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Surging unemployment threatens US banks concentrated in consumer loans

A staggering 10 million initial jobless claims over just two weeks put the U.S. unemployment rate on a trajectory to reach levels last seen during the Great Depression. A wave of missed payments appears inevitable, endangering bank portfolios of home mortgages, and credit card, auto and other consumer loans.

The official unemployment rate has already jumped 0.9 percentage point to 4.4%, according to the most recent report, which showed heavy job losses in sectors that include restaurants, bars, hotels, retail stores, and even medical professions hit by postponements of non-emergency procedures. That figure is based on a survey during the first half of March, before business closures driven by the fight against the novel coronavirus registered in the nearly 10 million claims, an amount economists expect to grow rapidly as the damage spreads and states work through backlogs of benefit claims.

The economic free fall is also set to disrupt hiring, and projections that the unemployment rate will easily surge past peaks reached over the last 70 years to 15% or higher are common. For banks, that means that enormous numbers of customers in previously secure jobs face a deeply uncertain future.

Perhaps 12% of homeowners will need forbearance on their mortgages under a base case estimate by the Urban Institute that incorporates delinquency trends from the housing crisis a decade ago, along with an unemployment forecast of 12% to 15%. Banks would be shielded from a direct hit on the roughly 70% of mortgages that are backed by the federal government, but about 20% of mortgages are held directly on the balance sheets of U.S.-chartered banks.

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Overall consumer credit losses will depend on how quickly the country can control the spread of the pandemic and ease restrictions on movement and business activity, and how effective federal relief legislation will be in cushioning the blow. Regulators and legislators have encouraged banks to give borrowers breaks on payments until they can recover their footing, but the economy could suffer prolonged damage if outbreaks recur and businesses have difficulty reconstituting.

Extrapolating from recent recessions, credit card charge-offs are likely to climb the most steeply compared with other consumer loan categories, and once again drive much of the banking industry's credit expenses. After the 2007-2009 recession, the annual rate of credit card charge-offs to credit card loans among U.S. commercial banks peaked at over 10.5%, according to data from the Federal Reserve Bank of St. Louis. Charge-offs on single-family residential mortgages peaked at about 2.7% and charge-offs on other consumer loans, including automobile loans, peaked at about 3.3%.

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Structured finance analysts at BofA Global Research said in an April 3 note that they expect surging unemployment to drive a slide in credit performance on consumer loans that "reaches or exceeds" the 2008-2009 recession.

"There is no question that consumer finance companies will be significantly impacted in a recessionary scenario," analysts at Keefe Bruyette & Woods said in a March 30 report reevaluating non-mortgage consumer finance companies against expectations for higher unemployment and a deterioration in other economic conditions. "Card issuers see the most significant downside from an earnings standpoint" under the updated forecast.

Assuming an unemployment rate that peaks at 8% in the fourth quarter of 2020 and remains elevated at 7.4% through the fourth quarter of 2021, and making adjustments for customer credit scores across lender portfolios, KBW estimated that the credit card charge-off rate at Capital One Financial Corp. would increase by 280 basis points to 7.39% in 2020, and by more than another 100 basis points to 8.46% in 2021. For American Express Co., whose customers tend to have higher credit scores, the KBW analysts forecast that charge-offs would increase by almost 300 basis points from 2019 to 5.04% in 2021.

KBW estimated that auto loan charge-offs at Ally Financial Inc. would increase by 122 basis points from 2019 to 2.51% in 2021. Ally's auto loan borrowers tend to have high credit scores, although the company agreed to buy the nonprime card issuer CardWorks Inc. for about $2.65 billion in February in a transaction that was poorly received by investors because of late-cycle fears.

The analysts estimated that share prices at the time generally incorporated lower loss expectations than KBW anticipated in its baseline. However, under a more optimistic scenario where lender forbearance and federal relief payments to workers and businesses cut projected increases in loss rates by half, KBW calculated that its estimates for 2021 tangible book value at Capital One and Amex would increase by about 20%. Further, trading prices represent significant discounts to the analysts' targets, developed using baseline forecasts for 2021 tangible book value and historical multiples.

A broad-based deterioration in consumer credit quality would hit most of the banking industry, but the relative damage will ultimately be determined by product concentrations and the quality of individual portfolios.

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