From A Credit Boom To A Credit Crisis?

by: EconReporter

Former Fed chair Janet Yellen has worried about loosening lending standards in the corporate debt market.

Comprehensive and timely lending standard data are hard to come by.

Economics research suggests there is a good proxy available.

The global financial market is in a tailspin in the last few weeks. Top among investors' worries is the question "What comes next?" Is this merely a stock price correction? Or could it turn into a full-blown financial crisis?

Debt markets are relatively resilient compared to the stock market, right now. Still, debt markets face a lot of headwinds: Fed rate hikes, global economic slowdown and lower corporate earnings, exemplified by Apple's latest earning forecast downgrade, are piling pressure on the (arguably) excessive corporate debt load accumulated during the last 10 years of low rate environment.

Could the credit market headwinds turn into a credit crisis soon? The essential question is what makes a credit boom turn "bad" and spiral into a credit crisis?

In an IMF working paper "Lending Standards and Output Growth," researcher Divya Kirti tried to answer the question. He thinks the answer is simple --- it is the lending standard of the debts that matters.

The problem is that the lending standard is sometimes hard to obvious. Timely and comprehensive data are often hard to come by.

For instance, many central banks conduct surveys of bank loan officers to monitor lending standards; unfortunately, these are not available widely enough to use as the primary measure of lending standards.

To solve this problem, Kirti tries to find a proxy indicator that can indirectly reflect the general lending standard in the debt market. In his research, he discovered that the high-yield (NYSE:HY) share of bond issuance could be quite a useful proxy for the lending standard.

Kirti found that, when bank loan officer surveys are available together with the HY share, the two measures of lending standards move in line with each other.

Below is an example of the US. The solid line is the share of investment-grade (NYSEARCA:IG) issuance, the reverse image of the HY share, and the dashed line is the lending standard reported by the Federal Reserve's Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS). You can see the two line mostly move in the same directions.

Source: "Lending Standards and Output Growth"

Kirti performed a similar comparison on 14 countries that have this kind of lending standard survey available, the result confirmed that lending standards in bond markets move in line with survey measures of bank lending standards, but the former is available more broadly, as the data can be found for all 38 sampled countries in his study. Hence, Kirti concludes that HY share is a powerful proxy for the general lending standard.

One crucial fact about the HY share is that it is procyclical. On average, it rises during periods of increasing growth and falls during periods of declining growth, on all horizons from 1 year to 5 years. This is in line with the findings in recent literature on the financial cycle that the eased financial conditions go hand in hand with the real business cycle.

It also seems to suggest that Hyman Minsky's conjecture might be right, that worsening lending standard might be the driver of excessive borrowing, which might create bubbles, and eventually a financial crisis.

Source: "Lending Standards and Output Growth"

The main finding of Kirti's paper is that lending standards do help separate good credit booms from bad booms; that is, credit booms with a rising HY share are followed by lower output growth over the subsequent three to four years.

As the result shows, given a credit boom, a one standard deviation increase in the HY share throughout the boom is followed by cumulative growth lower by nearly 1.5 percentage points three years later. (see figure below)

Source: "Lending Standards and Output Growth"

Another way to look at this finding is to separate the credit booms into three kinds. ‘Good' HY indicator is the ones with lowest quintile average change in HY share; ‘bad' HY indicator is the ones with highest quintile average change in HY share; and, "intermediate" changes in the HY share which is in between the two.

As you can see from the figure below, the conditional probability of economic downfall, defined as subsequent growth being in the lowest quintile in the sample, is three times higher given a ‘bad’ HY indicator relative to a ‘good’ HY indicator.

Source: "Lending Standards and Output Growth"

Kirti's thinks that the results consistent with the behavioral narratives of credit build ups and crises which championed by Minsky, in which market participants wrongly expect the booms they are participating in to continue, then creates excessive borrowing by lowering the landing standard and resulted in an economic downturn.

In essence, this is the problem that is worrying former Fed chair, Janet Yellen. In December, she said in a panel with Nobel winning economists Paul Krugman: "I think a lot of the underwriting of that debt is weak. I think investors hold it in packages like the subprime packages ... the same thing has happened. It's called CLOs, or collateralized loan obligations."

In sum, if you are worried about the bond market right now like Yellen does, you should keep an eye on the lending standard. It is advisable to keep a closer look at the Fed's Senior Loan Officer Opinion Survey on Bank Lending Practices data for January. The downside is the survey data is quarterly. For a more appropriate substitute, the high-yield share of corporate bond issuance should provide a time proxy.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.