Board of Governors of the Federal Reserve System

2. Borrowing by Businesses and Households

Vulnerabilities from business and household debt are moderate

Key indicators of vulnerabilities arising from business debt, including debt-to-GDP ratio and gross leverage, largely returned to near or below pre-pandemic levels, and median interest coverage ratios improved, reaching their highest level over the past two decades in the second half of 2021. Indicators of household vulnerabilities—including the household-credit-to-GDP ratio as well as mortgage, auto, and credit card delinquencies—were in the bottom range of the levels observed over the past 20 years. Nonetheless, rising inflation, increasing borrowing costs, and ongoing geopolitical tensions pose risks to the economic outlook, particularly for businesses that were most affected by the pandemic and for households that face the expiration of federal support programs. These segments of businesses and households might be more vulnerable to adverse shocks.

Table 2.1 shows the amounts outstanding and recent historical growth rates of forms of debt owed by nonfinancial businesses and households as of the fourth quarter of 2021. Total outstanding private credit was split about evenly between businesses and households, with businesses owing $18.5 trillion and households owing $17.9 trillion.

Table 2.1. Outstanding amounts of nonfinancial business and household credit

The ratio of business and household debt to gross domestic product continued to decline

Although the combined total debt of nonfinancial businesses and households grew throughout 2021, the debt-to-GDP ratio further declined from its pandemic highs because of the rapid pace of nominal GDP growth (figure 2.1). Regarding the individual sectors, the ratios of both business and household debt-to-GDP decreased in the second half of 2021 (figure 2.2).

Key indicators point to a reduction in business debt vulnerabilities, but balance sheet leverage remains high in some sectors

Overall, business debt vulnerabilities continued to decrease, even as business debt adjusted for inflation grew modestly in the second half of 2021, driven by robust commercial and industrial (C&I) loan origination volumes (figure 2.3). A number of factors were moderating vulnerabilities in the business sector during this period. Firms continued to maintain large cash buffers, as strong earnings offset a faster pace of share repurchases and increased capital outlays. Moreover, low interest rates continued to mitigate investor concerns about default risk arising from high leverage. The net issuance of high-yield bonds declined, while the net issuance of institutional leveraged loans remained strong as investors continued to demand floating-rate products amid expectations of rate increases. On net, issuance of total risky business debt—high-yield bonds and institutional leveraged loans—declined since the November report (figure 2.4).

Gross leverage of large businesses—the ratio of debt to assets for all publicly traded nonfinancial firms—declined to somewhat below pre-pandemic levels in the second half of 2021 (figure 2.5). This measure, however, remained at record-high levels for large firms in industries most affected by the pandemic, such as airlines, hospitality and leisure, and restaurants. The share of total nonfinancial public firm debt owed by these industries stood at 5.6 percent. Over the same period, net leverage—the ratio of debt less cash to total assets—held stable at below pre-pandemic levels among all large businesses, supported by ample cash holdings, but remained high relative to its history. Similarly, although net leverage in hard-hit industries edged up in the second half of 2021, it continued to remain below pre-pandemic levels.

As earnings among large firms continued to increase and interest rates remained low, the ratio of earnings to interest expenses (the interest coverage ratio) continued to rise during the second half of 2021, indicating that large firms were better able to service debt. The median interest coverage ratio reached its highest level in the past two decades (figure 2.6). Nevertheless, the effect of high inflation, rising interest rates, supply chain disruptions, and the ongoing geopolitical conflict on corporate profitability is uncertain. A significant decline in corporate profitability or an unexpectedly large increase in interest rates could curtail the ability of some firms to service their debt. In addition, the upward pressure on oil prices, if sustained, could curb the recovery in hard-hit industries such as airlines. (See the box "Commodity Market Stresses following Russia's Invasion of Ukraine.")

An important caveat to the noted improvements in leverage and interest coverage ratios is that comprehensive data are only available for publicly traded firms.⁹ These firms tend to be large and have better access to capital markets, which allowed them to more easily weather disruptions, such as those associated with the pandemic. By contrast, smaller firms that are privately held tend to have higher leverage than public firms and to primarily borrow from banks, private credit and equity funds, and sophisticated investors.

