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2006 Economic Outlook Roundtable:
Scenarios for the Next U.S. Recession

Introductory Remarks of Richard A. Brown, Chief Economist and Associate Director, Risk Analysis Branch, Division of Insurance and Research, FDIC

MR. BROWN: Good morning, everyone. Welcome to today's FDIC 2006 Economic Outlook Roundtable. My name is Rich Brown. I will be the Moderator for today's panel discussion.

I wanted to let you know that this is our fourth annual FDIC Outlook Roundtable. In previous years, we have discussed issues such as deflation, the art of forecasting, and the much maligned, but still undeterred, U.S. consumer sector. And this year we decided to cut to the chase and talk about the topic of recession and what the next recession might mean for the U.S. banking industry.

I'm very pleased today to have a distinguished panel of experts to give you their viewpoints on the U.S. economy and how it will affect banking. I will introduce them all at once before turning it over to them.

On my immediate left is Kathleen Camilli. Kathleen is Chief Economist and Director of Camilli Economics and is one of the nation's top economic forecasters. The Wall Street Journal named her one of the top five economic forecasters two years running, and Business Week has named her their number-one performing forecaster. Kathy formerly was the U.S. Economist at Credit Suisse Asset Management in New York before starting her own firm, and she chairs the Financial Roundtable at the National Association for Business Economics. Welcome, Kathy.

MS. CAMILLI: Thank you.

MR. BROWN: Next will be Arthur McMahon. Art is the Director of Economic Outlook and Bank Condition for the Office of the Comptroller of the Currency here in Washington. Art joined the OCC in 1993, and before that he was with the International Banking and Portfolio Investment Office of the U.S. Department of Treasury where he participated in negotiations for the Uruguay Round of the bilateral negotiations.

We make it a priority to regularly trade views with our colleagues at the Comptroller's Office, but this is the first time we've been able to have Art at one of our roundtables.

Art, it's nice to have you here today.

Last, but not least, we have Meredith Whitney. Meredith is Executive Director for CIBC World Markets, a subsidiary of the Canadian Imperial Bank of Commerce in New York. She serves as Senior Financial Institutions Analyst there, focusing on large and mid-sized banks, as well as a cross-section of independent commercial and consumer finance companies.

Prior to joining CIBC, she spent four years at the financial institution's Research Unit at Wachovia Securities, formerly First Union. She also comes to us with a forecasting pedigree; she was named the number-two stock picker in her category by The Wall Street Journal's Best on the Street Survey in 2002.

Meredith, welcome to the FDIC.

MR. BROWN: I have asked these panelists to be forward-looking in their remarks today. But as I was preparing for this discussion, I thought maybe it would be worth looking backward for just a moment and set up some historical background, a point of departure, for our discussion of recession and how it affects the banking industry. Therefore, I've put together a couple of remarks I'd like to share with you before we turn it over to our panel.

I think that our sense of the connection between banking problems and economic recessions goes back deep into our history. Before there was deposit insurance, economic recessions—or depressions, as they were then called—were often associated with banking panics. These episodes took place in 1857 and '58, 1873, 1884, 1907, and, most memorably, a series in the early 1930s, just before the introduction of the FDIC.

These events typically involved episodes of illiquidity, which led to bank runs and forced the liquidation of assets, leading in turn to declines in stock prices and real estate prices. So in that era, banking problems and bank failures were closely associated with economic downturns.

However, since the Great Depression, and after the establishment of deposit insurance, a lender of last resort, the social safety net, various economic stabilizers, and active programs of counter-cyclical policy, we've seen the connection between the U.S. business cycle and the fortunes of the banking industry become somewhat less clear cut than previously.

Recessions still affect credit quality and loan demand in ways that you would expect. Chart 1 shows how charge-offs tend to peak during recession periods, as you might expect.

Chart 1 Bank loan losses generally rise during recessionsd

Moreover, looking at loan demand in recession years versus non-recession years in Chart 2, you see that for most asset categories, with the exception of agricultural loans, loan growth has been higher during the expansion periods.

