After more than a decade of sustained growth following the 2008 financial crisis, it’s looking increasingly likely that the United States may face an even more serious downturn soon; partially due to economic contagion sparked by issues overseas.  Many financial experts, including JP Morgan’s Jamie Dimon, believe that another recession is on the horizon.  

 

The causes of a potential downturn are myriad,– and often unpredictable.  For instance, who saw COVID-19 coming?  We’re facing headwinds from several directions, with the war in Ukraine, oil shocks, and the lingering effects of the pandemic all still in play.  

 

While there has been a precipitous drop in equities and other assets as a result of higher interest rates, many lenders are still wondering if they’re doing enough to shield their portfolios against another recession, and the inevitable wave of borrower defaults that will come to pass if economic contagion were to spread from global markets to the US.  

 

 

Credit is harder to come by. 

 

It’s a tough time to borrow capital.  In the face of higher interest rates and lending standards, credit is starting to dry up, with mortgage credit availability falling to a 9-year low in September 2022.  Simply due to higher borrowing costs, fewer loans are being originated.  After borrowers enjoyed nearly a decade of record-low interest rates, many will now be reticent to take out loans at 6 or 7%; especially because housing price growth has stalled somewhat. 

 

 

Double-digit default rates are looming. 

 

Default rates are already rising, with Reuters’ Mike Dolan forecasting a “hurricane of double-digit default rates,” which will affect both the corporate sector and Main Street homebuyers.  Contagions in the domestic market don’t necessarily have to come from overseas — a widespread default in the corporate sector could also be the impetus for a recession leading to high default rates for mortgage lenders. 

 

 

What can lenders do to protect themselves from financial contagion and resulting defaults? 

 

Regardless of the source of contagion, as a lender, you need to be prepared for what’s coming.  If you take the proper precautions and the worst does occur, you will have the foundation you need to weather the storm and come out even stronger.  Just think about the folks that stuck it out after 2008, and the decade-long real estate bull run that followed. 

 

          1. Diversify! 

 

While every business is different, lenders should always consider whether to diversify their portfolios.  If you have “all your eggs in one basket,” so to speak, you are much more vulnerable to financial contagion.  Harry Markowitz presented the first modern understanding of diversification in 1952, as a key component of the “modern portfolio theory” he pioneered.  While this theory is most often applied to investments in the equities markets, it also holds value for lenders in a portfolio-wide context.  

 

For the most part, diversifying a lending portfolio reduces lender exposure to any single borrower, industry, or region.  Ideally, a lender wants to avoid having many borrowers default at the same time in a specific region or industry.  Much like what happened in Detroit with the automobile industry, focusing all of your resources in one area, or oversaturating a particular market, can lead to disaster.  

 

While the data on the value of a diversified loan portfolio is not necessarily definitive, it certainly has value in some situations.  Lenders should evaluate the prospective benefits of portfolio diversity within the scope of their current business model to make an informed decision about whether or not to embrace diversification.   

 

          2. Maintain Liquidity. 

 

To withstand the consequences of financial contagion and resulting defaults, it is also critical for lenders to maintain strong liquidity positions.  One option is to leverage a default risk-shifting tool like AXY Wrap®.  The Federal Reserve reports that market liquidity conditions have been declining since late 2021, threatening financial stability and exposing U.S. house prices to shocks. So it’s best to be prepared, by lowering risk through a diverse, counter-cyclical loan portfolio, and also leveraging a risk-shifting solution to maintain liquidity.  

 

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