Coronavirus-related business shutdowns across the country are driving an instantaneous surge in job losses, and a sudden, sharp turn in consumer credit performance appears inevitable.
Reports from individual states suggest that weekly unemployment claims could vault into the millions in March, economists say, vastly exceeding levels during the 2007 to 2009 recession. The extent of the pain puts the credit performance of broad bank loan portfolios in jeopardy, beyond the first-order impacts to concentrations in industries like restaurants, hotels and energy.
Analysts at Instinet forecast that net charge-offs at Capital One Financial Corp. will increase by 150 basis points from 2019 to about 4% in 2020, and by 225 basis points to more than 5% at Discover Financial Services under a base case scenario that anticipates that the unemployment rate will more than double to a peak of 8% in the second quarter.
Much depends on a wide range of unknowns, including the scale and effectiveness of federal aid to households and businesses, how quickly the spread of the virus can be contained and life can return to its normal rhythms, and whether loan modifications regulators are encouraging can help mute the damage.
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"There is a really significant, sharp spike in unemployment factored in here, with no modifications, no anything," Keefe Bruyette & Woods analyst Sanjay Sakhrani said in an interview, speaking about stock market valuations for credit card lenders. "All of these customers are going to be charged off, and that's going to impair tangible book value, is what seems to be priced in at this point. The question is, whether or not that's going to happen."
Among a group of 14 publicly traded, U.S.-based companies with large credit card loan portfolios, shares dropped a median 53.7% from the end of last year through March 23. The drop has lowered Capital One and Citigroup Inc. to nearly 50% of tangible book value.
Instinet's baseline scenario is relatively optimistic, and assumes that virus infections in the U.S. will peak in May, social distancing measures will start to ease in July, and that federal stimulus measures will be enacted and successfully "help bridge most consumers and small businesses through to the other side of the global pandemic," according to a report on March 20.
The Instinet analysts said that stock market valuations imply a more severe drop in employment than they believe is likely, and they projected that credit quality metrics will recover strongly in 2021. In a favorable scenario, "it is possible that the virus will be largely eradicated before credit card issuers ever experience any coronavirus-related losses since accounts entering delinquency in March will generally not charge off until August," they said.
Despite lowering EPS estimates and price targets for Capital One, Discover and American Express Co., Instinet upgraded its ratings on Capital One and Discover to "buy" from "neutral," and maintained Amex at "buy."
Widespread borrower relief in the form of payment deferrals that will not be recorded as past-due balances appear increasingly likely after regulators issued accounting guidance on March 22 for banks working with customers impacted by the pandemic. Still, structured finance analysts at BofA Global Research said they expect "extended periods of job loss" will drive card delinquencies and defaults higher even as lenders offer modifications. In part because of stronger underwriting compared with the period before the 2007 to 2009 recession, the BofA analysts said in a March 20 report that they "do not expect charge-offs to reach Great Recession levels."
Credit cards, a large category of unsecured loans encompassing about $1 trillion in total outstanding balances, have a major influence on overall credit performance across the banking industry, both when credit is weakening and when it is improving. JPMorgan Chase & Co., the country's second-largest credit card lender, estimated that cards would account for about half of its total loan losses of $38.6 billion under the key scenario in the annual supervisory stress tests. From 2010 through 2012, when credit quality was recovering after the last recession, credit cards accounted for about two-thirds of about $17 billion in loss reserve releases at the bank, delivering a substantial boost to earnings.
The credit card business' impact on loss provisioning would be further magnified under the recently adopted current expected credit loss accounting standard, which requires that banks create allowances for lifetime loan losses, as opposed to the old model where provisions were booked when losses became probable, and is heavily influenced by the macroeconomic outlook. Banks including JPMorgan Chase and Bank of America Corp. have attributed initial increases in allowances required under CECL to their credit card portfolios.
"Even before you see a delinquency, if an economic forecast is suggesting a sharp deterioration in the economy, that could result in a material provision related to CECL," Sakhrani said. He argued that CECL could also hurt consumers by making banks wary about expanding loan portfolios when they have to make large additional provisions to accommodate the growth.
Some analysts expect that the multitrillion-dollar stimulus legislation being considered by Congress will retain provisions that would allow banks to opt out of CECL until after the pandemic passes.
Credit card loan performance and employment levels have historically had a tight relationship, with aggregate charge-offs among commercial banks surging 619 basis points from the fourth quarter of 2007 to 10.4% in the second quarter of 2009, while the unemployment rate jumped 483 basis points to 9.6% over the same time, according to data from the Federal Reserve Bank of St. Louis. Charge-off rates subsequently declined, echoing a fall in initial jobless claims while the unemployment rate remained elevated as job seekers, many of whom had already lost access to credit card accounts, struggled to find positions.
Credit card lenders began to increase consumer lines again about a year and a half after the last recession officially ended in the second quarter of 2009, with unused lines growing by about $1 trillion from the end of 2010 to about $3 trillion at the end of 2019, according to data the Federal Reserve Bank of New York constructs using Equifax credit reports. Outstanding balances began to increase in 2013, growing about $260 billion from the second quarter of 2013 to about $930 billion at the end of 2019.
Charge-offs had been ticking up as the industry increased lines and loans, but at 3.69% among commercial banks in the fourth quarter of 2019, remained below an average of 4.85% since the fourth quarter of 2000, according to the data from the St. Louis Fed.
Overall, consumer balance sheets appeared relatively healthy going into the coronavirus crisis, with the ratio of household debt to assets falling to almost 12% in 2019, compared with more than 16% heading into the 2007 to 2009 recession, according to data from Moody's. Among the bottom 40% of income earners, however, this measure of leverage has increased to more than 20% since 2007.