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

Meredith Whitney, Executive Director, CIBC World Markets, a subsidiary of Canadian Imperial Bank of Commerce.


MR. BROWN: The last two presentations have really highlighted the importance of the housing sector to the economic outlook and the banking outlook, and that's something that Meredith Whitney is going to comment on in her presentation. I would like to mention that her recent paper, "The State of the U.S. Consumer: 10 Percent at Risk," really made an impression upon the staff here at the FDIC. A copy of the paper is in your folder. We are glad that she accepted our invitation to come and tell you about it today.

With that I'll turn it over to Meredith.

MS. WHITNEY: Thank you. That's music to my ears, because I analyze banks and financial institutions for a living, and I place particular focus in my career on the state of the U.S. consumer. It's of key interest to me, and, particularly because of what I do for a living, it's an enormous honor to present to all of you.

So with that said, the paper that we put out in October was really inspired by an analysis of Hurricane Katrina. So many Americans saw a side of the U.S. economy that I don't think many of us had seen before or had really digested as far as how it fit into the total U.S. economy. It challenged me to drill down deeper into the analysis of who was at risk in terms of any type of consumer softening, or a potential recession. My conclusion was that I believe 10 percent of the U.S. economy will actually experience a segmented consumer recession over the next 24 months (see Chart 36).

Chart 36

Chart 36 We believe there will be a segmented consumer recession over the next 24 months that will impact 10% of the U.S. consumers.d

Looking at [Chart 36], which we'll get back to in a second, my analysis divides the U.S. consumer market into three main buckets: those who have had newfound access to credit, those who have had a long-time access to credit, and those who, over the past decade, have had access to unprecedented amounts of credit.

The underlying thesis to our recession scenario is that an interruption in liquidity always precedes a recession (see Chart 37). You can look at the S&L crisis, especially, or, as Kathy did, to the Long-Term Capital Management crisis or to the Enron/WorldCom bankruptcies in 2002. We believe that the next interruption of liquidity will affect the consumer market specifically.

Chart 37

Chart 37 Our underlying thesis is that a strain in liquidity will be the catalyst to this consumer recession.d

Factors that will precipitate this event could include a continued rise in the fed funds rate, a capital strain caused by the ratings agencies, or the change in minimum payment guidelines for the credit card market.

Let's start with higher rates. We believe that the Fed is surgically targeting the housing market in its efforts to raise rates (see Chart 38). Let me just give you an example. Thirty-five percent of the housing market's new purchase originations in 2004 were adjustable-rate mortgages. Now, 30 percent of new home originations are adjustable-rate mortgages.

Chart 38

Chart 38 Fed has raised rates 13 times over the past 18 months: The Fed is surgically targeting the housing market.d

Just from an anecdotal perspective, if you know short-term rates are rising, and long-term rates are declining or at least staying static, wouldn't it be prudent to lock in a long-term mortgage? Why is 30 percent of the mortgage market still booking into adjustable-rate mortgages? Because we believe they couldn't otherwise afford to squeeze themselves into a home or they're squeezing themselves into a more expensive home for affordability factors.

I want to take out one major portion of the economy first, which is the corporate market. And this is not incongruous to what my esteemed colleagues have said already in the presentation. Today, 17 percent of corporate funding comes from banks. The vast majority of corporate funding comes from the public market. It's more efficient to go directly to the public market, and it's more cost effective. So this is a 38 percent decline since the last cycle. So we think that higher short-term rates have much less of an impact on the U.S. corporate market than they ever have before, and that Greenspan and the Fed governors are well aware of this (see Chart 39).

Chart 39

Chart 39 Higher Short-Term Rates Less Meaningful to U.S. Corporations This Cycled

In addition, as you look at cash levels on U.S. corporate balance sheets, they have never been better (see Chart 40). Cash as a percentage of long-term debt is at 42 percent. The last time they were at this level was when they were about 40, 41 percent in 1987. And as you remember, those were the days of Michael Milken, leveraged buyout fever, and tremendous consolidation. Because what are you going to do with piles of cash? You're going to invest, and you're going to consolidate. You're going to invest, and you're going to buy. Extra cash—go shopping.

Chart 40

Chart 40 Non-Bank Corporations Have the Best Balance Sheets in 25 Years.d

Okay. So the idea here is that U.S. corporations will probably extend a 14-month cycle of capital investment, and you will probably see near-record merger and acquisition levels this year. So in our analysis, we're not worried about the corporate market at all. It was exclusive of exogenous events that will actually put risk-based pricing back into the spread market. We don't see that, believe it or not.

At any rate, let's focus on the consumer, because this is really what our analysis is about. And this will be probably the most important thing I say today. You have to look at three separate buckets of the U.S. consumer market: those with traditional, good quality credit; those folks who have not had any access to credit; and then this segment of the market that has had new access, new and unprecedented access to credit (see Chart 41).

