Notwithstanding a slowdown in the fourth quarter of 2005, U.S. economic activity has grown at
a stable, robust pace for most of the last three years. Gross domestic
product (GDP) grew at a real annualized rate of at least 3.3 percent
in every quarter between March 2003 and September 2005 before sliding
to a rate of 1.6 percent in the final quarter of last year. Meanwhile,
FDIC-insured institutions turned in a fifth-consecutive year of record
earnings in 2005, posting net income of $134.2 billion. In addition,
today marks the 636th day since the FDIC last provided assistance
to a failed or failing bank—the longest such streak in the history
of the Corporation.
This string of positive reports on the U.S. economy and banking industry paradoxically
has led some analysts to ask a somewhat pessimistic question: How
long can these good times last? Experience teaches us that economic
expansions do not last forever and that some types of economic disruptions
can be associated with financial distress for banking organizations.
While forecasting recessions is, at best, a hazardous business, it
makes sense from a risk management perspective to explore various
weak-economy scenarios to better prepare for adversity down the road.
With this in mind, the Federal Deposit Insurance Corporation recently hosted
a panel discussion to gain insights into scenarios for the next recession.
The event was moderated by FDIC Chief Economist Richard Brown, and
the panelists included Kathleen Camilli, Chief Economist and Director
of Camilli Economics; Arthur McMahon, Director of Economic Outlook
and Bank Condition for the Office of the Comptroller of the Currency
(OCC); and Meredith Whitney, Executive Director for CIBC World Markets,
a subsidiary of the Canadian Imperial Bank of Commerce in New York.
CIBC World Markets
This issue of FYI addresses many of the themes presented at that
forum, discussing recent economic trends and potential areas of weakness
that could pose problems for banks in the next recession. This issue also
looks at the historical performance of the banking industry across business
cycles and how well the industry is positioned to effectively manage the
risks and challenges that may be associated with the next recession.
The Economy Is Strong
There can be little debate about the fact that U.S. economic performance
has been strong. The steady growth in real GDP noted above can be attributed
to several sources. For one, business investment has risen at a double-digit
pace during the past two years, fueled by several years of double-digit
corporate profit growth. In addition, home prices have boomed, acting
to support consumer spending despite less-than-stellar gains in average
real wages and an easing in real median family income since the late
1990s. Finally, fiscal and monetary policies have been favorable with
reduced tax rates, increased government spending, and steady, clearly
telegraphed interest-rate increases supporting economic growth while limiting
near-term policy uncertainty.
Despite the overall strong appraisal, real GDP growth
decelerated sharply, to a 1.6 percent annualized rate during fourth quarter
2005. This slowdown had been expected by many forecasters, including
the FDIC roundtable panelists, Kathleen Camilli. She introduced the notion
that the U.S. economy might have experienced a mid-cycle growth slowdown
in late 2005. These slowdowns have a precedent, as they have occurred
during expansions in both the 1980s and 1990s (see Chart 1). Ms. Camilli
that the recent historical pattern of real GDP growth points to recessions
occurring near the start of every decade. On that basis, the U.S. economy
may have a few more years of expansion ahead of it before entering the
here to link to the complete text of Ms. Camilli’s remarks in the transcript.)
Although fourth quarter GDP growth was weak, recent signs point to a resurgence
early in 2006. For instance, job growth has picked up and the unemployment rate
fell to 4.8 percent as of February. The economy added an average of 228,000 net
nonfarm positions per month between November and February, almost double the
average 125,000 per month gain from July through October. During January and
February, average weekly initial unemployment claims ran below 300,000, a
decrease from the 330,000 average in fourth quarter 2005. After a slow start,
business investment surged late in the fourth quarter. Shipments of nondefense,
nonaircraft capital goods jumped 3.8 percent in December following much weaker
monthly gains in October and November. These shipments again advanced modestly
in January. Meanwhile, monthly surveys of purchasing managers indicated robust
growth in both the manufacturing and services sectors during February. As of
early March, many forecasters were expecting annualized quarterly real GDP growth
of over 4 percent during the first three months of 2006 and over 3 percent for all
Three Key Economic and Banking Risk Concerns
Despite a favorable outlook, there are at least three widely acknowledged
areas of near-term concern that could pose risks to the economy going forward:
a spike in
energy prices, a decline in home prices, and a retrenchment in consumer spending
arising from record consumer indebtedness. The consequences that any of these
developments might have for economic growth could range from modest to severe,
depending on how events play out over the next few years. It should be noted
these three areas are by no means the only potential sources of risk. Financial
market panics, natural disasters, terrorism, war, and even changes to policy
among many other potential sources of disruption to the currently benign
economic and banking environment. It is difficult to assess many of these
they occur, but in 2005 the FDIC did examine so-called “stroke-of-the-pen” risk,
or risk that arises when tax, monetary, accounting and other policy changes
unintended consequences for the economy and banking.1
Because global excess crude oil production and refining capacity are limited,
the risk of supply-side energy shocks remains high. Strong global growth in
energy demand in recent years, coupled with decades of limited new international
investment in energy production capacity, have left the United States and the
world exposed to increased energy risks. Although the U.S. economy is less reliant
on energy today than in the 1970s, it can still suffer from energy supply disruptions
that result in spiking oil, gas, and gasoline prices.