Since the November report, the credit quality of outstanding corporate bonds remained largely unchanged at a strong level, in part because of high corporate profitability. The volume of credit rating upgrades continued to outpace that of downgrades. The fraction of nonfinancial corporate bonds with speculative-grade ratings—the higher-risk segment of the market—was little changed in the last quarter of 2021. Expected one-year-ahead bond defaults remained low, well below their long-run medians.

After falling sharply in 2021, default rates on leveraged loans stabilized below pre-pandemic levels as of March 2022, even as underwriting standards for newly issued loans weakened (figure 2.7). For instance, 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—exceeded historical highs (figure 2.8).

Many small businesses could be adversely affected by rising costs

Credit quality for small businesses continued to improve, with short- and long-term delinquencies declining below their pre-pandemic levels. Moreover, data from the April 2022 Census Bureau Small Business Pulse Survey showed that the share of small businesses with at least three months of cash on hand, relative to expenses, remains near its pandemic-era high. However, increasing labor costs and prices for other inputs may reduce small firms' earnings and their ability to service their loans.

Vulnerabilities from household debt remained moderate

The financial position of many households continued to improve since the previous Financial Stability Report, supported in part by a strong labor market, high personal savings, remaining pandemic relief programs, and rising house prices. Still, some households remained financially strained and more vulnerable to future shocks, especially with the expiration of loan forbearance and persistently high inflation.

Borrowing by households continued to rise in line with income and is concentrated among borrowers with low credit risk

Borrowers with prime credit scores (more than half of the total number of borrowers) accounted for all the increase in total household debt in real terms, including gains in mortgage and credit card debt. By contrast, loan balances for borrowers with near-prime and subprime scores stayed roughly stable (figure 2.9). However, subprime debt balances may increase with the expiration of loan forbearance programs.¹⁰

Credit risk of outstanding household debt remained generally low

Mortgage debt accounted 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 helped significantly reduce the effect of the pandemic on mortgage delinquencies (figure 2.11). The share of mortgages that were either delinquent or in a loss-mitigation program, including forbearance, fell to slightly above 4 percent in December 2021, below pre-pandemic levels. Forbearance for mortgages continued to wind down, but about 800,000 borrowers, representing about 1.5 percent of all mortgaged properties, were still in forbearance plans as of January 2022. The recent robust house price increases put many borrowers in a solid equity position (figure 2.12). Unlike in the years before the Great Recession, borrower leverage did not increase relative to home values, even when measuring home values as a function of rents and other market fundamentals (figure 2.13).

Most of the remaining one-third of household debt was consumer credit, which consisted primarily of student loans, auto loans, and credit card debt (table 2.1). Inflation-adjusted consumer credit edged down in 2021, as student debt declined, auto debt was flat, and credit card debt increased slightly in real terms (figure 2.14). Auto loan balances expanded moderately, on net, among borrowers with near-prime credit scores and contracted slightly among prime borrowers (figure 2.15). The share of auto loans that were either delinquent or in loss mitigation remained around 3.5 percent in December 2021, with outright delinquency rates rising above 2 percent but remaining low by historical standards (figure 2.16).

Aggregate real student loan balances continued to decline in the second half of 2021 (figure 2.14). The risk that student loan debt poses to the financial system appears limited because most of the loans were issued through government programs and are owed by households in the top 40 percent of the income distribution. However, some borrowers may be adversely affected by the scheduled expiration of forbearance relief programs in August 2022.

In the last quarter of 2021, consumer credit card balances increased slightly from the low levels reached following the pandemic (figure 2.17). Delinquency rates were roughly flat for borrowers with prime scores and ticked up slightly for near-prime and subprime borrowers in the fourth quarter of 2021 (figure 2.18). Although credit card delinquencies for subprime and near-prime borrowers remained far below pre-pandemic levels, they may be adversely affected by increasing interest rates.

 

References

 

 9. It is important to note, however, that the credit aggregates shown in figures 2.1, 2.2, and 2.3 include debt of both public and private firms. Return to text

10. Households may have been able to use the liquidity afforded by the forbearance programs to avoid borrowing more. Once that flexibility expires, these households may borrow more to finance their consumption. Return to text