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In this week's edition of the Morning Pour, I'll keep it light as you are likely with family for Easter or simply getting that final taste of Q1-2024.

Can you believe it’s already Spring? So much has happened over the last few months that it feels as if time’s blown by.

As always, I appreciate your comments on the Morning Pour – it’s always great to hear back from you. I’m glad you’re enjoying these (it’s been a pleasure writing them).

Anyway, I just wanted to touch on a few high-quality Morning Pour editions that offered interesting perspectives and insights in Q1-2024 and remain relevant to read but with some brief updated content.

So, sit back, enjoy your morning drink of choice, and savor this special edition of the last Morning Pour for Q1-2024.

Adem Tumerkan
Editor, Morning Pour

1. “Carmageddon”: Is The Auto Market Looking Fragile? I Believe So

In early January, I wrote to you about the increasingly fragile dynamics in the auto market (link above in case you missed it). I was growing concerned with some serious issues plaguing the auto industry – such as: the rapidly rising negative equity on used cars, tighter lending standards on auto loans, and soaring subprime loan delinquencies.

So, how are things since then?

Well, it’s steadily getting worse.

Put simply, car owners are increasingly struggling1 to keep up with their auto loan payments at a level that we haven’t seen since 2009-2010. This issue is primarily fueled by the combination of pricey vehicles and exorbitant interest rates on car loans. The situation is particularly dire for borrowers in their thirties, who now face the additional burden of resuming payments on federal student loans, amplifying their financial strain.

But what’s really troubling is the surge in subprime auto loan delinquencies (aka missing payments for more than 30 days).

·         Subprime is considered borrowers with poor credit ratings or deemed to be a potentially higher risk for default (like having low income relative to debt). They’re also the most marginal and sensitive group to interest rate changes.

To put this into perspective - according to the Federal Reserve2 - subprime auto loan borrowers delinquency rates climbed from 12% in the fourth quarter of 2019 to 15% in the third quarter of 2023. This uptick partly stems from a surge in delinquent subprime auto loan balances — the numerator of the subprime delinquency rate — which ballooned from around $30 billion in the fourth quarter of 2019 to $40 billion in the third quarter of 2023.

That’s a jump of over 30%. . .

A graph of a loan delinquency rate

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Figure 1: Note: U.S. Federal Reserve, January 2024, Delinquency measures the fraction of balances that are at least 30 days past due, excluding severely derogatory loans.

Now, while a 30% increase in four years is quite large. It gets worse when we consider the rate of change (aka momentum).

What I mean is subprime delinquencies declined after the hefty 2020 stimulus - courtesy of the government and Fed. In fact, by 2021, the subprime delinquency rate was below 8%.

But now, just two years later, it’s almost doubled.

Or said another way, the rate of change over two years for subprime loans going delinquent shot up roughly 100%. . .

And it doesn’t appear as if anything will change to suddenly fix this (even a couple of Fed rate cuts may prove meaningless).

Now with banks already suffering from commercial real estate issues, further auto loan issues definitely won’t help. . .

I will continue to monitor and update you.

2. The Commercial Real Estate Crunch: Are Small Banks Sitting on a Ticking Time Bomb?

Back in late January, I wrote to you about my concern with the banking system and the incoming tidal wave of commercial real estate debt – most of which is souring like milk on a summer day (link above if you missed it).

Two weeks after writing this – New York City Bancorp (NYSE: NYCB) saw its shares plunge after they were forced to acknowledge bad real estate loans and slash its dividend – kicking off a new wave of regional banking worries (lucky timing on my part).

So, was NYCB a one-off? Or is it the canary in the coal mine for further stress in the banking system?

Well, further evidence points to more potential trouble ahead. . .

For starters, banks – specifically the medium to smaller ones – have grown increasingly leveraged3 to commercial real estate.

A graph of blue bars

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Figure 2: Bloomberg News analysis of Y-9 filings for bank holding companies as of Sept. 30 [2023]

Now, the Federal Reserve, Federal Deposit Insurance Corp., and Office of the Comptroller of the Currency have signaled their intent to prioritize oversight of banks whose portfolios of commercial real estate loans exceed three times their capital (the higher the number, the more fragile things may become).