Given historically mild January weather, natural gas prices fell by roughly half
from their elevated early winter levels. Crude oil and gasoline prices have also
come down from their late summer peak because of an increase in imports and the
gradual return of damaged production capacity following the summer hurricane season.
Even so, oil prices remained 29 percent above year-earlier levels in February, and
gasoline prices were 19 percent higher.
With time the economy should be able to adjust to higher energy prices, but in the
short run, any supply-disrupting events, including labor strikes, severe weather, or
terrorism, may cause energy prices to jump. By varying degrees, these spikes would be
likely to weigh on overall economic growth while adding volatility to the outlook.
Moreover, this risk is likely to stay in play for several more years, given the long
lags required to add new energy production capacity and expectations for continued
global growth in energy demand.
The risk of a housing slowdown is another area of concern going forward. The recent
housing boom has been unprecedented in modern U.S. history.2 It has been suggested by
many analysts that the housing boom has been a significant contributor to gains in
consumer spending in recent years. Indeed, a number of the FDIC roundtable panelists
pointed to the apparent connection between rising real estate wealth during the past
four years and the sustained strength in consumer spending during that period.
Because consumer spending accounts for over two-thirds of U.S. economic activity,
any shock to consumer spending, such as that which might be caused by a housing
slowdown, is a concern to overall economic growth.
It is very likely that housing wealth has been a significant factor behind growth
in consumer spending. Through the use of cash-out refinancing, increased mortgage
balances, and greater use of home equity lines of credit, as well as through owners
selling homes outright and cashing in on their accumulated equity, it is estimated
that anywhere from $444 billion to $600 billion was liquidated from housing wealth
during 2005.3 Whichever estimate one uses, the total almost surely eclipses the $375
billion gain in after-tax income for the year. While probably not all of the home
equity liquidated during 2005 fed consumption spending (much of it was invested into
other assets, including second or vacation homes), these statistics illustrate how
important home equity has become as a source of household liquidity.
There are concerns, however,
that changes in the structure of mortgage lending could pose new risks
to housing. These changes are most
in the rising popularity
of interest-only and payment-option mortgages, which allow borrowers
to afford more expensive homes relative to their income, but which
also increase variability in
borrower payments and loan balances. To the extent that some borrowers
with these innovative mortgages may not fully understand the potential
variability in their
payments over time, the credit risk associated with these instruments
could be difficult to evaluate. In addition, the degree of effective
leverage in home-purchase
loans has risen in recent years with the advent of so-called “piggy-back” mortgage
structures that substitute a second-lien mortgage for some or all of
down payment. Meredith Whitney noted at the roundtable that the recent
use of revolving home equity lines of credit in lieu of down payments
has enabled an
increasing number of first-time buyers to qualify for homes that
they otherwise could not afford. (Click
here to link to the complete text of Ms. Whitney’s
remarks in the transcript.)
Overall, Ms. Whitney’s
research suggests that a group that includes approximately 10 percent of
U.S. households may be at heightened
risk of credit problems in the current environment. This group mainly
includes households that gained access to mortgage credit for the first
the recent expansion of subprime and innovative mortgage loan programs.
Not only do many borrowers in this group have pre-existing credit problems,
they may also be more vulnerable than other groups to rising interest
rates because of their reliance on interest-only and payment-option mortgages.