Chart 41

Chart 41 Breakdown of the U.S. Consumer.d

I want to focus on this statistic, which is pretty alarming. We estimate that 26 percent of the U.S. population lives at, near, or below the poverty level (see Chart 42). The number for the poverty level is living below $23,000 a year, and that covers 13 percent of the population. We go on to estimate, actually, that 26 percent of the population lives at, near, or below the poverty level. Now, these guys have no access to credit.

Chart 42

Chart 42 26 Percent of the U.S. Population Lives At, Near, or Below the Poverty Level.d

Now, my estimate seemed alarming when I came up with it. I've been told by leading consumer lenders that actually my estimate is low. It could be as high as 30 percent or higher. So what you need to do when you look at the U.S. consumer is extract this portion from the total pie at risk, because these guys don't have access to credit. These are the folks that shop at dollar stores primarily, where they use cash and food stamps for purchases. Dollar stores are nearby. They're not driving a car, so they're less impacted by commodity prices, in terms of prices at the pump, and, as a result, have not gotten wealthier or poorer over the last decade; they've stayed steady-state. And if you look at a lot of the dollar store results, they have essentially flatlined, which supports this point.

The next segment of the market, which we also extract from this pie, is the 64 percent of the market made up by what I will call "fat cats" (see Chart 43). Sixty-four percent was the traditional homeownership rate as far back as the 1970s to about 1994. This is as far back as the data show, so 64 percent is what we really call the "natural rate of homeownership."

Chart 43

Chart 43 64% Has Been the Long-Term, Over-the-Cycle Level of Homeownership in the U.S.d

Of course, you know that 69 percent of the U.S. population today owns homes. Greenspan, in his paper on the mortgage industry in September, targeted 5 percent of the U.S. population at risk in terms of very low equity levels in homes. Sixty-nine minus 64 is 5 percent. So these are the new, first-time homebuyers, which we see at risk.

Kathleen also talked about how amazing it has been if you have owned a home over the last decade. If you own a home, you've been sitting on the single-greatest wealth creator in the market, as opposed to equities or bonds. Homeownership has had a 10-year rate of return of around 8 or 9 percent. And last year, as you know, home prices grew by 10 percent.

In terms of equity in homes, it has declined by 9 percent. This is average equity in homes. So, in 1990, the average equity in homes was 60 percent; today it's 56 percent. So we think, actually, that has created a barbell between those folks who own their homes outright versus the new buyers, who have put very little down on their homes.

Now, [Chart 44] shows the 10 percent of the population that we're talking about, that we believe is at risk. They have had access to unparalleled levels of credit.

Chart 44

Chart 44 10% of the U.S. Population Has Only Recently Accessed Unparalleled Levels of Creditd

In 1994, the standards through which an individual could qualify for a home really relaxed considerably. And from that time, 15 million new homeowners were created in the United States. So it's not just a matter of money going from the equity market into the housing market. It's also the fact that 15 million new households became homebuyers, and an increased demand versus supply clearly sent home prices higher. So an expansion of 8 percent in the size of the market cannot be overestimated in terms of its impact on the market (see Chart 45).

Chart 45

Chart 45 After Underwriting Standards Relaxed in 1994, Homeownership Expanded Almost 8% or by Over 15 Million Householdsd

Since 1996, subprime lending has grown five-fold (see Chart 46). And these numbers actually may be understated, as a lot of large banks are reticent to admit that they actually have any type of subprime loans. Instead, it has been called non-prime, or non-traditional. What this shows is a five-fold expansion in the subprime lending volume.

Chart 46

Chart 46 Subprime Lending Has Exploded since 1996.d

[Chart 47] is an example of how lenders have loosened their underwriting standards. One obvious element that you are well aware of is lower documentation, in terms of credit scoring and also in terms of proof of income, proof of employment, et cetera.

Chart 47

Chart 47 Mortgage Lenders Have Eased Their Lending Standardsd

It's interesting that the National Association of Realtors recently came out and said that 43 percent of all new homes are purchased with no money down. You wouldn't have heard about that prior to 1994. So the ability to access credit has expanded dramatically.

Something I referenced a little bit earlier relates to the hazards of adopting an adjustable-rate mortgage and the negative amortization that is now associated with a lot of the adjustable-rate mortgage products (see Chart 48).

Chart 48

Chart 48 Example of a Negative Amortization Payment Optiond

Again, I want to talk about why someone would do this to themselves, why someone would take on an adjustable-rate product when you know short-term rates are rising. That doesn't make any sense. The only conclusion that you can draw from this is that, otherwise, these homes would not be affordable to these consumers.

