10 March 2021 COVID

Household and Corporate Debt: Covid vs the GFC

By Sam van de Schootbrugge
5 min read

Summary

A new FEDS note finds that the CARES act has significantly reduced the share of US borrowers in delinquency and/or forbearance.
Nevertheless, the percentage of household borrowers unable to repay loans has risen substantially during the pandemic, and in-line with trends seen during the GFC.
On the firm side, a BIS working paper explains that the effects on corporate insolvencies are only starting to be felt.
For countries with a higher expose to service sector businesses, such as the UK, credit losses will peak in 2021, but will not rise to GFC levels.

Introduction

The latest $1.9tn Covid-19 relief package could boost the 2021 US federal government deficit to over $3.5tn. This unprecedented level of fiscal support has, although to a lesser extent, also been seen across most developed economies. As a result, default rates and corporate insolvencies have been lower than past crises. Two new research notes by the Fed and BIS, explore how the crisis has affected both households and corporations. They find;

The widespread availability of loan forbearance decreased delinquencies and defaults, but the percentage of borrowers unable to pay back debt was similar to the Great Financial Crisis (GFC).
The Coronavirus Aid, Relief, and Economic Recovery (CARES) Act increased incomes during the pandemic, and lowered delinquency and/or forbearance rates on mortgages.
Corporate credit losses could cumulate to around 2% of annual GDP during 2020 to 2022, and over two-thirds of these losses are yet to materialise.
These losses will be lower than during the GFC, because service sectors, which have suffered disproportionately during the pandemic, account for a smaller share of total credit than goods and business sectors.

Household Debt in the US

Typically, default rates are linked to the business cycle and tend to rise in periods of economic stress and rising unemployment rates (Chart 1). Yet, delinquencies on mortgages and auto loans have fallen during the Covid-19 pandemic. A FEDS note gives several factors that could explain why.

Firstly, a penalty-free forbearance programme in the CARES Act allowed repayment freezes that were not widely available in past recessions. Loans in forbearance may also not be reported as delinquent if they were current at the time the accommodation was granted. Data on the share of borrowers with loans which are either in delinquency and/or in forbearance, i.e., the share of borrowers not required to make a full payment, shows non-payments during the pandemic did indeed rise with unemployment rates (Chart 2).

Second, generous income support meant the majority of unemployed workers faced income replacement rates over 100%, far higher than the 40% typical during recessions. Alongside stimulus payments, aggregate incomes rose during the Covid-19 pandemic (Chart 3).

Third, the residential real estate market in the pandemic has been strong, starkly contrasting the GFC where household income and home equity fell. According to the authors, between 2019 Q3 and 2020 Q3, US homeowners gained an estimated $1 trillion in aggregate equity, an increase of 10.8%.

In an Ordinary Least Squares regression, the article tests which factors may help explain changes in non-payment rates during the pandemic. The unemployment rate was the main culprit behind a higher share of mortgage borrowers in delinquency and/or forbearance (Chart 4). Higher case numbers across states also increased non-payment rates. Meanwhile, a one-standard-deviation increase in CARES income support generosity is associated with a 2ppt lower share of delinquency and/or forbearance rates on mortgages and auto loans. Higher stringency scores also reduced the likelihood of non-payments.

On the household side, therefore, the generous forbearance programme makes the traditional delinquency rate a misleading measure of household financial stress. Indeed, even with substantial income support, a similar share of borrowers as during the GFC are not repaying mortgage and auto loans in full. Developments within the labour market remain the main driver of household financial stress, showing the importance of further income support.

Corporate Debt in G7 Countries

Non-financial corporate (NFC) bankruptcy rates have been, and remain, fairly low in most countries, despite the sharp decline in economic activity. As credit support winds back, corporate bankruptcies and the associated credit losses will rise. The BIS paper constructs sectoral economic projections for nine countries (G7 + China and Australia), examining each sector’s exposure to debt and thereby forecasting the implications on each country’s GDP.

The large service sector blows dealt by the pandemic have been unusual. During the GFC, and more generally in recessions, goods industries such as manufacturing and construction experience the largest contractions, while service industries are more resilient (Chart 5). Therefore, projections of future GDP growth depend heavily on a country’s sectoral composition of output.

According to the authors, customer services sector output is expected to remain at least 10% below its pre-pandemic trend until late 2021. Recreation industries, such as cafés, restaurants and tourism, could be down as much as 20%. Meanwhile, output in the manufacturing and construction industries is projected to be no more than 1% below its pre-pandemic trend by the end of 2021. Aggregating to a country level (and assuming vaccinations remove social distancing restrictions by Q1 2022), countries with greater dependence on service sector industries will face more sluggish recoveries (Chart 6).

With slower recoveries comes more prolonged pressure on corporate level finances. In addition to the significant contemporaneous output effects in 2020, higher debt levels within countries with greater dependence on service sector businesses could face large credit losses.

Using market- and bank-level data sources, the authors measure NFC debt. From this, they capture up to 90% of total credit exposure within each country and show that customer service industries only account for 15-30% of that. The majority of this credit (70%) is in bank loans, larger than manufacturing and utilities industries but lower than construction and real estate.

Based on projections of economic activity and the size of the shock to GDP in 2020, the authors estimate the credit losses by sector and country. On a sectoral level, credit loss rates in the recreation industry could increase by more than 8ppt on average during 2020-22 compared with the pre-crisis period, while the trade, transport and social services industries are expected to see increases in loss rates of between 1.5 and 3ppt (Chart 7).

On a country level, credit losses will be largest in the UK, followed by Italy and France. Cumulated over the 2020-22 period, the increases in credit losses due to the pandemic amount to between 0.7% of annual GDP in China and 5.1% in the UK. Overall, projected credit losses total about $1tn above what would have been expected without the pandemic. Relative to the GFC, however, credit loss rates (for bonds) are not expected to be as high (Chart 8). This is mainly because the most-affected industries account for a smaller share of total corporate borrowing.

Bottom Line

Countries have so far been able to mitigate most of the household and corporate credit losses that would typically have been expected during recessions. Inevitably, defaults will start to pick up. The proportion of US borrowers not paying back loans in full is high and remains closely linked to developments in the labour market. Corporate credit losses will also increase, especially if recoveries are sluggish.

Citation

Dettling L. and Lambie-Hanson L., (2021), ‘Why is the Default Rate So Low? How Economic Conditions and Public Policies Have Shaped Mortgage and Auto Delinquencies During the COVID-19 Pandemic’, FEDS Notes, https://www.federalreserve.gov/econres/notes/feds-notes/why-is-the-default-rate-so-low-20210304.htm

Mojon B. et al, (2021), ‘How much stress could Covid put on corporate credit? Evidence using sectoral data’, BIS Quarterly Review, https://www.bis.org/publ/qtrpdf/r_qt2103e.htm