace with rising costs as their disposable incomes were crushed by a combination of high energy and subsequent food costs, and then the icing on the cake which was the interest rate increases driven by misguided central bank interventions. Is it any wonder that these sub-prime lenders are having to cook the books in order to stay alive as delinquency rates increase and ultimately defaults crater their business models?

A wider collateral issue has been developing in the interbank money markets. This has been highlighted by some recent significant use of the Federal Reserve overnight repo operation which provides liquidity to ensure smooth functioning of money markets. This Standing Repo Facility supposedly acts as a backstop where eligible institutions can borrow cash from the Fed overnight against high-quality collateral like Treasury securities. The facility was created to support monetary policy by preventing market disruptions and limiting upward pressure on overnight interest rates. However, overnight rates as guided by the secured overnight financing rate (SOFR) backed by US treasuries have recently gone above the Fed rate potentially indicating a preference for secured funding due to concerns over counterparty risk in unsecured markets and thus a tightening in liquidity. 

A question to ask maybe, is if these most recent combinations of events have any particular historical relevance in relation to previous episodes of financial stress. One could point to the the Bear Stearns situation in 2007 and it’s exposure to two highly leveraged hedge funds in sub-prime mortgages which ultimately led to an escalation culminating in a full blown liquidity crisis leading to the sale of the bank in March 2008. The possibility of a financial crisis driven by another sub-prime catastrophe is certainly not out of the question. The signals have been sounding for a number of years now as markets have been pricing in differences to official sources. Inverted yield curves and bull steepening in interest rate markets, gold prices soaring as the safe haven is demanded, lower oil prices as global demand drivers are severely curtailed and, whilst interest rate cuts have been forthcoming, yet again the central bankers have been slow to react as their historical inflation bias has assisted them in making terrible decisions for the global economy. A process is clearly underway, but how bad it becomes will not really be evident until it hits. By then, the panic will force the authorities into action which will likely lead to interests rates falling precipitously and leading us back to where we started in 2008. Anyone for a game of snakes and ladders?