Board of Governors of the Federal Reserve System

2. Borrowing by Businesses and Households

Vulnerabilities from business and household debt have continued to fall, reflecting ample government support and strong business earnings

Key measures of vulnerabilities arising from business debt including debt-to-GDP, gross leverage, and interest coverage ratios have largely returned to pre-pandemic levels. After jumping in mid-2020, business debt has since decreased on net. This decrease, combined with the continued recovery of earnings, the low level of interest rates, support from the Paycheck Protection Program (PPP), and fiscal stimulus, has helped restore the balance sheets of businesses. Nonetheless, risks to the economic outlook remain, particularly for industries most affected by the pandemic and for small businesses. Key measures of household vulnerability have also largely returned to pre-pandemic levels. A combination of extensions in borrower relief programs, fiscal stimulus, and high personal savings rates have helped the recovery of household balance sheets. However, uncertainty over the course of the pandemic and the expiration of relief programs may pose significant risks to household balance sheets.

Table 2 shows the amounts outstanding and recent historical growth rates of forms of debt owed by nonfinancial businesses and households as of the second quarter of 2021. Total outstanding private credit was split about evenly between businesses and households, with businesses owing $18 trillion and households owing $17.3 trillion.

Table 2. Outstanding Amounts of Nonfinancial Business and Household Credit

The ratio of business and household debt to gross domestic product fell significantly during the first half of 2021, returning closer to historical trends

Before the onset of the pandemic, the combined total debt of nonfinancial businesses and households grew roughly in line with nominal GDP, leaving the debt-to-GDP ratio essentially flat. In the first half of 2020, strong business borrowing and a precipitous drop in GDP pushed the debt-to-GDP ratio to historical highs. After that surge, the ratio declined in the second half of 2020—a decline that has continued in the first half of this year (figure 2-1).

The ratio of business debt to GDP decreased in the first half of 2021 as GDP growth outpaced the growth of business debt (figure 2-2). Business debt grew modestly as outstanding bank loans declined. In addition, the level of business debt adjusted for inflation fell in the second quarter of this year (figure 2-3). The decline in the ratio of business debt to GDP was accompanied by reduced outlays, a strong recovery in profits, and a slower pace of share repurchases that contributed to an increase in the cash buffers of firms. Moreover, low interest rates continued to mitigate investor concerns about default risk arising from high leverage. Meanwhile, the net issuance of risky business debt—high-yield bonds and institutional leveraged loans—surged in the second and third quarters of this year (figure 2-4).

Key indicators point to a reduction in vulnerabilities from business debt

Gross leverage of large businesses—the ratio of debt to assets for all publicly traded nonfinancial firms—declined to pre-pandemic levels in the first half of 2021 (figure 2-5). For large firms in industries most affected by the pandemic, such as airlines, hospitality and leisure, and restaurants, gross leverage is still high, but net leverage—the ratio of debt less cash to total assets—has dropped to levels last seen in 2018, driven by large cash buffers.

As earnings among large firms continued to recover and interest rates remained low, the ratio of earnings to interest expenses (the interest coverage ratio) moved up over the first half of this year, suggesting large firms were better able to service debt. The median interest coverage ratio among these firms rose to levels last seen in 2018 (figure 2-6). The share of firms with a negative ratio, which could stem from negative earnings, declined significantly. Coverage ratios for firms in the lowest quartile of interest coverage were below pre-pandemic levels in the second quarter of 2021. These firms were typically in the industries most affected by the pandemic.

An important caveat to these improvements in leverage and interest coverage ratios is that comprehensive data are only available for publicly traded firms.⁷ These firms tend to be large and have better access to capital markets, allowing them to more easily weather the disruptions associated with the pandemic. By contrast, smaller middle-market firms that are privately held tend to have higher leverage than public firms and primarily borrow from banks, private credit and equity funds, and sophisticated investors. Privately held firms, however, likely are also finding it easier to borrow because the commercial lending standards of banks have largely returned to pre-pandemic levels and because of recent regulatory changes for privately held firms.⁸

Credit quality, which deteriorated after the onset of the pandemic, has continued to improve in the first half of 2021. The rate of corporate bond downgrades remained low in the first half of this year. The fraction of nonfinancial corporate bonds that are high yield—the higher-risk segment of the market—is little changed since the May report. Expected one-year-ahead bond defaults have continued to decline and are now well below their long-run medians. Moreover, risky firms will need to roll over only about 3 percent of outstanding speculative-grade bonds within one year, as firms have continued to refinance existing debt with longer-maturity bonds at low interest rates.

