The Next Banking Crisis?

Tariff Tale: Trade counterparties, as well as investors, are expecting an end state for most tariffs to result in only slight increases, putting some upward pressure on inflation and downward pressure on growth. However, the biggest impact will be a loss in confidence in the US and the dollar and our debt. As foreign investors become less likely to fund our spending (infrastructure, investments, tax breaks, etc.), deficits will become harder to fund and more costly, giving us less margin for error to accomplish our goals. From an investing standpoint, there will be more stable places to invest, so we repeat that it is prudent to spread capital out of overly concentrated large US names to other segments domestically and globally.  

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Dodged One Ratings Agency Bullet, But Here Is One More… 

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Soundbite: Fitch warns that America’s largest commercial banks have accelerated their lending to private equity and private credit (PE), which could represent a systemic risk. For now, investors are ignoring the problem because bank balance sheets are strong. However, if rates continue rising, markets will be vulnerable to another round of liquidity troubles. If this illiquid asset class sees forced reductions at deep discounts, the credit extended to PE by the banks becomes far riskier. 

The Moody’s downgrade has come and gone, but there is another problem. Since the pandemic, businesses are increasingly using private credit as a source of funding, turning away from commercial bank lending. Commercial banks have pivoted to fill that vacuum by ramping up lending to those very same private equity and private credit firms that have been taking banks’ market share. Commercial bank lending to those firms (called “nonbank financial institutions, or NFBI) has increased by 20% in the last year alone and stands at over $1 trillion.  

Fitch is concerned about this latest ramp-up by the banks. Aggressive bank lending practices have often backfired, leading to asset quality problems that negatively affect banks and the economy in general. Confidence in the banks remains strong, and high yield spreads are 125 basis points tighter than early April, when aggressively rising 10-year yields (at similar levels to today) generated liquidity ripples. The current market calm reminds us of the halcyon days when CMO’s (Collateralized Mortgage Obligations) were popular before the 2008 housing problem that cascaded into a full-blown credit crisis.  

Festering market problems can continue for years without a spark, but that trigger may have arrived in the form of Donald Trump’s jihad against university funding. Government grants are applied to cover about two-thirds of a university’s overhead. The funding freeze could force a liquidity scramble, and we note that many elite universities’ endowments are over 80% invested in illiquid markets such as PE, venture capital, and real estate. MPI Research finds that PE holdings for the Ivy League are 37% of their endowments’ total assets.  

Yale and Harvard have announced they are selling a part of their private equity holdings, and if these secondary market transactions find weak demand and sell at a steep discount, that would quickly impact commercial banks’ willingness to continue lending to NBFI. It would reflexively hurt bank valuations as investors become anxious over loan portfolio write downs not seen since the housing crisis. There is a way to avoid such a credit crisis: a continuation of a stable economy with lower interest rates. We hope the economy can dance through the raindrops, but it is important to have a grasp of the potential downside.

Beth Hammack Has a Problem 

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Soundbite:  The members of the Federal Open Market Committee (FOMC) publish a new set of economic and rate forecasts at the June 17-18 meeting. Right now, they are operating off various economic scenarios, not an expected forecast. However, the meeting requires picking their most likely forecast. President Beth Hammack of the Cleveland Fed lists stagflation as her base case. If that turns out to be the consensus, the Fed Funds forecast will project fewer than March’s expectation for two cuts this year. That could unsettle the administration and the markets. 

President Hammack agrees with us that tariff uncertainty makes it difficult to have confidence in one economic path and laid out three different scenarios. The combination of the June 18 Summary of Economic Projections (SEP) for year-end inflation, unemployment, and fed funds predictions will shed light on which of the three scenarios they are leaning toward. 

First, she considers that tariffs could have a one-time effect against a backdrop of a slowing economy as businesses and consumers freeze spending plans. In that case, the Fed stands ready to cut rates, “potentially very quickly.” Any of the 19 FOMC members holding that view will drop their Fed Funds forecast and raise their Unemployment prediction, keeping their Core PCE inflation forecast for 2026 and beyond unchanged. She outlined a second situation analogous to 2020, where firms retain workers and inflation turns out to be sticky because tariffs are implemented over a long runway. Anyone expecting that possibility will hold Unemployment steady but nudge up their Fed Funds and core PCE forecasts.  

