KBRA Financial Intelligence

3 Things in Credit: Problem Loans, Geopolitics, and Default Forecast

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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.

So, we’re off and running into a new year. The Wall Street Journal’s Heard on the Street column says, “it’s hard to know whether the global economy is at the start, the middle, or the end of a cycle.” That doesn’t seem to matter to credit investors, where Bloomberg has characterized demand as “voracious.” Sounds like just another January to me.

This week, our 3 Things are:

1. The rise in problem loans at banks. Should we be worried?

2. Geopolitical risks. The radar is getting crowded.

3. KBRA Analytics default forecast. We’ve got a non-consensus view.

Alright, let’s dig a bit deeper.

Mounting problem loans.

By the time you hear this, you will have seen and heard about Q4 earnings from J.P. Morgan Chase and Bank of America. Both, obviously, great proxies for the broad economy—how consumers are doing, how businesses are doing, how they’ve done, and what their prospects are. Earnings conference calls will focus on the usual topics that equity analysts obsess over—growth of net interest income and expenses, trading results, prospects for stock buybacks.

Having looked at banks for longer than most, I’m here to tell you that not enough attention is directed to the risk side of the equation. And it should surprise no one that loan losses—the risk side—are what makes banks turbo-cyclicals. Leave it to the credit folks to focus on the downside. The fact of the matter is trends in loan quality are really what drive earnings and, ultimately, valuation—especially at this part of the credit cycle.

Loan quality risk is disclosed by the banks in three ways that reflect how current and expected economic trends are impacting the quality of the loan book. Specifically, we get:

• Net charge-offs, or losses on deteriorated loans.

• Nonperforming loans, which are deteriorating loans where typically the borrower has not made a loan payment in at least 90 days.

• The loan loss provision, which is an income statement line item of funds expensed out of current income that is set aside for projected future net charge-offs.

This issue did come into focus this week courtesy of a piece in The Financial Times, where a headline bellowed, “Largest U.S. banks set to log sharp rise in bad loans.” The piece highlights that consensus estimates for the four largest U.S. banks (J.P. Morgan Chase, Bank of America, Wells Fargo, and Citigroup) are calling for nonperforming loans to rise to $24 billion, $6 billion higher than the year-ago figure. Sounds like a lot. And a 33% jump in a bad thing is not a good thing.

But a little perspective here is important. These four banks have nearly $4 trillion in loans. That means $24 billion in nonperformers equals 0.6% of loans. Applying Charlie Munger’s favorite invert approach, that means that 99.4% of loans are in good shape. That is extraordinary. We start to get a bit worried when nonperformers get to 3%.

How about the loan loss provision? For all U.S. banks, that hit 8% of total revenue for the latest 12 months ended September. The longer-term annual average is 10%. For context, in the GFC it hit 35%, so we have a way to go before that starts to bite. To be clear, the trend here is not our friend. But the nonperforming ratio and the loan loss provision are just two more things that are normalizing. Given the de-risking phenomena banks have undergone post the GFC (moving a lot of loan risk into markets), the strength of consumer and commercial balance sheets in the aggregate coming into this downturn, and the soft landing that we see coming, we do not anticipate loan quality data to show material deterioration in this cycle.

Alright, on to our second Thing—Top geopolitical risks.

We often remind our clients that geopolitical risk developments generally do not impact markets all that much, except—except—when they materially affect supply and demand of key goods or services. Moreover, many perceived risks that fall into this category tend to be tail events. It doesn’t mean that they can’t impact markets; in many instances potential outcomes could significantly alter the course of history. It’s just that the probability of these events occurring tends to be very low. So, it’s hard to invest profitably around these prospects.

That said, the collection of geopolitical risks that are on the radar at the moment is as formidable as any time I can think of. This is undoubtedly a function of a world that is more interconnected than ever, yet bipolar if not multipolar in its power structure. Technology, of course, is fueling that interconnectedness, and it’s running far ahead of governments’ ability to control it. So, that has brought us closer together for good and bad.

Meanwhile, the U.S. and China continue to grapple for global leadership while a handful of rogue states have brought unwelcome disruption. Ian Bremmer of the Eurasia Group goes as far to say that we live in a “G-Zero” world, a world without global leadership. Mr. Bremmer is decidedly downbeat in his yearly tabulation of “Top Risks,” noting that three wars—Russia-Ukraine, Israel-Hamas, and the U.S. versus itself—are raging with prospects of achieving sustainable peace in any of those wars “not remotely close.” Happy New Year.

But let’s bring this back to markets. Starting, as we often do, with oil. The world in general, and Europe in particular, have adjusted reasonably well to the disruption in distribution caused by the Russian-Ukraine war. We are not prepared, however, for production or distribution disruption that could come from escalation of war in the Middle East. That escalation could affect more than just oil if it leads to shipping disruption in the Red Sea, through which an estimated 10%-15% of global trade flows.