These types of mortgages have the potential for significant payment shock
that occurs when low introductory interest rates expire, when index rates
rise, or when these loans eventually begin to require regular amortization
of principal including any deferred interest that has accrued (see Chart
Because of the importance
of mortgage lending to bank and thrift earnings, the large-scale changes
that have taken place in this sector
will clearly have
implications for the banking outlook. Bank exposure to mortgage and home
equity lending is now at peak levels. As reported in the FDIC’s latest Quarterly
Banking Profile (http://www2.fdic.gov/qbp/index.asp), 1-4 family residential
mortgages and home equity lines of credit accounted for a combined 38
percent of total loans and leases in fourth quarter 2005, well above the
share maintained at the beginning of the decade.
Housing analysts are in disagreement as to whether or not recent signs point to a
moderation in housing activity or the beginning of a more significant correction.
Currently, inventories of unsold homes and sales volumes are among the indicators
pointing to a housing slowdown. Inventories of unsold existing homes rose from under
four months of supply at current sales volume in early 2005 to 5.3 months of supply
as of January 2006. Meanwhile, the pace of existing home sales has been trending
lower since last summer. A clear trend in the direction of home sales and prices
may not be evident until the completion of the peak spring and summer selling
season later this year.
Many analysts argue that home prices in the hottest coastal markets,
especially in the Northeast and California, could be poised to decline
in the near future. For example, PMI Mortgage Insurance Company analysts
place essentially even odds that home prices will decline during the next
two years in a dozen cities in California and the Northeast.4
Should home prices either stop rising or begin to fall in these areas, local banks and
thrifts would need to look to non-residential loans to support revenue growth.
Art McMahon of the OCC
outlined the banking industry’s reliance
on mortgage lending during his remarks at the FDIC roundtable. (Click
here to link to the
full text of Mr. McMahon’s remarks in the transcript.)
Mr. McMahon acknowledged that previous historical episodes of large metro-area
home price declines were generally the result of severe local economic
distress.5 Should some regional housing market downturns occur, banks
may be hard-pressed
generate non-residential loans in great volume. Historically, regional
housing price declines have tended to be associated with a slowdown in
activity, with banks making fewer commercial and industrial loans in
addition to suffering mortgage and consumer portfolio stress.
Consumer Debt and Lack of Saving
A large, long-term increase in consumer indebtedness has raised concerns
that the next U.S. recession could originate in the household sector.
The housing boom of recent years has resulted in a surge in new consumer
debt, most of it in the form of mortgages. Historically, recessions have
provided an opportunity for households and businesses to retrench and rebuild
sheets that might have become strained late in the previous expansion.
The response of businesses during the 2001 recession provides a classic example
in this regard as investment, spending, and hiring activities were curtailed
sharply from their heady, late-1990s pace. In part because of the wealth-offset
provided by housing, however, the long “jobless recovery” following the 2001
recession did not weigh heavily on the consumer sector. Consumers did slow
their pace of spending growth in 2001 and 2002, but spending growth never fell
below a 1 percent annual pace in any quarter—and in no quarter did it actually
decline. By contrast, during the early 1990s recession, consumer
spending declined for two straight quarters. At this point in time, however,
the consumer sector has not experienced a real recession in 15 years.
In some sense, this
long recession hiatus itself raises concerns. Consumers have gradually
become more indebted over time—so much so that
they are now spending more in aggregate than they earn, resulting in
negative personal savings rate.6 The personal savings rate may turn out
to be a bit of a statistical anachronism in an economy where so much
spending is driven by the accumulation of wealth rather than current
home prices will not boom forever. Even a moderation in home-price growth
would reduce the amount of new home equity added to the economy each
year. This slower accumulation of wealth, coupled with rising interest
increase the cost of tapping that wealth, could soon begin to curtail
the pace of U.S. consumer spending growth. Just as there has been a positive
wealth effect from soaring home prices in recent years, the concern is
an end to the housing boom could result in a slowdown in consumer spending
growth. However, it is important to keep in mind that such an outcome
would likely play out over several years, as happened during the boom.
The risk posed by a slower
rate of home equity growth was also discussed by the FDIC roundtable panel.
It should be noted that in
only the first six
years of this decade, the value of net housing wealth (or owners’ equity)
held by U.S. households has risen by over $5 trillion. Keep in mind that
this is the net gain, after allowing for a record increase in mortgage
debt. Moreover, the increase in net housing wealth during the first half
of this decade alone was two to three times as large as the gains posted
during each of the prior two decades. Although some new buyers have put
very little down on their home and thus have accumulated little equity,
many longtime homeowners have accumulated significant additional equity
that remains untapped. At the FDIC roundtable event, panelist Kathleen
Camilli noted this untapped wealth as a potential area of support for
consumer spending going forward. History supports Ms. Camilli’s stance.