Default rates on leveraged loans have fallen, even as underwriting standards have weakened. The default rate on leveraged loans increased rapidly early in the pandemic but has declined to below pre-pandemic levels in the first half of this year (figure 2-7). Additionally, the average credit quality of outstanding leveraged loans has continued to improve over the same period.⁹ However, the share of newly issued loans to large corporations with high leverage—defined as those with ratios of debt to earnings before interest, taxes, depreciation, and amortization greater than 6—has exceeded the historical highs reached in recent years (figure 2-8).

Vulnerabilities from debt owed by small businesses have improved, but many small businesses could be affected by a worsening of the pandemic

While many small businesses closed or significantly scaled back their operations as a result of the pandemic, credit quality for small businesses that have continued operating or reopened has stabilized further in the first half of this year. Loan delinquencies have declined significantly in the first half of the year. Loans extended under the PPP provided financial support to many small businesses. However, even though the outlook for small businesses has steadily improved in the first half of the year, the Census Bureau's Overall Sentiment Index for small businesses indicates that, more recently, the improvements have stopped, likely reflecting the rise of the Delta variant.

Although conditions for many households have improved, the expiration of assistance programs may cause additional financial stress for some households

The financial position of many households has continued to improve since the previous Financial Stability Report, supported by pandemic stimulus programs, a recovering economy, and rising house prices. Still, some households remain financially strained and more vulnerable to future shocks. These vulnerabilities may be increased by the expiration of expanded unemployment programs, loan forbearance, and eviction moratoria as well as by a potential worsening of the public health situation, especially for low-income households.

Borrowing by households picked up in the second quarter

Household debt growth picked up in the second quarter of this year. Debt owed by the roughly one-half of households with prime credit scores continued to account for all the growth, driven by increases in mortgage, credit card, and automobile debt. However, accounting for inflation, household debt only edged up slightly and the ratio of household debt to GDP declined. The increase in mortgage and automobile debt reflects a surge in demand for housing and automobiles as well as substantial price growth in those categories. Furthermore, the growth in credit card balances may reflect a return to pre-pandemic spending patterns. By contrast, loan balances for borrowers with near-prime and subprime credit scores declined in real terms (figure 2-9). This decrease may be attributable to relatively tight lending standards for such borrowers and to a decline in the share of borrowers with low credit scores. Subprime debt balances may increase with the expiration of expanded unemployment programs, loan forbearance, and eviction moratoria or with a potential worsening of the public health situation.

The share of mortgages either delinquent or in loss mitigation has fallen well below pre-pandemic levels

Mortgage debt accounts for roughly two-thirds of total household debt, with new mortgage extensions skewed toward prime borrowers in recent years (figure 2-10). Mortgage forbearance programs have helped significantly reduce the effect of the pandemic on mortgage delinquencies (figure 2-11). The share of mortgages that are either delinquent or in a loss mitigation program, including forbearance, was slightly above 4 percent in August 2021, down from its peak of 8.9 percent in May 2020.

Borrowers still in forbearance may be vulnerable to the increased payments associated with the end of forbearance programs. Borrowers who received forbearance were more likely to have been delinquent before the pandemic, have low incomes, and have subprime credit scores.¹⁰ Those borrowers that have remained in forbearance are even more likely to have subprime credit scores.¹¹ Survey evidence also suggests that these borrowers are more likely to be employed in industries hard hit by the pandemic, to have suffered income losses in the past year, and to be delinquent or in forbearance on other forms of debt.¹²

Borrowers exiting forbearance are expected to resume making payments, and servicers are expected to work with these borrowers to modify their mortgages to achieve manageable payment plans. Should borrowers be unable to resume making payments even under a modified payment plan, a home sale could be a viable option, especially because the recent robust house price increases have put many borrowers in a strong equity position (figures 2-12 and 2-13).¹³ Estimates suggest that, as one would expect in a time of rapidly rising house prices, only a small fraction of borrowers currently in forbearance have equity cushions of less than 10 percent.¹⁴ The implications of such sales for aggregate house prices would likely be minor. As of September 21, there were about 1.5 million residential properties in forbearance; should those properties all be put on the market simultaneously—an unlikely event—they would add roughly two to three months of housing supply. Even so, with housing demand currently strong, such an increase in supply would likely not be enough to cause a drop in aggregate house prices.

