Board of Governors of the Federal Reserve System

2. Borrowing by Businesses and Households

Vulnerabilities from business and household debt remained moderate

On balance, vulnerabilities arising from borrowing by businesses and households were little changed over the first half of 2022 and remained at moderate levels. The business debt-to-GDP ratio and gross leverage stood at high levels (although significantly lower than the record highs reached at the onset of the pandemic). In contrast, median interest coverage ratios continued to improve, bolstered by strong earnings, and have reached record highs. Taken together, vulnerabilities from business leverage appeared moderate. Indicators of household vulnerabilities, including the household debt-to-GDP ratio and the aggregate household debt service ratio, remained at modest levels, but nominal household debt continued to rise. Going forward, we expect that inflation and rising borrowing costs may pose risks to the ability of some businesses and households to service their debts, especially for those holding adjustable-rate products. An economic downturn or a correction in real estate prices would also put pressure on business and household balance sheets.

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 second quarter of 2022. Total outstanding private credit was split about evenly between businesses and households, with businesses owing $19.5 trillion and households owing $18.5 trillion.

Table 2.1. Outstanding Amounts of Nonfinancial Business and Household Credit

The ratio of business and household debt to gross domestic product was stable and remained at a moderate level

The combined total debt of nonfinancial businesses and households grew roughly in line with nominal GDP in the first half of 2022, leaving the debt-to-GDP ratio essentially flat and close to its pre-pandemic level (figure 2.1). Regarding the individual sectors, the ratio of business debt to GDP edged up and stood at high levels, while the ratio of household debt to GDP inched down and stood at levels similar to those that existed before the buildup preceding the 2007–09 financial crisis (figure 2.2).

Key indicators point to little change in business debt vulnerabilities, which remained moderate relative to historical levels

Overall vulnerabilities from nonfinancial business debt remained moderate in the first half of 2022, as measures of leverage were little changed and solid earnings bolstered interest coverage ratios, while risky debt growth slowed. Nonfinancial business debt adjusted for inflation grew modestly in the same period (figure 2.3). However, net issuance of risky debt was subdued over the same period (figure 2.4). In particular, institutional leveraged loan issuance slowed notably in recent months—falling back to its historical average—as investor demand weakened amid market volatility. In addition, the net issuance of high-yield and unrated bonds remained negative so far this year.

Gross leverage—the ratio of debt to assets—of all publicly traded nonfinancial firms inched down in the first half of 2022, continuing the decline from its historical peak in mid-2020. That said, it remained elevated by historical standards (figure 2.5). Net leverage—the ratio of debt less cash to total assets—was also high relative to its history and edged up among all large businesses as they ran down some of their cash reserves.

The ability of large businesses to service their debt, as measured by the median ratio of earnings to interest expenses (the interest coverage ratio), continued to improve in the first half of 2022, on net, and reached its highest level in the past two decades in the first quarter of the year (figure 2.6). This development was due to solid earnings in the first half of 2022. In addition, the effect of rising interest rates was muted, as corporate bonds—which account for the majority of the debt of public firms—generally have fixed interest rates and longer-term maturities. In particular, only about 5 percent of outstanding bonds rated triple-B and 3 percent of outstanding speculative-grade bonds are due within a year. Nevertheless, further increases in interest expenses, combined with possible declines in profitability stemming from high inflation, supply chain disruptions, or an economic downturn, could curtail the ability of highly indebted firms to service their debt. Meanwhile, the median interest coverage ratio for the subset of all publicly traded non-investment-grade firms edged down in the first half of 2022 but remained at relatively high levels. While these firms represent a large share of the number of publicly traded firms (85 percent), their debt constitutes only 35 percent of the total debt in the sector.

The available data for smaller middle-market firms that are privately held—which have less access to capital markets and primarily borrow from banks, private credit and equity funds, and sophisticated investors—also indicate that leverage continued to decline over the first half of 2022 and was at levels similar to those at publicly traded firms. The interest coverage ratio for the median firm in this category also improved during the same period and is above the level at publicly traded firms. However, an important caveat is that the data on smaller middle-market firms are not as comprehensive as those on large firms.

The credit performance of outstanding corporate bonds remained generally solid since the May report. The volume of downgrades and defaults remained low, but market expectations of defaults over the next year rose somewhat, as investor perceptions of the macroeconomic outlook worsened. More than half of investment-grade debt outstanding continues to be rated in the lowest category of the investment-grade range (triple-B). In an economic downturn, widespread downgrades of bonds to speculative-grade ratings could lead investors to sell the downgraded bonds rapidly, as some are constrained in their ability to hold speculative-grade debt, potentially increasing market illiquidity and downward price pressures.

The credit quality of leveraged loans remained solid through the second quarter, but it has worsened lately. Over the summer, the volume of credit rating downgrades exceeded the volume of upgrades, and default rates inched up, although from historically low levels (figure 2.7). In addition, leveraged loans feature floating interest rates, so rising interest rates, in combination with a potential slowdown in earnings growth posed by the less favorable economic outlook, could put pressure on the credit quality of outstanding debt going forward. Amid low volumes, the distribution of loans by one measure of leverage was little changed, on balance, this year. For instance, the share of newly issued loans to large corporations with debt multiples—defined as the ratio of debt to earnings before interest, taxes, depreciation, and amortization—greater than 5 decreased slightly in the second and third quarters, indicating lower tolerance for additional leverage among investors in this market, although it remained around historical highs (figure 2.8).

