Credit Quality Monitor: December 2010 - More Signs of Improvement, but Still a Long Way to Go

More signs of improvement have emerged in credit quality since our last report. The overall loan
delinquency rate fell further in the third quarter. While all loan delinquency rates were down from
the prior quarter, except for non-credit card  consumer loans, real estate delinquency rates
remained higher on a year-ago basis as improvement in this area has been minimal.

The share of mortgage loans either delinquent or in foreclosure fell for the third straight quarter,
with nearly the entire decline coming from a drop in the foreclosure  inventory  rate  as  the
delinquency rate was basically unchanged. Moratoriums and loan modifications took many
homes out of the foreclosure process. Unfortunately, renewed home price declines and a sluggish
labor market led to a rebound in the share of homes entering foreclosure to the highest in a year.

This is not a good sign, as it shows that the housing market is a long way from returning to
normal, and could be a sign that a second leg down is close at hand. The halt in foreclosures by
some banks due to documentation errors did not show up in the third quarter data, but may lead
to a decline in the fourth-quarter numbers as some foreclosures continue to be contested.
Banks were more willing to lend on net in the third quarter, but a slightly smaller share said so.

While demand for consumer loans was still weaker than in the second quarter, the share of banks
saying so declined. Terms and conditions, such as required minimum down payments and
required minimum credit scores, were mixed, with large banks generally easing and small banks
generally tightening. Small banks are still grappling with souring commercial real estate and
construction loans, which comprise the lion’s share of their balance sheets, keeping their lending
practices conservative relative to larger banks, which are seeing declines in delinquency rates on
their bread-and-butter mortgage, consumer, and C & I loans.

As we expected, the jump in net new loans seen during the second quarter, which was fueled by
economic optimism emanating from the homebuyer tax credit and tax refunds, gave way to a big
decline in credit outstanding and much weaker net new loans in the third quarter. The decline in
credit was entirely due to credit cards as non-credit card loans outstanding actually rose, and the
vast majority of credit card contraction was due to charge-offs rather than household
deleveraging. The good news is that the charge-off level declined noticeably, but it remains nearly
three times higher than the pre-crisis average.

There was more good news on the bankruptcy front in the third quarter as both business and
personal bankruptcies dropped. However, while the decline in business bankruptcies was
genuine, the decline in personal bankruptcies may have been due to seasonal factors not being
captured by the seasonal adjustment process as some noticeable seasonality still seems to show
up in the seasonally-adjusted data. Strong profit margins are helping businesses, while sluggish
labor and housing markets are keeping personal bankruptcies elevated.

We expect the economic recovery to be sustained, but it will be slow. As such, job growth will
improve but remain unimpressive. Thus, credit quality should continue to improve, but in most
cases it will be gradual. There may finally be a light at the end of the tunnel, albeit quite distant.