Home equity, which has really been the consumer's ATM over the last certainly five to ten years, has enabled a lot of this affordability. A lot of the new home mortgages that are originated come with piggyback home equity loan features.

Now, I want to point out that [Chart 49] is only talking about revolving home equity lines. The total home equity number is closer to about $800 billion. So a lot of this home equity is acting like sort of a new version of a credit card for consumers.

Chart 49

Chart 49 Home Equity Loan Growth Has Outpaced Most Loan Products Growth at Banks.d


This is something that Art discussed previously. Bank exposure to mortgages and home equity is now at peak levels, having risen dramatically (see Chart 50). If you look at 1998, the total exposure to mortgages and home equity loans was about 25 percent. In the last quarter, the third quarter, it had risen to 37 percent.

Chart 50

Chart 50 Bank Exposure to Mortgages and Home Equity Is Now at Peak Levelsd

Now, there are a couple of reasons why this is the case. Many U.S. companies have managed to carry on without needing banks. We showed this in the slide that shows that only 17 percent of corporate funding is delivered by the banks.

The banks need to originate some product. One of the biggest problems for the bank industry today is tremendous deposit growth and very little asset growth. So you have institutions that are liability-rich and asset-poor, and they're going to put anything on the balance sheet they can. For the past five years or so, mortgages have provided the best vehicle for asset growth and any type of margin gain whatsoever—although we would also argue that that margin has been increasingly challenged over the last year.

There are a couple of things that we see happening to banks over the next 24 months, really triggered by liquidity strains. And I want to talk about the liquidity strains for the mortgage sector in two parts. First, you have a liquidity strain because of what I will call the denominator effect, which is caused by higher short-term interest rates (see Chart 51).

Chart 51
Chart 51 The Denominator Effect: Shrinking Portfolios Will Create Higher Loss Ratiosd

Over the past two months, home equity lines have declined for the first time in almost a decade because the yield spread between the 3-month LIBOR and prime has inverted (see Chart 52). This is undesirable for consumers, and it's undesirable for banks making these loans.

Chart 52

Chart 52 The Denominator Effect: Shrinking Portfolios Will Create Higher Loss Ratiosd

So there is a liquidity squeeze for consumers as rates rise, which is related to the affordability factor. In 2004, as I said, adjustable-rate mortgages were 35 percent of total purchase originations. Today, they're 30 percent. And I can't emphasize enough that the vast majority of subprime purchases are coming through adjustable-rate mortgage products.

The second factor which is significant is that the ratings agencies have required higher subordination levels associated with subprime mortgage origination (see Chart 53). So it's less profitable for banks and independent institutions to originate these mortgages. In the second quarter, capital required against subprime mortgage originations increased by 10 percent. That's a lot of dough, and that's a big impact to profitability.

Chart 53

Chart 53 Shrinking ARM Market Is a Prelude to Decelerating Subprime Originationsd

So what all of this creates, then, is smaller loan balances, and a smaller denominator makes your loss ratio become all of a sudden a lot higher, and your profitability become much more challenged.

We believe a shrinking adjustable-rate mortgage market is a prelude to decelerating subprime mortgage originations. Yesterday we saw that a subsidiary of First Franklin, which is one of the largest subprime mortgage originators, reported that it still has over 70 percent of its mortgage originations coming through adjustable-rate mortgages.

So as you see adjustable-rate mortgages decline in terms of total purchases, you will see subprime mortgages decline in terms of total originations. You already see declining home equity balances. You will begin to see declining mortgage balances.

The factor through which liquidity is challenged in the credit card market is the change in minimum payment guidelines, which prior to 2003 took the independent credit card lenders out of negative amortization.

In 2005, the OCC required all of the big banks to become compliant with negative amortization extraction in that, if you were a customer, you had to start paying down your principal. You could no longer continue to contribute to your debt burden each month. Well, that's a liquidity squeeze for the consumer, and we'll get into that in a second. It also shrinks balances at the credit card lenders.

I'm going to give a little background here. We believe credit cards have become the loan product of adverse selection, based on the expansion in homeownership (see Chart 54). The age-old rule by banks is that 80 percent of your losses come from 20 percent of your borrowers—the so-called "80/20 rule."

Chart 54

Chart 54 Credit Cards Have Become Loan Product of Adverse Selectiond

Well, if you've owned a home over the past decade, particularly over the past five years, and you all of a sudden refinanced your mortgage, you've either paid down your credit card debt or you've refinanced your mortgage and taken a home equity line out, which has tax advantages just like a mortgage does. It also carries a lower interest rate, because it's collateralized. So we believe that the home equity market has cannibalized the best credit card customers, leaving those folks who have revolving balances, which is about 40 percent of all U.S. credit card customers, as the folks to be worried about.

Now the growth in the credit card industry is in single digits. We're in an environment that's flush with cash. People have either not wanted to maintain revolving debt or they've transferred it, if they could, into home equity loans, or they're simply not revolving debt at all.