·         According to Bloomberg data, that’s two dozen lenders.

Meanwhile - at the largest U.S. banks - problematic commercial real estate loans have surpassed loss reserves following a significant uptick in late payments associated with offices, shopping centers, and other properties.

To put this into perspective: according to recent filings4 with the Federal Deposit Insurance Corporation (FDIC), the average reserves at JPMorgan Chase, Bank of America, Wells Fargo, Citigroup, Goldman Sachs, and Morgan Stanley have decreased from $1.60 to $0.90 for every dollar of commercial real estate debt where a borrower is at least 30 days late.

More alarming is that aggregate U.S. banks currently hold $1.40 in reserves for every dollar of delinquent commercial real estate loans, a decrease from $2.20 a year ago.

·         This marks the lowest coverage banks have had to absorb potential losses from commercial real estate loans in over seven years.

What does this mean?

Well, the crux of the matter revolves around loan allowances, also known as “reserves”, which banks set aside to anticipate future losses due to delinquencies (bad debts). And these provisions impact earnings, prompting banks to aim to minimize when and how they use them.

Simply put, if the bank increases these reserves, it’s considered an “expense” – and would negatively affect earnings.

Or worse, banks don’t even have enough reserves to cover mounting loan losses and must sell assets to raise cash.

Banks may also allocate less money aside as reserves because they’re optimistic they have enough already. However, I am skeptical of this approach.

For example – back in December, Bank of America (BofA) CEO Brian Moynihan stated that the bank identified only $5 billion in commercial property debt linked to declining property sectors—a small sum compared to the bank's yearly earnings of nearly $30 billion and assets exceeding $3.2 trillion. Moynihan expressed confidence, deeming it insignificant. However, in a recent FDIC filing, BofA revealed a 50% surge in delinquencies on loans tied to office, apartment, and other non-residential buildings in the final quarter of last year, totaling $2.1 billion. Despite this, the bank reduced its loss reserves for these loans by $50 million to just under $1.3 billion.

Reducing provisions at a time when loan losses are increasing seems like a flawed recipe. . .

Another issue is that banks aiming to decrease their involvement in commercial real estate may struggle to sell off those loans. Finding investors willing to take on loans tied to offices and other high-risk properties has proven to be a difficult task (who wants to catch a falling knife?).

The point is – I won’t be surprised if banks that looked O.K. six months ago begin looking not-so-O.K. in the next six months. . .

3. Trade Wars Redux? China's Manufacturing Glut and Its Global Implications

I just wrote this piece last week (link above) – highlighting China’s rush to save their weakening economy by investing heavily in manufacturing.

And while it hasn’t had much time to play out, I believe this will be a critical theme in the years to come.

In fact, Janet Yellen – the U.S. Treasury Secretary – earlier this week commented5 that, “Now we see excess capacity building in ‘new’ industries like solar, EVs, and lithium-ion batteries,” and that China's glut of goods, “hurts American firms and workers, as well as firms and workers around the world.”

A graph showing a line graph

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This will create significant trade tensions globally. Because as I’ve argued, China is heavily subsidizing manufacturing and exports to try and offset weak domestic consumption and ailing property markets.

The problem? This excess will flood into global markets and further crowd out competition.

·         For example, how can Europe, the U.S., Latin America, etc. compete if excess Chinese goods force down prices from too much supply?

This will likely push up global unemployment and slow down business activity, potentially leading to corporations closing doors.

Sure, China will keep its economy humming along from all the business and export activity (continue kicking the can). But it’s hard to see the rest of the world willing to deal with potential bankruptcies, unemployment, and rising deficits in order to subsidize their growth.

Thus, don’t be surprised if a global trade war amplifies – with all eyes on China (who is stuck between a rock and a hard place here).

Something to keep an eye out for in the coming months.

As always, this is just some food for thought.

Take care. 









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