Loan Delinquency Rates
  • The overall loan delinquency rate fell further in the third quarter to 6.9 percent from 7.0 percent in the second quarter. While the decline was small, it continues the downward trend seen since the peak of 7.5 percent was reached  in the fourth quarter of 2009. Still, the delinquency rate remains above peaks seen in prior recessions, so there is still a lot of improvement needed to get back to a more normal credit environment.
  • All loan categories saw improvement in delinquency rates from the previous quarter except non-credit card consumer loans. Agriculture saw the biggest decline, but this was mainly due to seasonality. On a year-over-year basis, real estate delinquency rates are still higher, despite recent improvement, which has been minimal. The good news is that the yearover-year rate of increase continues to decline. 
  • In contrast, consumer loan delinquency rates are lower than year-ago levels. Consumers continue to deleverage, but charge-offs remain the driving force behind lower outstanding balances. This, combined with stabilization in the labor market and fewer credit card accounts  open, has led to an improvement in the balance of good debt versus bad debt. 
  • In the commercial sector, real estate delinquency rates are still higher than a year ago but have come down from the peak reached in the first quarter of this year. Commercial and industrial loan delinquency rates also continue to improve and were down on both a year-over-year and quarterover-quarter basis in the third quarter
  • There was good news and bad news on mortgage foreclosures and delinquencies in the third quarter. On a non-seasonally-adjusted basis, the mortgage delinquency rate slipped to 9.39 percent from 9.40 percent. While the decline was miniscule, it compares to an average 0.38 percentage point increase in the third quarter over the last 30 years, so it is definitely good news. Meanwhile, the quarter-end inventory foreclosure rate fell to 4.39 percent. Taken together, the share of loans either delinquent or in foreclosure fell to 13.78 percent, the third straight decline. 
  • Unfortunately, the bad news is that the share of loans entering foreclosure during the quarter spiked to 1.34 percent from 1.11 percent. The average increase in the third quarter is 0.02 percentage points, so the 0.23 percentage point increase was very large indeed. In addition, most of the increase was for prime fixed-rate loans. The improvement in foreclosure rates at quarter end was due primarily to loan modifications and moratoriums rather than an improving economy, while the increase in the number of loans entering foreclosure was due primarily to continued labor market weakness.
  • Following the post-tax credit plunge, mortgage purchase applications have been slow to rebound, despite record-low mortgage rates, as millions of homeowners are still underwater and job growth has been tepid. Refinancing jumped on the low rates but has since petered out. The recent spike in mortgage rates could cut off many potential buyers. Then again, rising rates could prompt others to act.
Lending Trends 
  • According to the Federal Reserve, a net 20.0 percent of banks were more willing to lend for consumer loans in the third quarter, slightly less than the 22.6 percent in the second quarter. Just like last quarter, both large banks (more than $20 billion in assets) and small banks were more willing to lend. Despite this, consumer loan growth worsened slightly during the quarter to -5.5 percent year over year, after it appeared that loan growth was starting to improve in the second quarter. This is particularly worrisome considering loans outstanding fell in the third quarter of last year as well, but the decline in the third quarter of this year was even larger. 
  • Although demand for consumer loans was still weaker than the prior quarter, the net percent of banks reporting weaker demand improved slightly to 5.6 percent from 7.5  percent. However, while large banks reported somewhat stronger demand, small banks reported weaker demand, similar to last quarter.  
  • Just like last quarter, there were also differences between large and small banks on terms and conditions. For non-credit card loans, large banks reduced required minimum credit scores, while small banks increased them. Large banks reduced required minimum down payments, while there was no change for small banks. Both large and small banks narrowed spreads over cost of funds, reducing bank profit margins. Mortgage standards tightened slightly, but while small banks tightened for prime loans, large banks eased a bit.
Consumer Credit
  • Following the brief and miniscule $1.8 billion increase in consumer credit outstanding in the second quarter, consumer credit contracted by $12.0 billion in the third quarter, the fifth decline in the last six quarters. The expiration of the homebuyers’ tax credit, which supported home sales and generally provided optimism, was a factor in the renewed contraction in credit. In addition, fading support from tax refunds may have left consumers feeling a bit less wealthy and less inclined to borrow. 
  • However, the entire decline in credit came from credit card loans, which fell by $15.2 billion. But nearly all of that decline came from $14.3 billion in charge-offs, suggesting that bad debt, rather than household deleveraging,  was the main factor. Meanwhile, non-credit card loans actually rose by $3.2 billion. Since the middle of the third quarter, though, non-credit card loans outstanding have declined noticeably.
  • Net new loans declined in  the third quarter to just $5.1 billion from $23.5 billion in the second quarter. Thus, with the exception  of the second quarter surge, the economy has had a difficult time generating credit growth during the recovery. We expect this to c0ntinue amid high unemployment and tight credit conditions. 
  • Although spending has held up relatively well recently, driven by tax refunds and government incentives earlier this year and built-up savings and labor market stabilization more recently, the growth rate has slowed slightly.  This has come as home prices have started to fall again.
  • There was good news on the bankruptcy front in the third quarter. Overall bankruptcies, the vast majority of which are personal bankruptcies, dropped. However, while the numbers are seasonally adjusted, there still appears to be a bit of seasonality in the data as the second quarter appears to always see a spike. Thus, the decline in third quarter bankruptcies,  both last year and this year, could be due to some seasonal factors that the seasonal adjustment process is not capturing. Even so, bankruptcies are still higher than a year ago, but year-over-year growth has slowed to just 6.4 percent from the recent peak of 36.6 percent in the second quarter of 2009. Meanwhile, there does not appear to be much seasonality in the business bankruptcy data, so the big decline in business bankruptcies was very good news, and continued an overall declining trend since the peak in the second quarter of 2009.    
  • Personal bankruptcies remain high due to continued high unemployment, lack of sustained and significant job growth, a tight credit environment, high debt levels and a sluggish housing market. We expect these trends to continue for many months to come, which will keep personal bankruptcies elevated.
  • The decline in business bankruptcies has come as profit margins have improved, driven primarily by cost  cuts.  However,  with  producer  prices  rising faster than consumer prices, we are concerned about a possible narrowing of profit margins down the road. Still, the biggest cost for most companies is labor, and slowing wage growth will help margins. 
Consumer Purchasing Plans 
  • Consumer purchasing plans were mixed in November. It was not much of a surprise to see plans to buy a home decline. Tight credit conditions, high unemployment, negative equity and the fear of further price declines have kept buyers on the sidelines. Meanwhile, pent-up demand and favorable financing deals have supported vehicle sales recently, and the recent up-trend in auto purchasing plans suggests vehicle sales will trend higher in the coming months.
  • Plans to purchase a major appliance have trended up recently as well, but remain far below prerecession levels. Plans to buy a refrigerator and washing machine have been trending higher, while plans to buy a TV have waned.
  • Despite stagnant income expectations, real ex-gas retail sales growth has been on a tear recently. After the summer slowdown following the spring surge, sales growth has jumped again over the last couple months. The rebound in real hourly earnings growth during the spring could have been a factor in the recent rebound in sales growth.  In addition, savings built up during the recession, along with recent improvement in income growth, is giving consumers greater spending capacity.  Furthermore, while job growth has been lackluster during the recovery, October’s strong 172,000 job gain surely supported spending. Another factor is that while sales have strengthened this year, sales were in a bit of a slump in September and October of last year, making for stronger year-over-year comparisons.
Full report: Credit Quality Monitor: December 2010 - More Signs of Improvement, but Still a Long Way to Go