During the past 50 years, the nominal value of U.S. housing wealth has
declined only once in a meaningful way—in 1990, in the midst of the bi-coastal
residential real estate bust. Although falling home prices might take
a dent out of wealth and spending, it would take some time to totally neutralize
the effects of a $5 trillion wealth gain.
The Banking Industry Appears Well Positioned for the Next Recession
Historically, the fortunes
of the banking business have varied with economic cycles, but the worst
of times in recent
memory were not predominantly the result of recession. During the roundtable
discussion, FDIC Chief Economist Richard Brown pointed out that, as one
would expect, loan growth
tends to decline and charge-offs tend to rise during recessions. Even so,
the industry has seen its biggest swings outside of the U.S. business cycle.
As an example, Mr. Brown
pointed to the “100-year flood” of losses in the banking and thrift industries,
or the failure of over 2,500 federally-insured banks and thrifts between 1980
and 1993. Chart 3
shows that while there have been increases in bank failures during and immediately
after recessions, these increases are dwarfed by the episodic surge in failures
and 1993. This wave of failures took place during a period that included
two U.S. recessions and a seven-and-a-half-year economic expansion. During
according to Brown, the U.S. economy experienced a rolling regional recession
that moved from the farm belt to the oil patch to the Northeast to Southern
This rolling regional recession featured some significant regional boom and
bust cycles in real estate. These real estate busts were partly due to the
to federal tax laws on real estate investments. This tax policy change essentially
dampened demand for commercial real estate investment and put downward pressure
real estate prices.7 Poor risk management practices and fraud also were common
factors in the episodic wave of bank and thrift failures.(Click
here to link to the complete
text of Mr. Brown’s remarks in the transcript.)
The lesson of this episode appears to be that the business cycle is not
necessarily the dominant
factor in explaining banking industry performance—and failures, in particular—in
the modern period.
The first half of this
decade provides another example of how the fortunes of the banking industry
need not directly follow the performance
of the U.S.
economy. During and just after the 2001 recession, the U.S. economy experienced
the loss of trillions of dollars in stock market wealth and the failure
hundreds of publicly traded companies, including Enron and WorldCom.
Associated with this corporate turmoil was a significant credit event
for large banks that
had made loans to corporate borrowers. Between 2000 and 2002, the annual
loan loss provisions for FDIC-insured institutions rose by $18 billion—a
61 percent increase. Meanwhile, job growth recovered very slowly, with
not reaching its pre-recession level until early 2005. Despite this adversity,
FDIC-insured institutions posted record earnings every year between 2001
Part of the reason that
the banking industry has been able to produce such strong financial results
amid economic adversity was the
response of monetary
policy to the recession itself. Between 2000 and 2002—as the corporate credit
event was boosting the industry’s provision expenses—low nominal interest rates
and a steep yield curve were helping to boost net interest income by
some $33 billion, while the industry was also able to realize gains on the
securities of $11 billion. These offsetting factors were more than double
the increase in credit losses.
Given its strong current
financial position, the banking industry appears to be generally well positioned
to meet the challenges
of the next recession.
At the January roundtable, both Brown and McMahon pointed to the banking
industry’s historically strong earnings, reserves, and capital as significant
buffers against future economic downturns. That said, as always, risk management
practices will play a crucial role in determining how economic adversity might
affect the industry’s bottom line. Strong underwriting practices, effective
management of loan concentrations, proper servicing procedures, and well-designed
policies to hedge against market volatility were all cited as essential
risk management tools for the industry. The true test of these industry practices
will occur down the road when the recession scenario finally becomes
To access the complete transcript of the 2006 FDIC Economic Outlook proceedings,
The more conservative $444 billion estimate is the sum of Freddie Mac’s estimates for cash-out refinancings and increased loan balances from mortgage consolidation ($279 billion in 2005) plus the $165 billion gain in home equity lines of credit during 2005. The bigger estimate calculated by some analysts takes the $1,067 billion growth in total residential mortgages in 2005 and subtracts the $467 billion in new residential construction put in place last year.
According to the Bureau of Economic Analysis, the savings of U.S.
households in 2005 totaled a negative $34 billion, or -0.4 percent of total
disposable personal income for the year. Although the personal savings rate
has trended consistently lower over the last 20 years, 2005 marks the first
year since the Great Depression for which the ratio fell below zero.
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expressed in FYI are those of the authors and do not necessarily
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Some of the information used in the preparation of this publication was
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by the Federal Deposit Insurance Corporation.