Kafka vs. Keynes

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The Hateful 8: The H.8 Report

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Soundbite: Camouflaged financials causing bank losses bring back memories of the 2008 housing crisis, and data center and vendor financing recall the froth of 1999 and 2000. Can investors avoid repeating history just by remembering it? The Federal Reserve’s H.8 report is now required reading. The H.8 category “Loans to nondepository financial institutions” tracks commercial bank loan exposures to private equity and private capital firms. As we wrote months ago, this loan category is growing at a 20% annual rate and makes banks vulnerable to alternative asset investment company default risk. What we did not know back then was the upcoming reclassification of over $200 billion Consumer and Commercial & Industrial loans to nondepository financial institutions (NDFI) loans. The Fed quietly made the change a few weeks ago, and they backdated it to January 1, 2025. Any more stealth reclassifications will be a trigger for a new wave of selling in bank stocks.

Markets have a new focal point: Loans to Nondepository Financial Institutions update at 4:15 p.m. every Friday in the central bank’s H.8 report. Any new spike in that NDFI loan portfolio could mean there may be many more shoes to drop regarding faulty loan underwriting by private credit that could signal a credit bust. However, we believe the bigger story will end up being its impact on the data center buildout’s blended cost of capital.

The liquidity spigot turned on this year by the banks to the private credit industry may be over, thanks to commercial bank write-offs on Tricolor and First Brands. At the very least, loan standards and terms will be tightened for this category, and the H.8 data will reveal a slower growth trajectory in NDFI loans.

If loan growth slows as we expect, it will raise private credit and private equity interest expense. These private investment firms are expected to fill about three-quarters of the hyperscalers’ capital needs. Increased funding costs widen the chasm between projected revenues and total capex spend. At some point, this funding gap/revenue shortfall will create a negative backdrop, causing investors to question the untarnished AI theme. As concerns grow, it will be difficult to justify current valuations for the Magnificent 7.

Investors are still positive on the long-term positives of the capex spend, plus their expectations for beneficial tax write-offs and deregulation keep everyone fully invested. However, the proverbial straw could come in the form of either more negative loan loss reports or if the Fed is forced to reclassify more loans in the riskier NDFI category. Friday’s latest H.8 did not see any reclassification boost, but any revision reported in the Asset and Liabilities report on any given Friday after the markets close will spark selling on the open when the Sunday session opens in Asia.

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Vertigo at the Top

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Soundbite: The question of the hour is how much risk is embedded in the NDFI lending market. We expect more bad loans to become public, but we cannot be certain of the degree. The direction of the economy will determine whether risks can escalate to become systemic. CEO Jamie Dimon warned during JP Morgan’s earnings call that based on Tricolor and First Brands, “Everyone should be forewarned on this one… I suspect when there’s a downturn, you will see…credit losses in certain categories…worse than a normal credit cycle downturn.” As we cautioned last week in our title “Is the Tide Going Out?”, a window exists for the economy to propel stocks higher, but it may be closing.

JP Morgan CFO Jeremy Barnum voiced his concern that “we have already seen slowing growth…it’s pretty easy to imagine a world where the labor market deteriorates from here.” This opinion reminded us of Philadelphia Fed President and 2026 FOMC voter Anna Paulson’s saying last week that the economy is holding on to a “narrow base of support for growth.”

In his comments about their $170 million Tricolor loss, Dimon got headlines from his “when you see one cockroach, there are probably more” comment, but more troubling was his follow-up, “There are a couple other ones out there that I’ve seen.” Dimon channeled his inner Gregor Samsa (Google it under “Kafka”) when he added, “My antenna goes up when things like that happen.”

We cannot know whether this develops into a wider problem. Still, Apollo President Mark Rowan’s description that these bankruptcies are “late-cycle accidents” does match the typical pattern of a credit boom-bust cycle. We agree with Rowan’s view that lenders during the credit boom become lax in a race to increase fee revenue in “competitive markets which sometimes leads to shortcuts.”

CFO Barnum concluded that JP Morgan’s lending to the NDFI community does not represent elevated risk. He described their private credit loan customers as “large, very sophisticated, very good at credit underwriting.” Notably, Jamie Dimon immediately took exception, shooting back that private credit can contain blowups due to lower standards, warning that “they are not all very smart.” This is a crucial point—credit busts can occur away from the best underwriting practices that lend only to the highest quality borrowers. Dimon drove home that point: “We don’t even know the standards that other banks are underwriting to some of these entities. Every now and then, we see what someone else is doing, and we’re surprised at their standards. They’re not particularly good…some of those deals may not be as good as you think.”

