When Credit Gets Crunched
The financial winds have been shifting: interest rates have been rising, and the days of cheap mortgages and zero-percent credit have faded into the distance. At a practical level, this means that businesses and consumers are finding it increasingly difficult to get new loans — and the impacts of a full-fledged credit crunch are becoming visible as corporate earnings reports are reducing their estimates for growth in 2023.
This is partly by design. Reducing economic activity and borrowing was a key reason the Federal Reserve started hiking interest rates in March 2022. Inflation rose rapidly during supply chain stresses — peaking at 9.1% in June 2022[1] — and the Fed sought to rein in soaring prices by making it more expensive to borrow money through a series of highly-telegraphed interest rate hikes.
The landscape unexpectedly changed again with the failures of Silicon Valley Bank and Signature Bank in early March 2023. While we wrote about the idiosyncratic issues that faced both banks, the aftermath of their failures led to further concerns that many banks would tighten their lending standards faster than expected, leading to an aptly-named “credit crunch.”
Signs of a Slowdown
In their own words, the Fed defined a credit crunch as “a dramatic worsening of firm and consumer access to bank credit.”[2] More simply, a credit crunch is when businesses and consumers can’t get loans when they need them, leading to a slowdown in the economy or even a recession.
Consumers began shifting their savings out of banks last year, where they weren’t earning any interest, and investing in money market funds and Treasuries that offered higher yields. This process accelerated dramatically following bank stresses in March. This migration of savings means that banks have fewer deposits, resulting in them getting pickier with lending out money. According to a Fed report that tracks the balance sheet of commercial banks in the US, bank lending declined by $105 billion in the final two weeks of March — the fastest decrease on record dating back to 1973.[3]
Recent data shows that lending standards have already started tightening. According to the Fed’s quarterly survey of senior loan officers, a tougher environment for lending started in Q3 of 2022, and that trend continued into the fourth quarter.[4] While these issues started last year with rising rates, they were kicked into overdrive with the banking turmoil in Q1. Investors are cautiously awaiting the Fed’s next quarterly survey of loan officers, to be released in May, to get clearer insight into how banks are reacting.
Household Impacts
At the household level, a credit crunch means it will be incrementally harder or more expensive to finance large purchases with borrowed funds. This means that aspirations of purchasing or remodeling a home, buying a car, or other large spending decisions will be re-evaluated in the context of higher financing costs. In some cases, these decisions may be delayed until the financing landscape is more favorable, while in other cases, it still makes sense to move forward, but with a clear understanding of the costs.
Lines of credit are also impacted during this part of the economic cycle. For anyone with a variable rate loan, such as a home equity line of credit (HELOC), a portfolio credit line, or credit card debt, the monthly payments have become noticeably more expensive. These loans no longer have the more reasonable carrying costs of a year ago, motivating many borrowers to explore ways to accelerate their timeline for paying down their balance. Another impact that arose during prior credit crunches is banks electing to pre-emptively cancel or decline to renew credit lines, even when they weren’t being used. That eliminated a safety net for borrowers but reduced potential risks for the banks.
The higher interest rates that accompany a credit crunch can nonetheless be a benefit to savers. For consumers who aren’t looking to take out a new mortgage or auto loan, the higher rates offered by banks will provide additional growth on cash reserves. CDs have recently emerged as another good option for savers, with current offerings yielding 4% or more.
Carvana Gets Crunched
In financial markets, a credit crunch can create two different types of impact. First, the intended impact is that higher borrowing costs will slow down the rate at which companies undertake new projects, hiring, or expansions. This adjustment will help to cool down inflation and helps to recalibrate future spending and borrowing.
The second impact is that higher rates will put more financial stress on companies that over-borrowed in recent years, taking on too much risk in the form of variable rate debt as they used leverage in pursuit of growth and profit. When the landscape of interest rates or consumer demand shifts quickly, it can be a painful adjustment.
One example is the online used car retailer Carvana. Eighteen months ago, Carvana’s prospects were boosted by pandemic demand, and markets optimistically valued the company at $80 billion. As that demand began to ebb, they were also hit by the credit crunch. They had taken on $6.3B of debt to finance their rapid growth, and higher rates meant that their borrowing costs rose substantially.[5] At the same time, their customers began re-thinking the decision to finance a used car purchase due to higher rates. Currently, the company’s value has plunged more than 98% to less than $1.5 billion and they are struggling to survive.
Carvana is an extreme example, but many other companies have also seen their fortunes dim. The unprecedented era of rock-bottom interest rates has abruptly ended, and the consequences are problematic for the most highly leveraged companies. More free cash flow is used to pay increased interest expense on existing debt, and the common practice of using debt to fund acquisitions that substitute for organic growth is also no longer as appealing.6 As Warren Buffett famously quipped, “Only when the tide goes out do you learn who has been swimming naked,” and the tide of cheap money is currently receding.
Healthy Adjustments
We’ve written in the past that zero-percent interest rates distorted the market for investors and consumers, and the shift back to historically normalized rates is a positive thing for the economy. We’ve also written that this transition from more than a decade of ultra-low rates to a period of higher rates could be tumultuous.
Under the weight of inflation and a slowing economy, both businesses and consumers have held up surprisingly well with the help of a strong labor market. Having the right amount of liquidity will continue to be key for both households and businesses. Liquidity allows you to handle regular expenses without stress and also allows you to take advantage of opportunities — personally or within the investment landscape — when they arise. In the near future, the cost of credit is likely to stabilize. Beyond that, at some point, interest rates will come down and again encourage personal spending and broad economic growth.
Resources
[1] Inflation Is (Still) at a Record High, but a Few Items Are Actually Getting Cheaper Money.com
[2] The Credit Crunch and Fall in Employment during the Great Recession www.federalreserve.gov
[3] Federal Reserve Statistical Release. April 14, 2023. www.federalreserve.gov
[4] Senior Loan Officer Opinion Survey on Bank Lending Practices. January 2023. www.federalreserve.gov
[5] Why Did Carvana Stock Crash? Forbes
[6] For Tech Companies, Years of Easy Money Yield to Hard Times NY Times
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