Economic update

The bad. This is an especially difficult period for lenders, as credit quality erodes and loan growth slows. Delinquencies and loan losses are rising across all types of lending. Delinquency rates on credit card loans, direct and indirect automobile loans, and mobile home loans are close to record highs. Mortgage delinquencies and losses also are on the rise, particularly for government and subprime loans. There were close to a record 1.5 million personal bankruptcy filings last year.

Meanwhile, credit growth has slowed sharply. After experiencing double-digit growth in 2000, total consumer credit outstanding has not grown since last spring of 2001. Outstanding commercial and industrial loans are falling.

The principal factor behind the weakening credit conditions is that the economy is engulfed in a fullblown recession in the wake of the September 11 terrorist attacks. Some 1.4 million jobs have been lost since the economy peaked last March, and the unemployment rate has jumped nearly two percentage points since its nadir to near 6%. Many who are holding on to their jobs are losing hours and suffering through pay cuts.

Household debt service burdens are very high among low and lower-middle income households, despite the lower interest rates and the resulting mortgage refinancing boom. Lenders were very aggressive in extending credit, particularly in the period surrounding Y2K, so the subsequent sharp decline in stock values has been hard on household balance sheets. Corporate debt loads are also onerously high for industries ranging from telecommunications to furniture manufacturing.

The ongoing erosion in borrower attitudes towards consumer debt repayment may also be contributing to the current credit problems. Driving this was the surge in personal bankruptcies during the mid and late 1990s, which reduced the stigma toward the nonpayment of debts. Indeed, as large numbers of households have gone bankrupt over the past decade, more people know someone who has defaulted on debt, making it more socially palatable for them to file themselves.

Although the recession is expected to be mild and short-lived by the standards of post-World War II recessions, ending early this year, the near-term outlook for credit conditions is poor. Personal bankruptcy filings are expected to peak at close to an annualized 1.8 million pace in the third quarter of this year, and delinquency and chargeoff rates for nearly all types of consumer credit will weaken substantially The credit card net chargeoff rate, for example, is expected to surge to a record near-7% this fall.

Subprime consumer installment and mortgage lending is expected to experience the most significant deterioration in credit conditions. While subprime lenders have had difficulty assessing credit risks during booming economic times, there is no precedent for gauging the magnitude of delinquencies and chargeoffs they can expect during a weaker economy. It is unclear whether lenders have adequately planned for such an eventuality.

In addition to rising credit problems, lenders will continue to struggle with weakening loan growth. Not only are households and businesses reigning in their borrowing in an effort to repair their weakened balance sheets, but lenders are now tightening their underwriting standards in response to the poorer credit conditions.

The good. While discouraging, the outlook for lenders could be even darker. It's expected that although the current recession will be approximately average in length and extraordinarily broad based, it will be very mild. Unemployment is expected to peak at not more than 6.5% this summer.

The basis for a recovery early this year is already developing. Confidence has firmed with the U.S. military's success in Afghanistan, monetary and fiscal policy have turned highly stimulatory, energy and import prices are falling, and businesses have largely cleared store shelves and warehouses of unwanted inventory.

Consumer spending is thus expected to revive and the downdraft in business investment is expected to end by this spring. Business expansion and investment plans are anticipated to gain momentum by the middle of 2003, ensuring that while modest, the recovery will be sufficient to stem further increases in unemployment by year's end.

Monetary policy has been highly stimulatory during the past year. The real federal funds rate, as measured by the difference between the nominal rate and core consumer price inflation, is now negative. Monetary supply growth is surging, with M2 and M3 expanding at a double-digit year-over-year pace. Real money supply growth is currently as strong as it has ever been.

The Federal Reserve's efforts are reaping economic benefits. Households, businesses, and government are using the lower interest rates to restructure their balance sheets. While household debt burdens are high, they have peaked. The mortgage-refinancing boom and falling rates on adjustable rate mortgages and other consumer credit are quickly slowing growth in debt service payments. Interest payments being made by nonfinancial corporations on their debt obligations also have begun to fall, which should provide some relief to hard-pressed profit margins.

It will take longer for lower borrowing costs to prompt businesses to borrow and creditors to lend more aggressively. However, the cost of capital is now low enough that once confidence returns, so, too, will business expansion plans.

Most households and businesses are benefiting enormously from declining energy and other import prices. The price of oil has fallen from well over $30 per barrel this time last year to near $20 currently. The strong dollar and substantial excess global capacity are pushing down import prices for everything from apparel to steel. Meanwhile, retailers are using heavy discounting and cut-rare financing to lure customers into stores. Even homebuilders have seemingly reined in their prices to support sales, particularly for higher-end homes.

Although declining energy and retail goods prices is hard on energy and important competing U.S. companies and retailers, it is a boon to consumers. Consumer spending on energy products alone peaked last December at $360 billion annualized. Spending this December was likely less than $300 billion. If it costs consumers less to fill their gasoline tanks, heat their homes, and buy Christmas presents, then they are able to increase their spending on everything else. And since the nation as a whole consumes much more energy and retail goods than it produces, the economy in aggregate benefits.

The substantial economic drag resulting from businesses' efforts to rein in their overladen inventories is also set to lift. This is best seen in the vehicle industry, which, since mid 2001, has slashed production by 10% and employment by close to 125,000 in an effort to bring production back in line with sales. With sales since the terrorist attacks juiced up by the automakers' zero-percent financing deals, vehicle inventories are now considered even a bit lean. Although sales are expected to fall dramatically early next year as the financing deals fade, the automakers will at worst be able to keep vehicle production close to where it is today. The same process is underway, albeit less quickly, across all manufacturing, including IT. As the inventory liquidation comes to an end early next year, so too will the recession.

While fiscal policy stimulus will also contribute significantly to ending this recession, it will be even important in shaping the early stages of recovery. Since coming to office a year ago, the Bush administration has appropriated more than $100 billion in additional monies to support the ailing economy. Households have already received one-half of these funds through tax cuts, while the remainder is now being disbursed to defray the costs and support the economic victims of the terrorist attacks.

Lenders' problems will also be partially mitigated by the expectation that while house price growth will weaken, there will not be widespread house price declines. This contrasts with the 1990-1991 recession, when house prices in California and throughout much of the Northeast fell considerably. In California, for example, median house prices fell more than 10% between mid-1991 and mid-1995. Housing markets at the current time are very well balanced across the country with few signs of overbuilding or speculative increases in house prices. As such, while a recession will hurt housing demand and thus house prices, there is little risk of a significant decline in house prices.

The reality. Under almost any reasonable outlook, lenders will find it tough going this year. Unemployment and lost hours, as well as high debt loads and low personal savings, will cause continued deterioration in credit quality. House price gains will soon moderate and stock prices remain fragile. Credit growth is expected to slow due to tighter lending standards and the eventual winding down of the mortgage refinancing boom. But there's no cause for despair.

It is important to remember that our economic reality lies somewhere between the heavy pessimism today and the buoyant optimism of not too long ago.

COPYRIGHT 2002 The Risk Management Association
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