The recession that began in March 2001 represents a new test for risk management practices at U.S. banks and thrifts. Any significant slowdown in economic activity at the national level usually has adverse effects at most insured institutions. Typically, we would expect a decline in the demand for credit along with an increase in the number of borrowers who have trouble repaying existing loans, resulting in lower bank earnings. The ultimate effect of an economic slowdown on the banking industry hinges on three key factors: (1) how severe the downturn is, (2) how long it lasts, and (3) how well banks are prepared for economic adversity.
However, just as in the Back to the Future movie trilogy, we see that history does not play out the same way every time. This recession is unique in that it follows the longest economic expansion in U.S. history. This era came to be called the New Economy because of the changes technology and globalization are thought to have brought about in rates of inflation and productivity growth.1 What effects will a New Economy recession have on the U.S. banking industry? To answer this question, we will go "back to the future" and compare the current situation to past recessions.
The current recession can be best described as a "corporate sector recession" in that most of the bad economic news over the past two years has been corporate news. First, corporate equity prices tumbled after reaching a peak in the spring of 2000, particularly on the technology-heavy NASDAQ exchange. After-tax corporate profits fell by nearly 16 percent in 2001 from the year before--the sharpest annual decline since 1982. To make matters worse, the collapse of Enron in December 2001 sparked a flurry of questions about the quality of accounting information in corporate earnings reports and audit opinions as well as the reliability of equity analyst reports.
The result of these corporate woes has been a dramatic falloff in business investment spending. Chart 1 compares investment spending in this cycle with its average trend over the last five recessions, dating to 1960. The chart shows that while inflation-adjusted growth in investment outstripped the historical average prior to March 2001, it has significantly underperformed the average since then. Faced with weak earnings, corporations that had been investing billions in information technology (IT) in the late 1990s suddenly cut back. Lower demand for high-tech products in turn hurt the major suppliers of IT equipment and software, including Intel, Dell, and even Microsoft. Also hard hit by this corporate sector recession has been the telecommunications industry, burdened by excess capacity and high debt loads. Capacity utilization for the high-tech industry--including computers, communications equipment, and semiconductors--barely topped 60 percent at the end of 2001.
Earnings for the rest of the corporate sector also have been hurt by slow growth in top-line revenue in a highly competitive, low-inflation world. Total sales of U.S. manufacturing corporations fell by 8 percent in fourth quarter 2001 from a year ago, while their operating profits fell by more than half. Job cuts announced by all U.S. corporations more than tripled in 2001 from a year ago to 1.96 million. A record 255 U.S. corporations filed for bankruptcy protection in 2001, up from 176 the year before.2 The default rate on speculative bonds nearly doubled during 2001, reaching 10.2 percent by year-end.3 In addition, a record-high 60 investment-grade credits were downgraded to junk status ("fallen angels") in 2001.4 Rising defaults among corporate borrowers pushed up commercial and industrial (C&I) loan losses at large banks that tend to lend more often to large corporate borrowers. C&I charge-offs for large insured institutions (over $1 billion in assets) in fourth quarter 2001 were 1.58 percent of average loan balances, more than twice the level recorded at small institutions (under $1 billion).
2 Data on publicly traded bankruptcy filings from BankruptcyData.com.
3 Moody's Investors Service. January 14, 2002. December Default Report.
4 Lori Appelbaum, et al. February 6, 2002. Banks: Regional/Trust & Processing. Goldman Sachs Global Equity Research. The previous peak was in 1989, when the number of fallen angels reached 42.
Consumer Spending Comes to the Rescue
While the problems of the corporate sector were driving the U.S. economy into recession, consumer spending has continued to grow with barely a pause. Chart 2, comparing consumer spending growth in this recession with that in previous downturns, shows that consumer spending slowed briefly in the third quarter of last year, and then resumed a rapid growth in the fourth quarter that persisted into early 2002. This performance is all the more remarkable in light of the shock to consumer confidence that was recorded in the wake of the September 11 terrorist attacks. In spite of the turmoil, retail sales grew at a brisk 5.5 percent nominal rate in fourth quarter 2001 on the strength of a 15.5 percent increase in sales of autos and auto parts.