Hammack said her baseline scenario is stagflation, and if that is the most popular path at the June meeting, the SEP will reflect higher Unemployment and Core PCE inflation forecasts than March’s 4.4% and 2.5%, respectively. If that happens, then the critical variable is whether the Fed Funds forecast of two cuts is changed to one, or no action at all for the rest of the year. Our guess is that the near certainty of tariffs will warrant an increase in their June rate forecast. A change in the rate outlook could create friction coming from the White House and unsettle markets. 

…And an Unfunded Ricochet  

Soundbite: Record PE fundraising in 2021 and 2022 was followed by a flurry of Fed rate hikes that crushed deals’ attractiveness. This resulted in a number of deals that did not put enough capital to work, leaving a huge amount of future allocations promised to PE managers (known as unfunded commitments). College endowments’ current obligations to fund future PE investments dwarf frozen government funding. That means that endowments have even more problems than is generally understood. As PE firms call those unfunded commitments, investors normally hope that prior deal distributions help offset their need to fund their obligation. With the current poor distribution environment, that important funding source is lacking, and investors will need to make up the difference by raising cash, with few positive outcomes.

No question, the PE industry is facing a dilemma. The funding of capital calls is sourced either from liquid investments or distributions from existing PE investments. There is at least $2.6 trillion in unfunded commitments, and if only one-third of that is called, with a very bullish assumption that half is covered from deal distributions, that still requires investors to come up with over $400 billion.  

What is the fallout? 

Our expectation is that universities will look for liquidity in one of three ways: 

• Tap the bond market at unattractive rates, 

• Tap the secondary market to sell illiquid securities at unattractive levels, or 

• Sell its public market securities holdings, such as U.S equities or Treasuries. 

The only way institutional investors can escape a bad outcome is to reinvest and hope the environment brightens, but they may have already tried this escape hatch. There is a great deal of hope riding on deregulation and fiscal stimulus to increase deal volume. 

Charlie Munger used to joke about a man who had a marvelous horse, but it could turn destructive at any moment. He went to his vet, who said he could solve the problem. When the man asked, “Ok, what should I do?” the vet replied, “The next time your horse is behaving well, sell it.” That was his definition of private equity, and we hope that, for once, Charlie is proven wrong.   

What to Look for This Week  

(All times D.S.T.) 

1. Now it is starting to get interesting. Tuesday, May 27 at 8:30 a.m. April Nondefense Durable Goods Orders Ex-Aircraft. Tracks closely with business capex. Because this is an April number, it contains the post-Liberation Day (but not the post-Geneva talks) reaction. Companies have discussed pausing their investments, this will give us a clue as to the degree. At 10:30 am on Tuesday, The Dallas Fed Manufacturing Index is out for May. In April, it fell to its lowest level since May 2020.  

2. Wednesday, May 28 at 2:00 p.m. the FOMC minutes are released from the May 6-7 meeting. We will be looking for how slanted the board—and especially note the staff outlook—is toward a stagflationary outlook, but we need to scale the comments back because the meeting took place just before the Geneva discussions between China and the U.S. Earlier that day, the Richmond Fed Manufacturing Shipments Index for May is released, and that is not a widely followed series, we are eager to see if firms replied that shipments continued to fall, and to what degree.  

3. Friday, May 30 at 8:30 a.m. April core Personal Consumption Expenditures Price Index. The Cleveland Fed’s Inflation Nowcast expects 2.6%, matching March’s 2.6% print, which was the softest inflation data in four years. If it comes in soft again, we will see if the market ignores it, or rallies. If the latter, then investors are still assuming a positive tariff environment. At 10:00 a.m. we will see whether the final May data from the University of Michigan inflation expectations pulled back from the lofty preliminary numbers. 

FOMC Voters Speaking: Outside of the minutes, there are no Fed Governors speaking, but NY Fed President John Williams takes part of a moderated discussion in Tokyo Tuesday May 27 at 8:00 p.m. Chicago Fed President Austan Goolsbee speaks Thursday May 29 at 10:40 a.m. (also a moderated Q&A) and again on Friday May 30 after the market close.   

Earnings Note: Earnings are winding down, and the only company of consequence is highly anticipated as NVDA reports after the close on May 28, following the FOMC.