Lesson 1 of 25 · 7 min

What a credit cycle is, measured in terms rather than in rates

Most of a tightening happens in what counts as collateral, and no published figure records that part.

A credit cycle is usually described as the cost of borrowing going up and then coming down. That description captures the part that gets published and misses most of what moves.

Credit is sold as a bundle of four things, not one. There is the price, which is an index plus a spread. There is the quantity, which is how much may be drawn. There is eligibility, which is what counts as collateral at all. And there are the terms around those three — the haircut, the notice period, the width of the lender's discretion. Over a cycle all four move in the same direction, and the price is usually the smallest of the four.

One illustrative fourteen-month stretch, on a single unchanged facility:

The spread went from 1.85 points over the index to 2.60 — a rise of 75 basis points.
The advance rate on the mid-sized company row went from 55 percent to 38.
The minimum price for a share to be eligible at all went from $5 to $8.
The notice period on a collateral call went from three business days to one.

Only the first of those arrives in a letter with a number in it. Put the first and the second side by side on one holding. On a $400,000 balance the 75 basis points cost $3,000 a year. On a $1,240,000 holding of mid-sized shares, the advance rate moving from 55 to 38 percent took lending value from $682,000 to $471,200 — $210,800 gone, a 30.9 percent reduction in what that holding can support.

A cycle read off a rate sheet is a cycle read off its smallest component. The rate is the part that is easy to publish, not the part that decides anything.

Key terms

Credit cycle: The joint movement of price, quantity, eligibility and terms across a lending market. All four tighten together and loosen together.
Non-price terms: Everything in a credit arrangement other than the interest rate. Usually the larger part of a tightening and almost never disclosed as an event.
Standards: A lender's internal settings for who qualifies, what collateral counts and how much is advanced against it. Revised far more often than a rate.

Worked example

Fourteen months, one portfolio, nothing traded

Illustrative figures. A $1,240,000 holding of mid-sized company shares, a $400,000 drawn balance, and the four changes listed above.

Extra interest from the spread move: $3,000 a year
Lending value before: $682,000
Lending value after: $471,200
Capacity removed: $210,800
Ratio of the two changes: 70 to 1

The change that was announced cost three thousand dollars a year. The change that was not announced removed two hundred and ten thousand dollars of borrowing capacity.

Check yourself

Over one year a line's spread rises 0.90 points on a $520,000 balance, and the advance rate on an $860,000 holding falls from 60 percent to 47. Which change is larger, and by how much?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.