Three related factors may help explain why consumers have continued to increase their spending throughout this recession. First, the Federal Reserve lowered interest rates 11 times in 2001, for an unprecedented cut of 475 basis points in the federal funds rate. As long-term mortgage rates declined late in the year, millions of homeowners were able to refinance their mortgages at lower rates. Moreover, because of high rates of home price appreciation in many markets across the nation in recent years, many homeowners had the opportunity to "cash out" a portion of the equity in their home to pay down nonmortgage debt or finance new purchases.5 One estimate shows that mortgage refinancing provided about $150 billion in additional liquidity to consumers during 2001.6 The Federal Reserve Flow of Funds data show that total mortgage indebtedness of households and nonprofit organizations grew by $491 billion, compared with personal saving of only $118.6 billion out of current income. Finally, despite the recession-induced job losses, real disposable personal income grew by a solid 3.6 percent last year, helping to offset losses sustained in the slumping stock market.
5 According to Freddie Mac, 60 percent of loans refinanced in third quarter 2001 and 48 percent in fourth quarter 2001 were cash-out refinancing. Freddie Mac defines cash-out refinancing as refinancing activities that result in new mortgages at least 5 percent higher in amount than the original mortgages.
6 Credit Suisse First Boston. March 14, 2002. Household Sector Focus: A $300 Billion Puzzle.
Continued growth in consumer spending amid corporate-sector distress illustrates the fact that workers and consumers wield a substantial amount of competitive power in the New Economy. For example, during fourth quarter 2001, car buyers responded to zero-percent financing and cash incentives, which boosted sales but left U.S. auto makers with more than $7 billion in operating losses for the year.
Recovery Appears on the Way
Recent signs indicate that the U.S. economy may have begun to recover in first quarter 2002.7Chart 3 points to four factors--consumer confidence, housing starts, manufacturing, and job growth--that appeared to head upward simultaneously during the first quarter. Preliminary estimates of first quarter U.S. economic activity reinforce this picture; real gross domestic product (GDP) grew at an annualized rate of 5.8 percent in the first quarter. A survey of 50 leading corporate economists by Blue Chip Economic Indicators shows that analysts expect the U.S. economy to grow at a rate of 3.1 percent in the second quarter and 2.8 percent for 2002 as a whole.8
7 Official starting dates for U.S. recessions are determined by the National Bureau of Economic Research (www.nber.org). Typically, the NBER does not make these official determinations until some months after the fact.
Chart 4 compares U.S. GDP growth during this recession with that in the previous five recessions. It shows that, like growth in consumer spending, the economy barely paused in third quarter 2001 and then began to recover sooner and stronger than the historical norm. If this trend continues, this recession could be one of the shortest and mildest on record. However, a return to a vigorous economic expansion is by no means certain. Given vulnerabilities that still exist in the consumer and corporate sectors, two other scenarios could develop: (1) a slow-growth expansion during the remainder of 2002, or (2) a "double-dip" recession. Either scenario could have significant ramifications for banking industry earnings.
History suggests that a return to consistently high rates of economic growth will require consumer spending to remain strong while business investment stages a large-scale recovery. However, this combination may be difficult to achieve in the immediate future. For the business sector, excess capacity in key industry sectors, high corporate leverage, and a general lack of pricing power could make profit growth a slow process. Many U.S. corporations have taken advantage of the recession to recognize restructuring charges and other one-time expenses that will clean up their balance sheets and set the stage for higher earnings growth during the expansion. However, without a turnaround in demand, these efforts do not guarantee an improvement in the corporate earnings picture to the point where large-scale increases in business investment are imminent. While total business investment grew by $79.1 billion in the first quarter, some $83.1 billion of the growth was simply a reduction in the amount of shrinkage in business inventories. Business fixed investment still fell slightly in the first quarter.