Chart 2 Loan volume also tends to be procyclical, rising faster during economic expansions and slower during recessionsd

Despite these empirical connections, I'm going to argue that the business cycle has not been the dominant factor in explaining banking industry earnings and failures in the modern period. One episode that I think illustrates this point is what we refer to as the 100-year flood of losses in the banking and thrift industries, or the failure of over 2,500 banks and thrifts between 1980 and 1993.

Chart 3 shows this wave of bank failures. We see up ticks of bank failures during some of the recession periods, but, clearly, they are orders of magnitude smaller in size than the increase in failures we saw during the 1980s.

Chart 3 The wave of bank and thrift failures during the 1980s and early 1990s dwarfs all other episodes of financial institution distress since the 1930sd

Chart 4 shows you the same episode, starting in the 1980s, from the perspective of return on assets.

Chart 4 Industry earnings have not always fluctuated in sync with the business cycled

Now, this great wave of failures spanned more than a decade and encompassed two U.S. macroeconomic recessions, but I'm going to argue that it was not primarily a product of the U.S. business cycle. Rather, it was more closely related to what has been called a "rolling regional recession" that traveled from the farm belt to the oil patch to the Northeast to Southern California.

There were a lot of factors involved in this wave of bank failures, including risk management problems, fraud, and self-dealing. But probably the biggest single economic factor related to boom and bust cycles in real estate. For more information, I would refer you to the FDIC's History of the '80s study, which is on the FDIC Web site. 1

Another case in point is the experience of the last five years, from 2001 through 2005. We saw trillions of dollars in stock market losses starting in 2000 with the failure of hundreds of publicly traded companies, including Enron and WorldCom, followed by a very slow recovery in job growth over the next couple of years.

How did all of that affect FDIC-insured institution? They earned record profits every year from 2001 through 2004. Year-end results are not in yet, but 2005 also looks like it could well be another record year.

Part of the reason the industry was able to post this strong performance was the response of monetary policy to the recession itself. Low nominal interest rates and a steep yield curve helped the industry boost its net interest income and realize gains on the sale of securities that offset the increase in credit losses.

Let me give you an example. Between 2000 and 2002, the annual loan loss provisions for FDIC-insured institutions increased by $18 billion—a 61 percent increase. This was a major credit event that was concentrated at large banks that made loans to large corporate customers.

But also during that two-year period we saw annual net interest income rise by some $33 billion. At the same time, during those two years the industry was able to realize gains on the sale of securities of $11 billion. So these offsetting factors outweighed the increase in credit losses by a factor of almost two and a half to one, which shows the power of counter-cyclical monetary policy and low interest rates in influencing the industry's bottom line.

We had a similar experience in the previous recession (1990-1991), where an increase in net interest income helped to overcome credit losses.

But as an investment advisor might tell you, past performance is not necessarily indicative of future results. We can't necessarily expect that the banking industry will always be so well insulated from the effects of recession.

I think the main lesson here is that the boom and bust cycles, or the particular sectoral incidence of a cyclical downturn, are more important than recession itself in determining which institutions are affected.

As you know, good old-fashioned risk management plays a big role in terms of how well prepared the industry is for an economic downturn. Loan underwriting and servicing, managing concentrations, and hedging against volatility are all important. But it's very difficult to come up with an overall measure for risk management practices of the industry.

We do have our list of problem institutions, those with the lowest two supervisory ratings. Chart 5 shows that the number of problem institutions has fallen to historically low levels, in order of magnitude less than they were 15 years ago.

Chart 5 The number of FDIC-insured 'problem institutions' has fallen to historical lows during this expansiond

Capital, reserves, and earnings also matter as a cushion against losses. In Chart 6 we see that together, cushion appears fairly large compared with previous historical periods. That shows that the industry probably is in a fairly good position to withstand the adversity that would be associated with an economic downturn.

Chart 6 The banking industry's capacity to absorb losses has climbed to a historically high leveld

So with these observations as a historical prologue, we'll now turn to our panel of experts as they consider the economic future and ask them to describe what they see as the probable nature of the next U.S. downturn and what banks and thrifts need to be doing to prepare for that inevitability.

1 See: http://www.fdic.gov/bank/historical/history/.

Last Updated 04/12/2006 communications@fdic.gov