It has been like waiting for the second shoe to fall.
The first shoe was the Covid-19 pandemic, which forced the U.S. economy into lockdown mode in March 2020. Many banks prepared for an expected credit apocalypse by setting up big reserves for future loan losses — and those anticipated losses were the second shoe. Sure enough, the economy shrank 31.4% in the second quarter of 2020 as the lockdown took hold, but the expected loan losses never materialized. The economy quickly rebounded the following quarter – growing an astonishing 38% — and the feared economic apocalypse never occurred.
In fact, two and a half years later, that second shoe still hasn’t dropped. To this day, the industry’s credit performance since the beginning of the pandemic has been uncommonly good. According to data from S&P Global Market Intelligence, net charge-offs (which is the difference between gross charge-offs and any subsequent recoveries) for the entire industry were an average of 23 basis points for 2021. Through the first six months of 2022, net charge-offs were just 10 basis points.
Surprisingly, the industry’s credit quality has remained strong even though U.S. economic growth was slightly negative in the first and second quarters of 2022. The Bureau of Economic Analysis, which tracks changes in the country’s gross domestic product, had yet to release a preliminary third quarter number when this article published. However, using its own proprietary model, the Federal Reserve Bank of Atlanta estimated in early October that U.S. GDP in the third quarter would come in at 2.9%.
This would suggest that the industry’s strong credit performance will continue for the foreseeable future. But an increasing number of economists are anticipating that the U.S. economy will enter a recession in 2023 as a series of aggressive rate increases this year by the Federal Reserve to lower inflation will eventually lead to an economic downturn. And this could render a significant change in the industry’s credit outlook, leading to what many analysts refer to as a “normalization of credit.”
So why has bank loan quality remained so good for so long, despite a bumpy economy in 2022? And when it finally comes, what would the normalization of credit look like?
Answering the first question is easy. The federal government responded to the pandemic with two major stimulus programs – the $2.2 trillion CARES Act during President Donald Trump’s administration, which included the Paycheck Protection Program, and the $1.9 trillion American Rescue Plan Act during President Joe Biden’s administration — both which pumped a massive amount of liquidity into the U.S. economy.
At the same time, the Federal Reserve’s Federal Open Market Committee cut the federal funds rate from 1.58% in February 2020 to 0.05% in April, and also launched its quantitative easing policy, which injected even more liquidity into the economy through an enormous bond buying program. Combined, these measures left both households and businesses in excellent shape when the U.S. economy rebounded strongly in the third quarter of 2020.
“You had on one hand, just a spectacularly strong policy response that flooded the economy with money,” says R. Scott Siefers, a managing director and senior research analyst at the investment bank Piper Sandler & Co. “But No. 2, the economy really evolved very quickly on its own, such that businesses and individuals were able to adapt and change to circumstances [with the pandemic] very quickly. When you combine those two factors together, not only did we not see the kind of losses that one might expect when you take the economy offline for some period of time, we actually created these massive cushions of savings and liquidity for both individuals and businesses.”
The second question — what would a normalized credit environment look like? — is harder to answer. Ebrahim Poonawala, who heads up North American bank research at Bank of America Securities, says the bank’s economists are forecasting that the U.S. economy will enter a relatively mild recession in 2023 from the cumulative effects of four rate increases by the Federal Reserve — including three successive hikes of 75 basis points each, bringing the target rate in September to 3.25%. The federal funds rate could hit 4.4% by year-end if inflation remains high, and 4.6% by the end of 2023, based on internal projections by the Federal Reserve.
“There’s obviously a lot of debate around the [likelihood of a] recession today, but generally our view is that we will gradually start seeing [a] normalization and higher credit losses next year, even if it were not for an outright recession,” Poonawala says. While a normalized loss rate would vary from bank to bank depending on the composition of its loan portfolio, Poonawala says a reasonable expectation for the industry’s annualized net charge-off rate would be somewhere between 40 and 50 basis points.
That would be in line with the six-year period from 2014 through 2020, when annual net charge-offs for the industry never rose above 49 basis points. And while loan quality has been exceptional coming out of the pandemic, that six-year stretch was also remarkably good — and remarkably stable. And it’s no coincidence that it coincides with a period when interest rates were at historically low levels. For example, the federal funds rate in January 2014 was just 7 basis points, according to the Federal Reserve Bank of St. Louis’ FRED online database. The rate would eventually peak at 2.4% in July 2019 before dropping back to 1.55% in December of that year when the Federal Reserve began cutting rates to juice a sagging economy. And yet by historical standards, a federal funds rate of even 2.4% is low.
Did this sustained low interest rate environment help keep loan losses low during that six-year run? Siefers believes so. “I don’t think there’s any question that cheap borrowing costs were, and have been, a major factor,” he says.
If interest rates do approach 4.6% in 2023 — which would raise the debt service costs for many commercial borrowers — and if the economy does tip into a mild recession, the industry’s loan losses could well exceed the recent high point of 49 basis points.
“There is a case to be made that a recession could look a bit more like the 2001-02 [downturn] in the aftermath of the dot-com bubble [bursting],” says Poonawala. “You saw losses, but it was an earnings hit for the banks. It wasn’t a capital event.”
That recession lasted just eight months and the decline in GDP from peak to trough was just 0.3%, according to the National Bureau of Economic Research. The industry’s net charge-off ratio rose to an average of 107 basis points in 2002 before dropping to 86 basis points in 2003, 59 basis points in 2004 and bottoming out at 39 basis points in 2006.
This same cyclical pattern repeated itself in 2008 — the first year of the financial crisis – when the average net charge-off rate was 1.30%. The rate would peak at 2.67% in 2010 before declining to 68 basis points in 2013 as the economy gradually recovered.
When we talk about the normalization of credit, what we’re really talking about is the return of the normal credit cycle, where loan losses rise and fall with the cyclical contraction and expansion of the economy. Banks have experienced something akin to a credit nirvana since 2014, but it looks like the credit cycle will reappear in 2023 — aided and abetted by higher interest rates and an economic downturn.