For consumers, two factors pose a threat to continued high rates of spending growth. The first is the large amount of new debt consumers have taken on in recent years. Chart 5 shows that net financial investment by consumers has totaled negative $471 billion over the past three years as households have taken on large amounts of new consumer and, especially, mortgage debt. Mortgage indebtedness of households and nonprofit organizations rose by $491 billion in 2001 alone. The second--and related--threat is the degree to which recent growth in consumer spending has depended on home price appreciation and the ability to borrow against home equity. This source of wealth and liquidity, which is available to the 68 percent of U.S. households who own their own home, has helped to cushion the blow of equity market losses in recent years.9 If home price appreciation should slow significantly or reverse itself, households may be forced to rein in their spending, lowering the growth rate of the U.S. economy.
The Financial State of the Banking Industry Continues Strong
Bank earnings have continued to be solid in this recession, with commercial banks earning a record $74.3 billion in 2001. However, both large and small banks experienced a slight decline in return on assets (ROA) over the past year. Pretax ROA for large banks slipped by 8 basis points to 1.76 percent in 2001, primarily because of higher provision for loan losses. For small banks, pretax ROA slipped by 13 basis points to 1.58 percent mostly because of smaller net interest margins (see Chart 6).
As corporate borrowers experienced significant earnings difficulties, credit quality for C&I loans deteriorated noticeably in 2001. The ratio of noncurrent C&I loans among all insured institutions rose by 75 basis points to 2.40 percent during 2001, while the net charge-off rate for C&I loans rose by 70 basis points to 1.48 percent. Consumer loan losses also rose in 2001, in tandem with a record 1.45 million personal bankruptcy filings. The net charge-off rate for consumer loans among insured institutions increased by 34 basis points to 2.61 percent.
Despite the deterioration in credit quality, problem loans still represent a significantly smaller portion of bank loan portfolios than they did in the 1990-1991 recession. By way of comparison, noncurrent C&I loans among insured institutions were 4.51 percent of loan balances at year-end 1991 (1.8 times higher than now), while noncurrent commercial real estate (CRE) loans totaled 8.19 percent of outstanding balances (8.9 times higher than now).
Because credit problems tend to lag the business cycle, bank credit losses may continue to rise for a number of quarters. However, the industry as a whole appears to be well positioned to withstand further credit quality deterioration. At the end of 2001 the equity-to-assets ratio for all insured institutions stood at 9.22 percent, compared with only 6.51 percent at the end of 1991. Even more important, only 149 insured institutions had an equity-to-asset ratio below 6 percent at the end of 2001, compared with 2,244 at the end of 1991. In contrast to the 1990-1991 recession when widespread banking problems exacerbated the overall economic downturn, the relative absence of capital-impaired institutions in this recession is a key factor supporting the tentative economic recovery. By providing credit to creditworthy borrowers, well-capitalized institutions with relatively low levels of nonperforming loans are likely to play an important role in economic recovery this year.
Banking Risks Remain on the Horizon
In spite of the overall strength in the banking industry, risk management challenges remain in an uncertain economic environment. Given the ongoing distress in the corporate sector, C&I credit losses can be expected to remain at elevated levels. Although commercial loan losses have been more concentrated among large institutions thus far, there are some signs that credit problems may be spreading to small- to medium-size business borrowers, who often depend on small banks for credit. The extent to which commercial loan losses spread from larger banks to smaller institutions will depend in large part on the speed and strength of the economic recovery.
On the consumer side, recent large increases in consumer indebtedness have focused particular attention on subprime and high loan-to-value (LTV) lending.10 These loan programs, which have been developed largely since the last recession, have grown rapidly in recent years, introducing higher levels of credit risk into consumer loan portfolios. Losses associated with these higher-risk consumer loans have been rising fast over the past year. Chart 7 shows that a large number of lenders experienced higher-than-expected subprime loan losses in 2001.11
10 Subprime loans are loan products specifically designed for borrowers with "weakened credit history." For more details on subprime lending, see the interagency release, Questions and Answers for Examiners Regarding the Interagency Expanded Guideline for Subprime Lending Programs Issued January 31, 2001, July 30, 2001, http://www.fdic.gov/news/news/press/2001/pr0901a.html. High loan-to-value loans are usually residential real estate loans that equal or exceed 90 percent of the real estate's appraised value.
