Board of Governors of the Federal Reserve System

2. Borrowing by businesses and households

While household borrowing is at a low-to-moderate level relative to incomes, business-sector debt relative to GDP is historically high and there are signs of deteriorating credit standards

Overall, vulnerabilities arising from total private-sector credit appear moderate. Among businesses, debt levels are high, and there are signs of deteriorating credit standards. In addition, recently, debt has been growing fastest at firms with weaker earnings and higher leverage. By contrast, household borrowing has advanced more slowly than economic activity and is largely concentrated among low-credit-risk borrowers.

Table 2 shows the current volume and recent and historical growth rates of forms of debt owed by businesses and households. Over the year ending in the second quarter of 2018, business credit grew 4.5 percent, and household credit grew 3.5 percent.

Table 2: Outstanding Amounts of Business and Household Credit

Total private credit has advanced roughly in line with economic activity...

Borrowing by businesses and households in excess of their ability to pay back that debt has often led to strains on borrowers and the financial system. However, over the past several years, total debt owed by businesses and households expanded at a pace similar to that of nominal GDP. As a result, the ratio of such debt to GDP has been broadly stable at levels similar to those in mid-2005, before the period of most rapid credit growth from 2006 to 2007 (figure 2-1).⁵

Figure 2-2 shows the credit-to-GDP ratio disaggregated across two broad categories of borrowers: households and businesses. (Note that these businesses are nonfinancial; leverage of financial firms is discussed in the next section.) Before the crisis, household debt relative to GDP rose steadily to levels far above historical trends. After the crisis, household debt contracted sharply and has grown only moderately since then. Business borrowing tends to track the economic cycle more closely. After the crisis, business debt also contracted but has expanded significantly over the past several years.

. . . but debt owed by businesses is historically high, and risky debt issuance has picked up recently

After growing faster than GDP through most of the current expansion, total business-sector debt relative to GDP stands at a historically high level. However, growth of this debt slowed markedly in the first half of 2018 (figure 2-3).⁶

Growth in riskier forms of business debt--high-yield bonds and leveraged loans--which had slowed to zero in late 2016, rebounded in recent quarters (figure 2-4). The rebound reflected a decline in high-yield bonds outstanding more than offset by a notable pickup in growth of nonfinancial leveraged loans outstanding. On net, total risky debt rose about 5 percent over the year ending in the third quarter of 2018 and now represents over $2 trillion in debt outstanding.

Moreover, credit standards for some business loans appear to have deteriorated further...

Credit standards for new leveraged loans appear to have deteriorated over the past six months. The share of newly issued large loans to corporations with high leverage--defined as those with ratios of debt to EBITDA (earnings before interest, taxes, depreciation, and amortization) above 6--has increased in recent quarters and now exceeds previous peak levels observed in 2007 and 2014 when underwriting quality was notably poor (figure 2-5). Moreover, there has been a recent rise in "EBITDA add backs," which add back nonrecurring expenses and future cost savings to historical earnings and could inflate the projected capacity of the borrowers to repay their loans. However, in part reflecting the strong economy, the credit performance of leveraged loans has so far been solid, with the default rate on leveraged loans at the low end of its historical range (figure 2-6).

The credit quality of nonfinancial high-yield corporate bonds has been roughly stable over the past several years, with the share of high-yield bonds outstanding that are rated "deep junk" (B3/B- or below) staying flat at about one-third from 2015 to early 2018, below the financial crisis peak of 45 percent in 2009. In contrast, the distribution of ratings among investment-grade corporate bonds has deteriorated. The share of bonds rated at the lowest investment-grade level (for example, an S&P rating of triple-B) has reached near-record levels. As of the second quarter of 2018, around 35 percent of corporate bonds outstanding were at the lowest end of the investment-grade segment, amounting to about $2-1/4 trillion. In an economic downturn, widespread downgrades of these bonds to speculative-grade ratings could induce some investors to sell them rapidly, because, for example, they face restrictions on holding bonds with ratings below investment grade. Such sales could increase the liquidity and price pressures in this segment of the corporate bond market.

. . . and leverage of some firms is near its highest level seen over the past two decades

A broad indicator of the leverage of businesses, the ratio of debt to assets for all publicly traded nonfinancial firms, including speculative-grade and unrated firms, has been roughly flat since 2016 but remains near its highest level in 20 years (figure 2-7). An analysis of detailed balance sheet information of these firms indicates that, over the past year, firms with high leverage, high interest expense ratios, and low earnings and cash holdings have been increasing their debt loads the most. This development is in contrast to previous years when primarily high-earning firms with relatively low leverage were taking on the most additional debt. High leverage has historically been linked to elevated financial distress and retrenchment by businesses in economic downturns. Given the valuation pressures associated with business debt noted in the previous section, such an increase in financial distress, should it transpire, could trigger a broad adjustment in prices of business debt. That said, with interest rates low by historical standards, debt service costs are at the lower ends of their historical ranges, particularly for risky firms, and corporate credit performance remains generally favorable (figure 2-8).