The link to potential systemic risk for banks lies with these unregulated loans. If one assumes nonbank lending standards are weaker, the market will shoot first and ask questions later if more bad data comes to light. Therefore, the perceived risk of lending outside the regulated perimeter may have crossed the point of no return, but investors may get temporary amnesia about loan losses and only focus on Jeremy Barnum’s upbeat assessment that for now, the “consumer is resilient, spending is strong, and delinquency rates are…below expectations.” Investors may require even weaker growth data before they turn bearish.

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Small Fry

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Soundbite: Investors and central bankers are enamored with the view that tariff inflation was blown out of proportion, given that goods inflation has been relatively contained. The National Federation of Independent Business (NFIB) Small Business Trends Survey for September uncovers an inventory problem that may explain the cause of well-behaved inflation. The NFIB found small business owners who view inventories as too high jumped more between August and September than at any other time in its 50-year history. September’s level matched the April 2020 pandemic highs. Prices may have been capped solely from selling goods out of inventories at pre-tariff prices. That means prices may be low not from exporters eating tariffs, or U.S. distributors cutting margins to preserve market share, but from a lack of demand that has yet to see pre-tariff inventories fully turning over.

This inventory backup makes us wonder if optimism over companies finding creative ways to avoid passing tariffs onto their customer is misplaced. If tepid demand has caused bloated inventories, and that is the reason prices have not risen, this is not a constructive development.

Once those low-cost inventories run down, prices will rise unless margins absorb higher inventory costs. Assuming U.S. firms cannot compress margins indefinitely and demand does not pick up, we could see stagflationary forces arise.

The most recent Challenger Report showed alarmingly low hiring and hiring announcements for September, the key month for retail holiday hiring. Challenger also reported that state hiring data showed drops in leisure and hospitality hiring at the state level, a reliable indicator of weak consumer demand. Challenger’s finding reinforces the fear of a weak sales outlook, similar to the NFIB data on excessive inventory build.

We have maintained that investors’ hope for a string of rate cuts will not be due to a soft landing, but a need for the FOMC to cut rates to avoid a recession. The NFIB data points to that scenario.

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What to Look for This Week

(All times E.S.T.)

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1. Friday, October 24 at 8:30 a.m. September Consumer Price Index is released nine days late. The last two core CPI numbers were 3.10% for July and August. The Philadelphia Fed’s Inflation Nowcasting forecasts September to round up to 3.0%, so if that is correct, then the market will rally on confirmation of a 25-basis point cut for the FOMC meeting.

2. Tuesday, October 21, at 10:00 a.m. September State Employment and Unemployment data. Normally this is not a focus, but given the absence of Nonfarm Payrolls, this will be scrutinized by investors to back into the September employment situation.

3. Friday, October 24, at 4:15 p.m. the Federal Reserve releases its. H.8 report on Assets and Liabilities of Commercial Banks in the U.S for the week ending October 15. Line 26 on the fourth page of the report, which details the balance sheet of commercial banks regulated by the Fed, contains a category labeled “Loans to nondepository financial institutions.” That shows the growth of lending to private credit and equity companies, among others. There were upward revisions to reclassify loans as NDFI loans after the Tricolor bankruptcy. We will be looking for another potential revision higher for First Brands, or any other borrower that has loans out with commercial banks that need to be reclassified as a financial entity.

FOMC Voters Speaking: In the blackout period before the October 28-29 Federal Open Market Committee rate meeting, so no public statements until after the meeting.

Earnings: Q3 earnings season continues in earnest: Tuesday, October 21, after market close, Netflix (NFLX) will be the highlight. Texas Instruments (TXN) also reports after market close. Wednesday, October 22 after market, Tesla (TSLA) is featured, and we will look at Las Vegas Sands (LVS) also out with TSLA, to see how travel and the consumer are faring during their guidance discussion. Thursday October 23 Blackstone (BX) before market open to see if there is any discussi on the Private Equity or Private Credit outlook.

By Peter Corey

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