This experience indicates that these institutions may need to adjust their credit risk models to better reflect changed economic conditions. Similarly, credit losses rose sharply last year in the Federal Housing Administration and Veterans Administration loan programs, which provide terms similar to those offered by private high-LTV mortgage lenders. Should consumer credit problems continue to rise in the months ahead, they not only would hurt the earnings of consumer and mortgage lenders, but also could induce consumers to slow their rate of spending.
During the last recession, commercial real estate (CRE) lending was one of the leading sources of credit losses in the banking and thrift industries. Then, much of the problem was related to overbuilding in previously fast-growing metropolitan areas, poor underwriting of CRE and construction loans, and high concentrations in these loan types. During the latter years of the 1991-2001 expansion, the Federal Deposit Insurance Corporation issued a series of reports showing that CRE construction was again on the rise and urged lenders to ensure that their underwriting practices reflected the possibility of higher vacancy rates ahead.12
12Regional Outlook, third quarter 2000, "Ranking Metropolitan Areas at Risk for Commercial Real Estate Overbuilding," and Regional Outlook, first quarter 1999, "Commercial Development Still Hot in Many Major Markets, but Slower Growth May Be Ahead." Both articles can be found at: http://www.fdic.gov/bank/analytical/regional/index.html.
However, few could have foreseen the events of 2001, when demand for office and industrial space in most major U.S. metropolitan areas collapsed. This unprecedented "negative net absorption" of U.S. office space has lifted vacancy rates dramatically in a number of metro areas.13
To date there has been little increase in the level of noncurrent CRE loans on the books of insured institutions. While improved market information and more solid underwriting may be helping to keep losses low, CRE credit problems could begin to rise over time if a strong economic recovery fails to materialize in 2002.
The challenge of rising CRE vacancy rates is particularly acute in metro areas that grew faster than the national economy as a whole during the 1990s and in which banks and thrifts have particularly high concentrations of CRE and other traditionally high-risk loans such as commercial and construction loans. Economic conditions in some previously robust metropolitan areas declined sharply in the second half of 2001. The ten markets identified in Chart 8 collectively lost 280,000 net jobs during 2001 after creating an average of 430,000 jobs annually during the preceding five years. The slowdown in many of these markets has been led by weaknesses in the high-tech sector, which had previously contributed to their strong growth. Some of these markets also were affected adversely by disruptions in the travel and tourism sector in late 2001.
With slowing economic conditions, CRE markets in most of these metropolitan areas have deteriorated rapidly and to a greater extent than reported nationally. Absorption of existing space declined significantly in 2001 even as considerable new office and industrial space entered these markets with the completion of projects. This supply and demand imbalance led to rising vacancy rates. In San Jose, for example, vacancy rates soared from less than 2 percent at year-end 2000 to an estimated 14.5 percent at year-end 2001.
Many banks and thrifts operating in these markets continued to add to credit exposure levels even as economic conditions began to deteriorate. In some markets, such as San Francisco and San Jose, the increase in loan volumes was the result of funding commitments to lend that were made before economic conditions began to change. In other markets, such as Atlanta, Las Vegas, Portland, and Salt Lake City, both funded and unfunded credit exposure levels have increased.
Recent economic data have signaled that recovery may be on the way, but lingering uncertainties remain over the strength of the recovery. The recession that began in March 2001 finds the banking industry in generally strong financial condition. Nevertheless, a number of risk management challenges remain for bankers going forward. In particular, credit losses, which have been concentrated among large bank commercial lenders and subprime consumer lenders thus far, may spread to other lenders and remain at elevated levels before leveling off. The history of past recessions is only an imperfect guide for what to expect in this recession. We may find that much history has been rewritten by the changes that have taken place in the economy and the banking system since the last recession. To the extent that this is the case, the best risk management practice is to look forward rather than back.
Richard A. Brown, Chief Economic and Market Trends Section
Robert Burns, Senior Financial Analyst
Lisa Ryu, Financial Economist