KBRA Financial Intelligence

3 Things in Credit: Fed Cuts, Airline Read-Across, Syndicated Loan Quality

Listen to Van Hesser's insights on: Spotify | Apple | YouTube Music

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.

As we find ourselves in the midst of a market “correction” (by the way, we need a new word for “selloff”—“correction” implies that markets were wrong). Anyway, in the midst of a correction, researchers at MIT have found that the U.S. is not very good at building physical things. Construction productivity has fallen 40% in the past 50 years, and our infrastructure construction costs are now more than double the OECD average. Not hard to imagine in an economy fueled by services and intellectual property. So, addressing the U.S.’s most pressing needs—affordable housing, sufficient electricity, efficient transport—will not be easy. Or cheap. Happy Friday.

This week, our 3 Things are:

1. Fed cuts. The decisions won’t be just data driven—it’ll be behavioral.

2. Airline read-across. Markets and managements seem to disagree about the near-term outlook.

3. Syndicated loan quality. There are some surprising developments in a recently released regulatory report.

Alright, let’s dig a bit deeper.

Fed cuts.

The U.S. economy is slowing. So says the survey data and updated estimates from the Street. And likely from the Fed.

Goldman has revised its 2025 GDP estimate to 1.7% from 2.4% set at the beginning of the year. Morgan Stanley cuts to 1.5% from 1.9%. The Fed’s Summary of Economic Projections is at 2.1%, but that was set back in December, during “peak Trump.” We’ll get an update next week, and if I’m a betting man …

The reasons driving slowdown are not news. It’s normalization—the running off of stimulus-fueled excess growth. It’s the tapping out of spending and borrowing capacity by less wealthy households. And it’s uncertainty introduced by economic policies that have undermined consumer and commercial confidence and created a powerful negative wealth effect in financial markets. Enter the “Powell Put.” Time to cut interest rates in order to stimulate growth. Textbook stuff. In fact, the market is now pricing in three cuts in 2025.

It wasn’t long ago that it became fashionable to assume zero cuts. The Fed’s “needs attention” gauge, split by its dual mandate balancing maximum employment and price stability, is now tipping toward the max employment—i.e., growth, side, right?

Well, not so fast. That pesky inflation thing continues to hang around. True, we got relatively benign CPI and PPI numbers this week, suggesting we are still on track to bringing inflation back to target. But we’re not there yet.

And those data, of course, are backward looking—as in, prior to tariff and immigration impacts, both of which figure to bring upward pressure on prices in the near future. Then you have price pressure from long-term investment needs stemming from the above-mentioned infrastructure updating, the energy transition, and security of everything. As we talked about last week, we are getting more than a whiff of stagflation here. And that just might keep the Fed on hold here for a while.

Remember, the many members of Team Transitory, as Chair Powell not so fondly remembers being the skipper of, had their reputations scarred by not recognizing the risk of inflation. Obviously, there’s no science here, but my guess is that Chair Powell and his FOMC compatriots believe job one is whipping inflation. In Fedland, your legacy rides on how successfully you fought inflation, less so whether you presided over a recession. Look at Paul Volcker. That suggests that the Fed could drag its feet here, and ultimately may not act as aggressively as the market would like. That’s less than ideal for credit.

Alright, on to our second Thing—Airline read-across.

Airline risk is being repriced. This time, it’s not about fuel costs. The trend there has actually been quite favorable. This time, it’s what Delta CEO Ed Bastian referred to as a “parade of horribles” the industry has endured over the past few months, including bad weather, California wildfires, high-profile plane crashes, and deteriorating consumer sentiment and financial wherewithal.

Demand for air travel, ever sensitive to economic and sentiment headlines, has taken a hit in Q1 in reaction to the aforementioned factors. Mr. Bastian warned at a conference this week of a $500 million revenue hit in the quarter—that’s 4% below what was expected. By his estimate, about half of that is expected to come back. So, call it a 2% revenue hit to flow through or reclaim over the balance of the year, presumably offset by lower fuel costs. Indeed, management reiterated full-year guidance. United Airlines, speaking at the same conference, is of a similar mind, saying that “nothing we’ve seen in the short-term impacts what we think is going to be happening even a year from now.”

