Tighter loans today, more defaults tomorrow

A net 45 per cent of American banks were tightening credit in the Federal Reserve's January Senior Loan Officer Opinion Survey (SLOOS), and that was before the March banking panic. The survey rarely makes the front pages, but credit researchers regard it as the most reliable early warning of corporate defaults. When the net share of banks tightening standards on commercial and industrial loans passes 40 per cent, history has a clear message: a nasty default cycle has followed roughly two to three quarters later. The credit cycle now appears to be entering its final, contracting phase.

The path from tighter lending to default is fairly mechanical. Small and mid-sized firms depend on revolving bank credit to meet payroll and cover seasonal swings in inventory, as well as to bridge the wait for customers to pay.

What the survey measures

The SLOOS is a quarterly questionnaire sent to senior lending officers at roughly eighty large domestic banks and a group of American branches of foreign banks. It asks whether they have tightened, eased or left unchanged their standards and terms for different kinds of loan over the previous three months, and whether demand has risen or fallen. The headline number is a net figure, the share of banks reporting tighter standards minus the share reporting easier ones. A reading of 45 per cent therefore means that tightening banks outnumber easing banks by a wide margin, not that 45 per cent of loans are being refused.

Its value as a forecasting tool comes from timing. Lending officers change their standards as soon as they see trouble ahead, long before borrowers miss payments and long before the damage appears in bank accounts or bankruptcy courts. The survey also covers credit supply directly, which most economic data do not.

Less credit, and dearer

When banks tighten standards, they do more than raise rates. They cut the amount of credit on offer. Loan-to-value requirements go up and covenants get stricter, and credit lines are pruned hard.

For a business with thin cash buffers, failing to roll over an existing credit line can be fatal. It cannot wait for the Fed to cut rates. It runs out of working capital, and a formal restructuring or chapter 11 bankruptcy follows.

Rising rates make the arithmetic worse for companies that keep their credit. Most leveraged loans and bank credit lines float over a short-term benchmark, which has risen by more than 4.5 percentage points since early last year. A firm that borrowed when its interest bill was comfortably covered by earnings may now find that coverage thin or negative, just as its bank asks for tighter terms at renewal. Lenders who see coverage falling tighten further, and the loop feeds on itself.

The record since 1990

The historical pattern is consistent enough to take seriously. Net tightening on business loans rose above 40 per cent around the recessions of 1990, 2001, 2008 and 2020, and each time business defaults rose substantially in the following quarters. In the first three episodes, the default wave ran for more than a year as weak borrowers were squeezed out of the credit market.

The 2020 episode shows how policy can cut the cycle short. Banks tightened sharply in the spring of that year, but Congress passed large grant and loan programmes for small businesses and the Fed set up facilities to buy corporate bonds. Defaults rose briefly and then fell. No such rescue is on offer this time, since the Fed is still trying to bring inflation down and fiscal policy is tied up in the fight over the debt ceiling.

Charge-offs arrive in six to nine months

Statistical models show that shifts in bank lending standards lead charge-offs on commercial and industrial loans by six to nine months, with a strong and consistent relationship.

The sharp tightening in early 2023 points to a big rise in corporate bankruptcies in the second half of the year and into 2024.

March will make the next reading worse. The January survey captured caution about the economy; the failures of Silicon Valley Bank and Signature Bank added fear about funding. The Fed's Beige Book of regional business anecdotes, published this week, reported tighter lending standards in several districts. The next SLOOS, due in early May, will cover the first quarter and should show how far the banking scare pushed standards beyond where they already were.

Who is exposed

The pain will not be spread evenly. Large companies with investment-grade ratings fixed much of their borrowing costs by issuing long-dated bonds in 2020 and 2021, and they can keep funding themselves in the bond market. The vulnerable borrowers are smaller firms that rely on banks, and companies owned by private equity whose floating-rate loans were arranged when rates were near zero. Commercial property owners face a similar squeeze where their loans come due.

There are winners in a tightening cycle, too. Private credit funds, which raised large sums in recent years, can lend to firms that banks turn away, at higher spreads and with tighter protections. Distressed-debt investors will find more to buy. Banks themselves will book higher loan-loss provisions, which will eat into earnings that are already under pressure from rising deposit costs.

Where the signal could mislead

The strongest argument against a severe default cycle is that corporate America starts in good shape. Many firms locked in low fixed rates before 2022, hold more cash than usual and face few large maturities this year. Unemployment is still close to a half-century low, and revenue has been supported by high nominal growth. A tightening of standards that bites mainly on marginal borrowers could raise default rates without causing a broad wave of bankruptcies.

The historical record is also short. A relationship built on four or five cycles, each with its own causes, is a guide rather than a law, and the growth of private credit means that bank standards now cover a smaller share of corporate borrowing than they once did. Neither point changes the direction of travel. They argue mainly about the size of the coming rise in defaults, not about whether it happens.

Central bankers weighing further rate rises are watching jobs figures that look backwards. The SLOOS shows bank credit has already been cut off, and corporate defaults are likely to climb from the second half of 2023 into 2024.