In risk markets, we also worry about China, where its ambitious to say the least attempt to fundamentally alter the course of its economy has introduced significant risk into global growth. Mr. Bremmer observes that, “consolidation of power at the top has snuffed out policy debate and animal spirits just as China’s past growth engines have been exhausted, and there is little the government will do to reverse either trend.” Bloomberg consensus has taken 2024 China estimated growth down to 4.5% from 5% back in May 2023. That’s quite a fall from 8.4% averaged annually for the past 20 years. A lot of this is factored into sub-potential growth in the developed world for 2024. But, for now, that growth—the consensus view is 2.6%—is still expected to be positive.

Alright, on to our third Thing—KBRA Analytics updated default forecast.

Van: Joining me is Eric Rosenthal, who generates our forecast as part of his work with KBRA DLD, our direct lending news and analytical platform. Eric, welcome back to the podcast!

Eric: Thanks, Van, for having me back on the podcast.

Van: So, Eric, since we last talked the soft-landing narrative has taken root, where inflation continues to reduce toward target, while economic growth remains buoyant and the labor market tight. And that has kept investor sentiment (and more importantly, liquidity) relatively upbeat. Is your bottom-up default forecast synching up with this view?

Eric: For high yield, this is exactly what I’m seeing and why we believe the default rate on a dollar basis finishes slightly lower in 2024 than in 2023. Six months ago, our Default Radar Red List stood at $44 billion with 24 issuers and is currently down to $33 billion with just 19 issuers.

Van: Can you give a 30-second description regarding the Default Radar and the bottom-up approach?

Eric: Definitely, our Default Radar identifies the most troublesome credits for potential defaults. Credits are flagged red or orange depending upon the severity of the situation, with the most worrisome deemed red. We believe secondary bid levels are the most predictive for determining potential defaults but other factors such as market news, ratings, maturity, and industry are certainly examined. These loan, high-yield, and direct lending Default Radar borrowers are published in our monthly report.

Van: I noticed in your press release earlier this week that you are calling for syndicated loan default volume in 2024 to exceed high yield by the largest ever margin. Can you discuss?

Eric: Sure, we are forecasting roughly $60 billion of syndicated loan defaults versus approximately $39 billion for high yield for 2024. If you compare that to last year, that translates to an increase of about $8 billion for loans and a decrease of $5 billion for high yield. Loan default volumes have surpassed high yield for three consecutive years. One of the reasons we believe this occurs again in 2024 pertains to credit quality: there is a notably higher portion of issuers rated B or lower in syndicated loans compared with high yield. The biggest reason though, that centers on the Default Radar.

Van: What do KBRA’s Default Radar numbers show?

Eric: There is $53 billion of loans in outstandings versus $33 billion for high yield on our Red List. From a count perspective, there are 46 loan companies compared with the 19 for high yield. If we extend to the Orange List, there are another 85 loan borrowers versus 37 for high yield. Essentially, more than two times as many loan issuers are on our Default Radar. This ties back to why we expect syndicated loans to surpass high yield in 2024 and by a wide margin.

Van: Your 3% high-yield default forecast by volume is below consensus and even the long-term average. Is there any path to a higher rate, like 5%?

Eric: It’s not impossible but highly unlikely, because to reach 5% requires $65 billion of default volume, meaning a $20 billion jump from 2023. Recall there were sizable issuers last year that propelled the numbers, such as Carvana, Diamond Sports, Ligado, and SVB. Now, there are still some big issuers projected to default in 2024 via distressed debt exchanges that should propel the volume, such as Lumen. Essentially, to hit 5% you would need at least two of Bausch, DISH, or Community Health to file for bankruptcy coupled with the macro environment to worsen imminently. When you factor in that BAML’s distressed ratio, which looks at spreads over 1000 bps, is at its lowest level since May 2022, and a 5% rate seems as likely as the Eagles defense morphing into the ‘85 Bears.

Van: Whoa. I see what you did there! You’ve put this all in a language I unfortunately understand! Speaking of distressing situations, you mentioned distressed debt exchanges. Is that something you see continuing in 2024?

Eric: At least your team is still in it, my squad was done four offensive plays into the season. As to distressed debt exchanges, we believe this continues to play a huge role in producing loan default volume and contributes to the anticipated 4% rate for 2024. What is interesting is that from 2008 to 2018, this source of defaults accounted for just 8% of the loan total. Over the past five years, distressed debt exchanges now comprise 32% of the volume. Furthermore, over the second half of last year, more than half of the default amount involved distressed debt exchanges. We have already seen Travelport and Resolute Investment Managers complete sizable ones in 2024 and more are on the way.

Van: I got it. Thanks, Eric, for joining us today.

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

1. The rise in problem loans at banks. It bears watching, but it’s a long way away from being meaningful.

2. Geopolitical risks. Watch the Middle East for an impact on oil and shipping.

3. KBRA Analytics default forecast. We believe it’s going to be below consensus.

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