So, how does that square up with the selloff in airline risk? At Delta, its stock is down 36% from its recent high in February and five-year CDS has widened 40 bps from its recent tight in January. United Airlines stock is down 37% and its CDS 122 bps wider. Southwest stock is down 11% and its CDS 25 bps wider. American Airlines stock is down 43% from its recent high. All of this suggests investors are more concerned about the risk of a consumer-led economic slowdown.

Commentary from others hint at the uncertainty. At Southwest, CEO Bob Jordan referred to “a kind of broad softness in the macro economy,” while American Airlines CEO Robert Isom called the economic uncertainty “a big deal.”

The good news here is that wage growth continues to edge above inflation, and the labor market remains solid. Those things have been constant for some time now. What’s new on the economic front is the negative wealth effect from stocks selling off, and increased uncertainty that is chipping away at consumer and commercial sentiment. Those headwinds figure to be with us through much of the year. The trend here is not the airlines’ friend.

Alright, on to our third Thing—Syndicated loan quality

U.S. bank regulators—the Fed, the FDIC, and the OCC (aka, the Comptroller of the Currency, an independent bureau of the U.S. Treasury)—released this week their latest results of the Shared National Credit (SNC) Program, phonetically known as the “Snick” review. The program reviews the quality of loan commitments of $100 million or more shared between at least three banks. The latest iteration covers loans originated prior to June 30, 2024.

The report grades loans as Pass—all good—or Non-pass. Non-pass are graded Special Mention and Classified. Special Mention loans are performing loans but have potential weaknesses that deserve management’s close attention. Classified loans are problem loans, broken down into Substandard (weaknesses that could turn into some loss of value), Doubtful (worse than Substandard), and Loss (write it off). Regulators also track nonaccrual loans—loans where interest is no longer being accrued. There, you can now be a bank examiner.

We keep track of the SNC report, as it is a window into trends in credit and the ongoing ability of banks to continue to lend. We judge these things via the problem loan ratio, or Classified loans to total loans. The report also highlights sector trends by industry or collateral type like commercial real estate.

Overall, the regulators characterize SNC credit risk in its latest review as “moderate.” Admittedly, that’s not terribly helpful. So, let’s look at some data.

“Classified,” or problem loans, rose 9.7% from the 2023 report, to 6.7% of total commitments. That’s up from 6.2% the prior year and 4.2% in 2019 before COVID. That’s less than ideal for an economy that was growing at significantly above potential. Still, it’s not all that worrisome when you consider the worst on record going back to 1989 is 15.5%, recorded in 2009 in the wake of the GFC. I guess the latest result squares up with “moderate.” Still, in 2002, the year after the WorldCom/Enron recession, the ratio hit 8.4%—so 6.7% and heading into slowdown suggests that we are approaching a flashing yellow environment, where the risk is some degree of bank credit crunch.

Here’s an important mitigant. It’s important to remember that significant large corporate and real estate lending has moved into private markets, which, in our opinion, will be less likely to pull back aggressively on lending, as they do not have to worry about regulators (other than markets) having a say on lending risk appetite, something the large banks cede control of to regulators in downturns.

Looking at the data by sector, it may come as a surprise that commercial real estate and construction had the lowest concentration of problem loans (including Special Mention loans) of the five “Focus Industries” targeted by the regulators. technology, telecom, and media had the highest, at 19.7% of commitments, followed by commercial services at 17.4%, health care & pharma at 14.4%, materials & commodities ex-oil & gas at 12.4%. CRE brings up the rear at just 8.2%. I’ll bet if you ask 100 market participants which of those five sectors had the least problem loans, no one would come up with CRE. Wisdom of the regulators? Time will tell.

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

1. Fed cuts. The transitory scar will likely keep cuts to a minimum.

2. Airline read-across. Markets are pricing in a consumer spending slowdown.

3. Syndicated loan quality. CRE is well behaved, but the overall trend here bears watching.

As always, thanks for joining. We’ll see you next week.