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Economic Research: Financial Fragility Indicator Deteriorates Rapidly As Household And Firm Balance Sheet Weakness Approaches Historical Average


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Economic Research: Financial Fragility Indicator Deteriorates Rapidly As Household And Firm Balance Sheet Weakness Approaches Historical Average

This report does not constitute a rating action.

The FFI plummeted in the second quarter and is now on the precipice of the zero line--the historical average. From -0.95 in first-quarter 2022 and its cyclical low of -1.6 in 2021, it was -0.05 in the second quarter, indicating that financial conditions have weakened dramatically, as the private sector has tapped into its savings. Fortunately, the FFI is still in relatively healthy territory, though the speed in which the private sector reached its historic mean is worrisome (see chart 1). And with the Federal Reserve frontloading its aggressive monetary policy into this year and an expected recession next year, conditions are pointing to rising financial fragility in 2023.

Both the household and nonfinancial corporate sectors experienced deteriorating financial conditions. The private sector remains just below the historical average, signaling healthy balance sheets. Our concern is how rapidly balance sheets deteriorated. Household financial conditions worsened by 83% quarter-on-quarter while nonfinancial corporate financial conditions worsened by 103% during the same period. Leverage risks and liquidity risks for both nonfinancial corporates and households continued to worsen, leading to deterioration of net wealth.

Private Sector Financial Conditions Worsen Across Sectors

Chart 1


Nonfinancial Corporates (NFC)

The FFI of U.S. nonfinancial corporates spiked above zero to 0.06 in second-quarter 2022 from -0.92 in the first quarter, breaching the historical average and advancing closer to vulnerability territory. The increase in financial fragility was led by both higher leverage risk and liquidity risk in the second quarter--primarily as short-term debt (that must be refinanced at potentially higher interest rates) increased and market value declined as the stock market turned bearish.

Chart 2


Leverage risk

Leverage indicators in second-quarter 2022 worsened from the first quarter, in terms of their annual growth rates. The exception was interest coverage ratio, which increased to 9.8%, past its then all-time high of 8.8% at the end of March 2022. Net debt to EBIT worsened to 2.49x from 2.31x, pointing to increased leverage, while the debt to asset ratio remained relatively flat at 22.9% from 22.6% the prior quarter.

Liquidity risk

Liquidity conditions for nonfinancial corporates worsened in the second quarter, with the liquid asset to short-term debt ratio dropping to 76.6% from 88.4% in the previous quarter. Short-term debt took a larger share of total debt in the second quarter, rising to 32.5% from 31.6% in the previous quarter.

Other NFC Composite And Indirect Indicators

The return-to-asset ratio inched up further in the second quarter to 3.7% from 3.2%, diluting part of the financial vulnerabilities associated with leverage risk. Its year-over-year growth rate worsened from the previous quarter, raising the FFI as financial vulnerabilities increased. The market-to-book ratio declined further, to 1.31x in the second quarter from 1.58x in the first quarter of 2022 as the stock market turned bearish, further pushing the FFI up as corporate value declined. The dramatic drop this year seems on par with declines seen during the dot-com market crash in 2000. With the stock market plummeting further into bear market territory in the third quarter, we expect the market-to-book ratio will worsen.

Lower growth rates of the return-to-asset and market-to-book ratios indirectly suggest higher financial fragility that may have come from liquidity or solvency, according to their positive correlations with liquidity and solvency indicators.


The FFI of U.S. households shot up to -0.17 from -0.97 in the previous quarter--indicating more financial vulnerability for U.S. households--with leverage, liquidity, and net worth showing signs of deterioration, according to the latest Financial Account release from the Fed. This is the largest quarter-over-quarter jump into worsening territory for the household financial vulnerability indicator since its inception in March 1987. Fortunately, household balance sheet looks robust, with most household financial indicators pointing away from weak vulnerability.

Chart 3


Leverage risk

U.S. households faced higher leverage risks in the beginning of 2022 compared to year-end 2021. Debt to disposable personal income remained flat at 1.02x compared to the first-quarter level, but it increased 5% year over year. Meanwhile, the charge-off rate on consumer loans is trending upward; it was 1.1% in the second quarter after rising for the first time in the first quarter (0.95%) since second-quarter 2020. The loan-to-value ratio also remained relatively stable at 27.3% in the second quarter, having reduced to 27.7% the prior quarter. Finally, the debt-service ratio rose marginally to 9.6% from 9.5% in the first quarter. Growth in consumer loans likely affected debt service by a greater margin than mortgage servicing. Despite the slight worsening in leverage, all leverage indicators stayed at multi-decade lows.

Liquidity risk

Liquidity worsened more as liquid assets to short-term liabilities declined significantly to 9.19x in second-quarter 2022 from 10.37x in the previous quarter. Short-term debt as a percentage of total debt remained stable at 33.1%, nearly unchanged from 33.2% in the previous quarter.

Wealth effects

Net worth to debt declined further in the first half of 2022, to 7.59x at the end of June 2022 from 8.16x at year-end 2021. As stock market entered bear territory, households took a major hit from the slide. Still, the ratio of net worth to debt is very robust, indicating healthy balance sheet conditions despite the moderate deterioration in the first half of 2022.

More On The Indicator

The FFI is a weighted average of indicators that reflect the financial fragility of corporates and households from different perspectives. We use principal component analysis to construct the indicator. The FFI includes not only the individual indicators at present but also their recent history to account for the possibility that financial risk may take time to mature and affect the economy. Zero represents sector financial vulnerability at historical average levels, positive values indicate higher vulnerability compared with history, and negative values indicate lower-than-historical average vulnerability. For more information on how we construct the FFI, see "Economic Research: The Financial Fragility Of U.S. Households And Businesses Hit A Decade Low In The First Quarter," published July 30, 2021.

Chart 4

U.S. Chief Economist:Beth Ann Bovino, U.S. Chief Economist, New York + 1 (212) 438 1652;
Contributor:Joseph Arthur, Iowa City
Research Contributor:Shruti Galwankar, CRISIL Global Analytical Center, an S&P affiliate, Mumbai

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