Consumer delinquencies declined further as conditions for households continued to improve and forbearance on student loans was extended again through the end of January 2022

Most of the remaining one-third of household debt is consumer credit, which consists primarily of student loans, auto loans, and credit card debt (table 2). Inflation-adjusted consumer credit edged down in 2021, as student and auto debt were flat and credit card debt declined in real terms (figure 2-14). Auto loan balances expanded moderately, on net, in 2021, driven primarily by borrowers with prime and near-prime credit scores (figure 2-15).

The share of auto loans that were either delinquent or in loss mitigation declined further to about 3 percent by August of this year, with outright delinquency rates reaching 2 percent (figure 2-16). However, delinquencies in auto loans have increased significantly in the subprime category and may accelerate with the expiration of stimulus programs—state and federal expanded unemployment programs and eviction moratoria—or if economic growth stalls as a result of the pandemic. High automobile prices due to pandemic-related shortages may mitigate potential adverse effects of such delinquencies on financial institutions.

The risk that student loan debt poses to the financial system appears limited at this time. Most of the loans were issued through government programs and are owed by households in the top 40 percent of the income distribution. Moreover, protections originally in the Coronavirus Aid, Relief, and Economic Security Act—later extended by the Department of Education—currently guarantee payment forbearance and stop interest accrual through January 2022 for most federal student loans.

Consumer credit card balances have contracted, on net, since the onset of the pandemic (figure 2-17). Delinquency rates were roughly flat for borrowers with prime credit scores, decreased moderately for near-prime borrowers, and dropped steeply for subprime borrowers in the first half of this year (figure 2-18). Delinquency rates may increase going forward as spending levels pick up or if the economic growth stalls as a result of the pandemic. Additionally, credit card delinquencies for subprime and near-prime borrowers may be adversely affected by the expiration of stimulus programs.

 

References

 

 7. It is important to note, however, that the credit aggregates shown in figures 2-1, 2-2, and 2-3 include debt from both public and private firms. Return to text

 8. See Securities and Exchange Commission (2020), "SEC Harmonizes and Improves ‘Patchwork' Exempt Offering Framework," press release, November2, https://www.sec.gov/news/press-release/2020-273. Return to text

 9. According to S&P Leveraged Commentary and Data, the share of outstanding leveraged loans rated B or worse has decreased significantly through October of this year. Return to text

 10. See Andrew Haughwout, Donghoon Lee, Joelle Scally, and Wilbert van der Klaauw (2021), "Keeping Borrowers Current in a Pandemic," Federal Reserve Bank of New York, Liberty Street Economics (blog), May 19, https://libertystreeteconomics.newyorkfed.org/2021/05/keeping-borrowers-current-in-a-pandemic. Return to text

 11. See Andrew Haughwout, Donghoon Lee, Joelle Scally, and Wilbert van der Klaauw (2021), "Forbearance Participation Declines as Programs' End Nears," Federal Reserve Bank of New York, Liberty Street Economics (blog), August 3, https://libertystreeteconomics.newyorkfed.org/2021/08/forbearance-participation-declines-as-programs-end-nears. Return to text

 12. See Lauren Lambie-Hanson, James Vickery, and Tom Akana (2021), "Recent Data on Mortgage Forbearance: Borrower Uptake and Understanding of Lender Accommodations," brief (Philadelphia: Federal Reserve Bank of Philadelphia, March 4), https://www.philadelphiafed.org/consumer-finance/mortgage-markets/recent-data-on-mortgage-forbearance-borrower-uptake-and-understanding-of-lender-accommodations. Return to text

 13. The significant growth in house prices over the past year, noted earlier in this report, has contributed to the very low estimated share of outstanding mortgages with negative equity (figure 2-12). Consistent with higher house prices, the ratio of outstanding mortgage debt to home values continued to fall in the first half of this year and remains at a modest level (figure 2-13). Return to text

 14. See Black Knight (2021), "Tappable Equity Rises $1 Trillion in Q2 2021 Alone to Hit All-Time High of $9.1 Trillion; Quarter Also Sees Largest Volume of Cash-Out Refis in 15 Years," press release, September 8, https://www.blackknightinc.com/black-knights-july-2021-mortgage-monitor. Return to text