Borrowing by households, however, has risen in line with incomes and is concentrated among low-credit-risk borrowers

Expansion of household debt has been in line with income gains, and, for the past several years, all of the net increase in total household debt has been among borrowers with prime credit scores and very low historical delinquency rates. Loan balances for borrowers with a prime credit score, who account for about one-half of all borrowers and about two-thirds of all balances, continued to grow in the first half of 2018, reaching their pre-crisis levels (after an adjustment for general price inflation). In contrast, loan balances for the remaining one-half of borrowers with near-prime and subprime credit scores were essentially unchanged from 2014 to the middle of 2018 (figure 2-9). These trends are particularly evident in new mortgage extensions and underscore the marked shift toward less-risky lending and borrowing that is broadly consistent with stronger underwriting standards (figure 2-10).

Credit risk of outstanding mortgage debt appears to be generally solid...

Mortgages represent two-thirds of overall household debt outstanding. An early indicator of payment difficulties in this segment is the rate at which existing mortgages transition into delinquency. This transition rate has been very low for several years among borrowers with prime and nonprime credit scores and for loans in programs offered by the Federal Housing Administration and U.S. Department of Veterans Affairs (figure 2-11). Similarly, delinquency rates for newly originated mortgages, which give us a sense of recent underwriting standards, have also been low. In addition, the ratio of outstanding mortgage debt to home values is at the moderate level seen in the relatively calm housing markets of the late 1990s, suggesting that home mortgages are backed by sufficient collateral (figure 2-12).⁷ Similarly, the share of outstanding mortgages with negative equity--mortgages where the amount owed on a property exceeds the value of the underlying home--has continued to trend down (figure 2-13).

. . . although some households are struggling with their debt

Student loans, auto loans, and credit card loans represent the majority of the remaining overall household debt outstanding (figure 2-14). Student loans are the largest of these, with aggregate balances of about $1.5 trillion at the end of the second quarter of 2018. Over 90 percent of these loans are guaranteed by the U.S. Department of Education and were extended through programs that did not involve traditional loan underwriting. Through the first half of 2018, student loan delinquency rates continued to improve gradually but remain elevated by longer-run standards. Growth in auto loans to borrowers with subprime and near-prime credit scores and growth in credit card debt owed by borrowers with nonprime credit scores seem to have peaked after having been relatively strong for several years (figure 2-15). Responses to the SLOOS suggest that the leveling off in nonprime credit card borrowing may reflect some tightening of lending standards. Similarly, payment delinquency rates for subprime credit cards and auto loans, which were on the rise for the past few years, also seem to be stabilizing, although, in the latter case, they remain relatively high (figure 2-16). In addition, early payment delinquencies (delinquencies occurring on relatively new credit accounts) remain high for credit cards and have continued to rise for auto loans in the first half of 2018, suggesting that underwriting standards might continue to be looser than usual in these two segments and underscoring the need for ongoing monitoring of associated vulnerabilities.

 

References

 

 5. An often-used alternative measure to assess whether credit is currently high or low by historical standards is the credit-to-GDP gap--that is, where the ratio of the level of total debt to GDP is relative to its longer-run statistical trend. Currently, the ratio of total debt to GDP is noticeably below an estimate of its trend, implying a sizable negative gap. However, such comparisons need to be treated with caution because interpreting long-run trends involves a fair amount of judgment. In fact, alternative indicators for current credit conditions, such as the three-year cumulative credit growth rate of the credit-to-GDP ratio, point to a credit level more in line with current economic activity rather than one lagging behind. Return to text

 6. While figure 2-3 is about total business debt, most of the business credit discussion that follows is focused on publicly traded corporations because more information is available regarding their balance sheets. The debt owed by other types of businesses is predominantly in the form of bank loans rather than market-based sources of credit. Return to text

 7. Home values, in this context, are computed both using current market values and using the level of house prices predicted by a staff model based on rents, interest rates, and a time trend shown in figure 1-19. To the extent that aggressive mortgage lending is associated with rapid increases in home prices (as in the early-to-middle 2000s), it is preferable, when assessing systemic vulnerabilities, to relate mortgage debt to home values that are closer to what would be implied by economic fundamentals instead of market values. Return to text