So what is left in the credit card industry is those folks who have nowhere else to go, those folks who are playing credit card roulette, because it is certainly a source of borrowed funds. And I want to point out that those folks have been plied with seven times the rate of capital than the standard credit card industry. In other words, the growth in the subprime market has exceeded the growth in the traditional credit card market by a factor of seven times (see Chart 55).

Chart 55

Chart 55 Credit Card Debt Growth Has Expanded Largely through Subprime Growthd

Why is minimum payment compliance such a significant factor? Just as you've heard about mortgage payment shock that occurs when your mortgage reprices, this is effectively a repricing of a consumer debt burden, a monthly consumer debt burden. And this change in minimum payment, at least in the example that we provide with a $10,000 beginning balance, increases a consumer's minimum payment by almost a factor of two times.

By the end of 2005, everyone except for J.P. Morgan and Citi (who are two of the top three largest credit card issuers in the United States) was compliant with the minimum payment guidelines (see Chart 56).

Chart 56

Chart 56 Liquidity Catalyst: Minimum Payment Compliance: JPM and C Still Not Yet Compliantd

So let's say, for example, you're a Capital One credit card customer. Your minimum payment has already been revised to meet the new guidelines, as of 2003. Let's say you have a Capital One card, on which you're paying a higher minimum payment as required by Capital One.

Suppose you've also got an American Express card. Similarly, those issues apply. Then you also have a J.P Morgan card and a Citigroup card. And by 2006, when these payment standards are adopted across the board, all of a sudden your credit card payment doubles on two of your cards. And most likely, in the subprime sector, you're not just carrying two cards. You're carrying several cards.

This is a massive liquidity squeeze. At a very minimum, it will shrink the growth in balances at the credit card issuer level. So, as I said with the denominator effect, these loan balances are going to shrink for Citi and J.P. Morgan, because customers are paying more of their debt off. At another level, your liquidity as a consumer is also strained, and that is what we believe will set up higher defaults at the bank issuers.

Now, Art had talked about how overall credit losses for banks are at a 15-year low. And from a corporate perspective, we think credit spreads are going to remain very narrow for an extended period of time because of the savings environment that we're in (see Chart 57).

Chart 57

Chart 57 Credit Losses Most Likely Will Worsen; Current Credit Losses Are at 15-Year Lowsd

And credit losses would have to deteriorate significantly from today's levels to have a major impact on banks. We estimate a 40 percent increase in credit losses would still not have a meaningful impact to earnings for a lot of these banks. But for banks like Citi and J.P. Morgan, where they have 20 to 25 percent of their earnings coming from credit cards, higher losses are going to create a very challenging environment for them to show earnings growth.

So I want to summarize all of this, and I hope I didn't go too quickly. I'm a New Yorker, so I've been told I speak quickly. If you segment the consumer market into three very important buckets, then take out the folks that have no access to credit and take out the folks that are what I would call the fat cats—who already had access to credit, have gotten a lot richer because they've owned homes, and may have taken on more debt but remain well positioned from a financial balance sheet—then we can really focus on the 10 percent of consumers that are at risk (see Chart 58).

Chart 58

Chart 58 Consumer Credit in Americad

Five percent of the U.S. consumer market is made up of folks that are new homebuyers. This is the 5 percent of the U.S. consumer market that Greenspan is worried about, that have such little equity in their homes that if home prices decline in any way, they owe more than they own. That's a bad situation, particularly as most of these guys are in adjustable-rate mortgage products, and they are going to be squeezed as rates continue to rise.

Then we add the other 5 percent of households, including the folks that are playing credit card roulette, who are going to be squeezed by this minimum payment guideline, who have never had access to credit before, who have gotten a lot richer over the past decade, and are about to get a lot poorer because of liquidity strain.

So when you look at this 10 percent of the market which we qualify as subprime, what does it mean to the total economy at large? Well, 40 percent of discretionary spending is done by the top 20 percent of the consumers. We don't think the subprime market correlates to the top 20 percent of the consumers.

The way I refer to this market is that these are probably the Wal-Mart customers. It's one level above the dollar stores, and probably one level below a Target store. And you've already seen spending at Wal-Mart contract somewhat. Many of these numbers can be confirmed by just looking at general trends in retail sales. You see no blip whatsoever at Nordstrom's and Neiman Marcus, all of the higher-end retailers, that have really been carrying a lot of the consumer spending. So we think consumer spending in a finite portion of the market will slow, and credit deterioration will increase dramatically in a finite segment of bank portfolios.

Again, we think 10 percent of the U.S. consumers will definitely go into a segmented recession, but the rest of corporate and consumer America looks pretty good.

MR. BROWN: Meredith, thank you.



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