- The banking crisis may be passing, but I see three risks remaining in the financial system.
- These are collapsing issuance in the leveraged loan market, falling commercial real estate prices, and ESG greenwashing.
The latest banking crisis in the US and Europe shows that the financial system still faces several risks, both old and new. Here are three that I am worried about.
The Leveraged Loan Market
This relates to private equity as they are big users of leveraged loans to finance buyouts. Essentially, leveraged loans are loans given to companies with low credit quality. In 2013, US issuance crossed $1 trillion for the first time. Between 2016 and 2022, it averaged $1.2 trillion per year (Chart 1). Issuance has collapsed this year.
- How many of these previously issued loans will default? Certainly, the rise in yields and, hence, leverage loan rates, will make it harder for them to be refinanced (Chart 2). Moreover, banks may be scaling back their willingness to issue new loans. And if we get a recession, then defaults will likely surge.
- How would this transmit through the system? Bank of America, JP Morgan, and Wells Fargo would likely have some exposure, given they are the biggest bookrunners in this market. But typically, the bulk of leveraged loans get packaged up into collateralised loan obligations (CLOs). These are then bought by asset managers and asset holders, such as pension funds and insurance companies. They would suffer losses and may end up selling their holdings.
Commercial Real Estate (CRE)
Anytime yields are low, real estate does well. The monetary and fiscal stimulus after the COVID-19 pandemic saw commercial real estate prices surge. Between March 2021 and March 2022, US industrial unit prices jumped 25%, apartment block prices jumped 23%, retail units jumped 20% and even office blocks rose 13% (Chart 3). The trouble is that price gains are moderating and, in some cases, turning into annual declines (apartment blocks and offices). This could prove problematic for banks with exposure to these sectors.
Screening US banks, we find smaller banks have a larger share of their loan book exposed to CRE. Notable banks include New York Community Bancorp (they also just bought some assets of failed Signature bank), and Valley National (Table 1). Both have loan books of around $40bn with more than half in CRE. Meanwhile, the larger banks like JP Morgan, Citi, and Bank of America have exposures less than 15% of their books to CRE. Europe has similar issues, notably the Nordic markets.
Environmental, Social, and Governance (ESG) Funds
This may seem odd, but aside from performance issues, there are regulatory and legal risks around greenwashing. Many funds may have classified themselves as ‘ESG’ but may not meet independent verification. Already, news sources suggest MSCI is in the process of reclassifying companies.
The trouble is that there has been a surge of inflows into ESG funds. Focusing on exchange-traded fund (ETF) markets, we find that since the starting of COVID, almost $500bn of flows have gone into ESG ETFs (Chart 4). Were these flows to reverse, asset managers could suffer losses, which in turn could induce other outflows. Moreover, if ESG ratings were to be found to be ‘manipulated’ this could become the next big financial scandal.
The era of low interest rates is over. We are now in a high rates environment, which is set to continue in the short and medium term. Time has become expensive again, and with it, long duration investments are increasingly unattractive. Accordingly, we stick to our recommendation of overweight cash outlined in our most recent Asset Allocation.