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Credit and the Domino Effect

Still, you could find a deal.

It’s anyone’s damn guess where this roller coaster is heading, up down or sideways. All of this madness may be a mere normalization of the post-pandemic boom, or the end of globalization as we know it. One thing is for certain though, that we are in an interest rate shock. And it is shocking.

The big banks have taken a beating in Q3 profits, but revenues are doing surprisingly well and will continue to do so as rising rates are allowing them to charge more. The pinch will be next year as rates make those big buyout deals more expensive, fewer and further between. Still, the since 2008 crisis they’ve been sitting on heaps of cash reserves. The banks will weather the storm. It’s not a bad idea to ask whose weatherproofing isn’t so secure.

First: Unsecured debt. Michael Burry, of The Big Short fame, who once worried about collateralized debt obligations, is now grumbling about oceans of unsecured debt in the consumer sector. It’s hard to argue his point. As the rates rise, these debtors are going to be the first to get hit, and are going to get hit with expensive bills about the time the recession starts to bite.

Next: Following those howls of consumer pain, will come the commercial real estate developers. We aren’t talking about a China syndrome real estate meltdown. It’ that the sector loves to borrow at floating rates and that once cheap debt service is about to get expensive at a time when workers are still stubbornly avoiding office space. If retail vacancies, which have dropped to pre-pandemic levels, continue to fill commercial space, they’ve got breathing room. Provided, of course, that the unsecured debt from the last paragraph, combines with nasty inflation and dry up consumer demand.

Then, and this is starting to get tricky, comes the auto-loans. There are a lot of them, and were customers give up on that car note that they can’t afford, and do it in waves, we’ll start seeing ripple effects. The only upside here are opportunities for you to fulfil that life-long dream of becoming a Repo-Man.

Finally, there are the mortgage defaults. A wave of auto loan defaults is problematic, if it spills into the mortgage defaults, it gets traumatic. Investors are already shedding credit-risk transfers (securities that act as insurance against defaults) issued by Freddie Mac and Fannie Mae. Understand that we aren’t looking at a repeat of the financial crisis, both lenders and borrowers are in much better shape that in 2007. There are signs of trouble though, some two years after the pandemic boom in house sales, some three quarters of new homeowners regret the purchase. And they are going to hate it when that floating rate mortgage suddenly gets more expensive.

All of which, is likely to cause a sour mood through next year, but nothing we’d call a systemic risk to banks. Since the financial crisis have gone from “too big to fail” to “too safe to fail.” Still, if you like the high yielding dodgier assets, there will be plenty to choose from.


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