I recently finished “The Most Important Thing” by Howard Marks (Trades, Portfolio), the chairman of Oaktree Capital. Marks' ability to lay out all the relevant considerations on any given topic in a way that is easy to follow and understand is what I most appreciate about his writing. As usual, I made the mistake of waiting so long: "The Most Important Thing" is one of the best investing books I have read in some time. If you have not read it yet, you should move it to the top of your list.
One concept I found particularly interesting was the discussion on credit cycles. In the book, Marks refers to a December 2007 memo that outlines a few of the major themes of a financial crisis. Here is a shortened list of the one's most relevant to this article:
- Too much capital availability makes money flow to the wrong places.
- When capital goes where it should not, bad things happen.
- When capital is in oversupply, investors compete for deals by accepting lower returns and a slender margin for error.
- Widespread disregard for risk creates great risk.
- Excesses correct.
These themes came to mind at the end of last week when I was reviewing the quarterly results for Wells Fargo & Co. (WFC, Financial) and JPMorgan Chase & Co. (JPM, Financial).
Consider this comment from Wells Fargo’s second-quarter conference call:
“While we remain the largest CRE (commercial real estate) lender in the country, our growth has been modestly below that of the industry for the first half of this year. We've remained disciplined in adhering to our underwriting standards in a competitive market.”
When asked to elaborate, CEO Tim Sloan said:
“The more typical commercial real estate loans were down a little bit, primarily due to some of the competitive pressures that we're seeing out there… One of the reasons why we've become the largest lender in the country is because of our consistent approach to how we manage risk. We've seen cycles before, and we'll see them again.”
The slide deck offered a bit more detail:
“CRE mortgage loans down $1.3 billion as we have maintained our credit discipline in a competitive, highly liquid financing market.”
I do not want to overstate this, particularly since Wells had more than $150 billion in outstanding commercial real estate loans at the end of the second quarter. Simply put, it sounds like the bank may be starting to see some impact from “too much capital availability.”
We heard similar (albeit less detailed) comments about CRE on the JPMorgan call:
“CRE showed growth of 2%, in line with the industry but below last year's pace on reduced origination activity as we continue to be selective at this stage in the cycle.”
It sounds like both of these banks are starting to see increased competition. Apparently there are capital providers out there willing to originate (or at least hold) loans that these banks no longer believe are worthwhile. In response to the increased competition, JPMorgan cut its full-year guidance for core loan growth, noting "we remain appropriately focused on quality and not quantity."
You can only take a step back if you are willing to let loan growth slow (which ultimately reduces net interest income and profitability). If you are not willing to do that, then you have no choice but to compete more aggressively. If capital is in oversupply, that ultimately means better loan terms, lax underwriting standards, or both. The margin for error slims.
It does not sound like this is constrained to CRE. We are seeing this in other areas as well, like auto. Wells Fargo, a leading orginator of auto loans ($30.5 billion in 2016), has tightened its underwriting standards in recent quarters. That led to a nearly 50% year-over-year decline in origination volumes in the second quarter. Management expects the decline in originations to continue in the back half of 2017. It's worth noting that Wells has had a self-imposed cap of ~10% on subprime auto loans (as a percentage of total originations) for a few years. Said differently, even if subprime originations went to zero, there's still a lot left to account for in the nearly 50% year-over-year decline.
These are two examples from large financial instutions where they're seeing competitive activity that leads them to conclude they should start being more selective. Best I can tell, it sounds like much of this lending is coming from alternative or non-bank sources. I think that is noteworthy.
To be clear, I am not trying to predict where we are going. I am simply trying to understand where we currently stand. Based on this information, it sounds to me like we are seeing some combination of increasing capital availability and a growing disregard for (or willingness to accept) risk.
Maybe you can argue we are still experiencing the hangover from the worst financial crisis in nearly a century - that this move is taking us from “too cautious” to something that resembles a more “normal” credit environment. If that is the case, maybe there is nothing to worry about.
Time will tell.
Disclosure: Long WFC
