KBRA Financial Intelligence

3 Things in Credit: Credit card losses, Bank risk appetite, Private credit’s middle market trends

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Welcome, market participants, to another 3 Things in Credit. I’m Van Hesser, Chief Strategist at KBRA. Each week we bring you 3 Things impacting credit markets that we think you should know about.

Nothing like a dovish jobs report to turn the market loose: “Companies Flood Markets With Debt Sales as Rates Fears Ease,” screamed a Bloomberg headline this week. But I probably didn’t have to remind you—overworked market participant. But just in case you needed confirmation, financial conditions across just about all credit asset classes are about as constructive as we’ve seen in some time. The ABS market is humming and even leveraged loans are ripping. Certainly beats the alternative.

This week, our 3 Things are:

1. Credit card loan losses. They’re at the highest level in 13 years despite unemployment at historically low levels. Does that make sense?

2. Bank lender risk appetite. The latest Senior Loan Officer Survey is out. We’ll tell you what you need to know.

3. Direct lending into the middle market. A new KBRA report, which has gotten a lot of market attention, sheds much-needed light on asset quality trends.

Alright, let’s dig a bit deeper.

Credit card loan losses.

Credit card delinquencies and loan losses have been getting a lot of attention lately, and for good reason. Card performance is a great barometer for the health of the consumer, and its ability to drive economic growth. And the trend is not our friend.

It should come as a surprise that card losses (the lagging indicator, delinquencies the more real-time indicator) are at the highest level in 13 years. This at a time when the unemployment rate is historically low. Put another way—the last time card losses were at this level, unemployment was 8.7%! What does that say about the consumer, and the big banks that dominate this space?

First question—what accounts for this? The answer lies in what we call our “Two Economies,” one consisting of wealthier consumers and big business, which are doing just fine, and, two, mid- to lower-income consumers and small businesses, which have been impacted more by inflation, and where there is greater financial vulnerability. There is a group of consumers that got used to a certain lifestyle fueled by stimulus that is now struggling. They’ve burned through excess savings, ordinary savings, wage gains, and have now tapped out credit capacity. Inflation has hit this group hard, and they’re at the end of their rope.

Second question—where is this headed? For perspective, there is no better yardstick than the GFC—a consumer credit bubble that spectacularly burst. Card losses peaked in that cycle at 10.5%. When the Fed releases its data for Q1, we expect the loss rate to be around 4.6%. The beauty of the card business from a lender’s perspective is that you can adjust underwriting standards continually—raise rate, cut credit lines, do what you have to do to adjust to changing market conditions. And lenders have seen this wave coming. Guidance from two large lenders, Capital One and Citigroup, implies that losses are likely to peak over the near term at levels that are not far off of Q1 levels.

Third question—is this a credit issue for the big banks? No, the margins on the card product are super high to begin with and can be adjusted as conditions warrant, meaning borrowing rates are moving toward record highs.

Which brings us to our fourth question—is this an issue for the broader economy? This is worth watching. The canary in the coal mine? Maybe. It certainly is a reminder that the above-potential growth in the U.S. is driven by leftover stimulus, whose positive impact is diminishing. And it is worth bearing in mind that the top 40% of household income earners account for about 60% of total spending, so the impact of what’s happening among lower-income cohorts is muted to some degree.

So, to sum up, we’re not all that worried about what we’re seeing on the card loss front, and, like everything else, it seems what happens on the jobs front will really determine how impactful this all is.

Alright, on to our second Thing—Bank lender risk appetite.

The SLOOS is back! The Fed’s Senior Loan Officer Opinion Survey. In a word, banks remain “cautious” in their lending risk appetite. Whether that comes from concern that the Fed’s history is to overshoot when tightening monetary conditions, or concern that stiff competition from nonbank lenders has compromised risk and reward is unclear. But what is clear is that the banks have a view of credit that doesn’t quite sync up with an economy that is performing at above-potential growth.

On balance, banks are still tightening lending standards for commercial and industrial loans, commercial real estate loans, credit card, auto, and other consumer loans, as well as many categories of residential real estate. Granted, the survey period was last week of March to first week of April, but the soft-landing narrative was firmly in place at that point.

Banks tightening commercial loans cited a less favorable or more uncertain economic outlook, a reduced tolerance for risk, and worsening of industry-specific problems as reasons for their conservatism. On CRE, the most cited reasons for tightening credit were less favorable or more uncertain outlooks for CRE market rents, vacancy rates, and property prices—no surprise there. Over on the consumer side, a “significant” share tightened the box on credit cards, raising minimum credit score requirements. Similar action was taken against auto and other consumer borrowers as well, but not to the same degree.

It is worth noting that, overall, the trend is better from a year ago in the wake of the three midsized bank failures. But to be clear, credit is tightening among bank and nonbank lenders and interest rates are clearly restrictive. The combo is not as ominous today as a year ago, but this is consistent with economic slowdown in the back half of 2024.

Alright, on to our third Thing—KBRA’s view of middle market private credit borrowers.

KBRA’s private credit ratings group is out with its First-Quarter 2024 Middle Market Borrower Surveillance Compendium, which reviews corporate credit assessments of 450 direct lending borrowers in Q4 2023 and 462 in Q1 2024. These credit assessments were drawn from nearly 3,500 corporate credit assessments KBRA has compiled over the past two years, and the data related to these assessments continue to provide unique insight into the otherwise opaque direct lending landscape. KBRA monitors these credit assessments as part of our surveillance of 100s of KBRA-rated private credit feeder notes, collateralized loan obligations (CLO), and private credit NAV/leverage facility transactions. In private credit, KBRA has 900+ ratings on more than 800 transactions and issuers for more than 100 different sponsors.

Our latest review is noteworthy in that the full impact of higher base rate interest costs is being absorbed. Not surprisingly, our review found downward credit migration is occurring as some companies struggle with higher interest rates and other liquidity pressures. In Q1 2024, 21% of reviewed estimates migrated lower versus 13% in Q4 2023. Defaults are rising but remain muted, with only eight payment defaults out of 462 reviewed assessments in Q4 2023, and eight payment defaults out of 450 reviews in Q1 2024.

By sector, acute pressures in some portions of the health care services and technology sector account for some of this downward migration in credit, with entities from this sector accounting for 23 out of 95 lowered assessments in Q1 2024. The software sector’s relative resilience is evidenced by its smaller relative percentage of downward assessment actions despite representing a slightly outsized proportion of the quarter’s surveillance portfolio. Interestingly, there were more upgrades than downgrades of assessments that began as ccc+ scores in both quarters. This reflects the presence of many companies growing into their levered capital structures, particularly in the software sector. You can find the full report on our website, KBRA.com.

So, there you have it, 3 Things in Credit:

1. Credit card loan losses. Not all is well with the consumer.

2. Bank lender risk appetite. Banks remain cautious, as does the Fed. That’s a headwind for growth and credit.

3. Direct lending into the middle market. Not surprisingly, KBRA’s updated review found downward credit migration is occurring as some companies struggle with higher interest rates and other liquidity pressures.

As always, thanks for joining. See you next week.