Delinquencies at small businesses edged up, but credit quality remained solid

Credit quality for small businesses remained solid even as delinquency rates edged up lately from relatively low levels. Borrowing costs increased in the first half of 2022, but they remained lower than the prevailing pre-pandemic rates. In addition, the share of small businesses that borrow regularly is rising, according to the National Federation of Independent Business Small Business Economic Trends Survey, but it is still low relative to historical levels; the share of firms with unmet financing needs remained quite low.

Vulnerabilities from household debt remained moderate

Despite a sharp decline in equity prices in the first half of 2022, household balance sheets remained strong, with elevated levels of liquid assets and large home equity cushions. In addition, prime-rated consumers continued to account for most of the increases in nominal total household debt. That said, many households started to draw down the buffers of savings that had accumulated during the pandemic. Some households remain financially strained and more vulnerable to future shocks, especially with persistently high inflation and the accompanying declines in real income and increases in borrowing costs.

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

Outstanding household debt adjusted for inflation edged down across the credit score distribution, remaining about flat for prime borrowers and decreasing for near-prime and subprime borrowers (figure 2.9). Nominal household debt, however, continued to grow in the first half of 2022, except for student loan debt. Borrowers with prime credit scores, which accounted for more than half of the total number of borrowers, continued to drive most of the growth. A note of caution, however, is that this trend reflects both increased borrowing by prime-rated borrowers and a significant increase in the share of households rated as prime after the distribution of pandemic-related relief payments.⁵

Credit risk of outstanding household debt remained generally low

The ratio of total required household debt payments to total disposable income (the household debt service ratio) increased somewhat in the first half of 2022, suggesting that some households have become more vulnerable to shocks. However, the ratio remained at modest levels after reaching a historical low in the first quarter of 2021 amid extensive fiscal stimulus, credit card paydowns, and low interest rates. With interest rates rising, the ratio could increase further. Only a small share of household debt has a floating rate, mostly in the form of credit card debt, which should limit the effect of increased interest rates in the near term. For most other types of household debt, rising interest rates increase borrowing cost only for new loan originations.

Mortgage debt accounted for roughly two-thirds of total household debt. New mortgage extensions skewed heavily toward prime borrowers in recent years, with originations of subprime loans adjusted for inflation running at 25 percent of the peak level in 2006 (figure 2.10). The share of mortgage balances in a loss-mitigation program continued to decline and stood at low levels. However, the early payment delinquency rate—the share of balances becoming delinquent within one year of mortgage origination—started to rise. This rise resulted in an uptick in the overall delinquency rate from a historically low level (figure 2.11). Amid continued house price growth, just 1.9 percent of mortgage borrowers had negative equity in the second quarter of 2022 (figure 2.12). However, mortgages recently originated with low down payments are subject to entering negative equity quickly if house prices decline significantly. About half of recently originated purchase mortgages have loan-to-value ratios above 90 percent, a share that has been about unchanged for the past decade. In addition, these highly leveraged mortgage originations tend to be associated with somewhat lower average borrower credit scores. Other measures of riskiness remained modest. Estimates of housing leverage when measuring home values as a function of rents and other market fundamentals increased in the first half of 2022, yet they remained significantly lower than their peak levels before 2008 (figure 2.13, black line). In addition, interest rate risk for mortgage borrowers is currently limited. The share of adjustable-rate mortgages in new home purchases rose to 10 percent in recent months but has been at or below that fraction since 2009. Moreover, available data suggest that the nonqualified mortgage share of purchase originations edged up, albeit from extremely low levels.⁶

The remaining one-third of household debt was consumer credit, which consisted primarily of student loans, auto loans, and credit card debt (as shown in table 2.1). Inflation-adjusted consumer credit edged down with respect to the same time last year, as the increase in credit card debt was more than compensated for by the declines in student loan debt and auto debt (figure 2.14). The contraction in real auto loan balances was driven by declines among near-prime and prime borrowers, while balances for subprime borrowers remained about unchanged on net (figure 2.15). The share of auto loan balances in loss mitigation continued to decline and stood at a low level, but those in delinquent status have increased significantly in the past several quarters. Still, those increases were to levels similar to the modest rates observed during most of the previous decade (figure 2.16).

Aggregate real credit card balances increased across the credit score distribution from a year earlier, driven by double-digit nominal credit card debt growth (figure 2.17). This rapid increase was driven not only by a higher level of credit card spending among consumers who pay their balances in full each month, but also by an increase in revolving balances, especially during the first half of the year. Revolving balances remained about 10 percent below pre-pandemic levels. With the rise in balances, delinquency rates started to increase from a year earlier, especially among subprime borrowers, although from historically low levels (figure 2.18).⁷

After rising rapidly for over a decade, nominal student loan debt edged down in the first half of 2022 and declined significantly in inflation-adjusted terms over the same period. The decline was driven by a combination of factors, including lower loan originations; a pause on interest accumulation for most student loans; repayment; and loan discharges due to disability, school closure or misconduct, and other factors.

 

References

 

 5. Analysis suggests that the marked decline in the share of subprime-rated borrowers during the pandemic was in part driven by the Coronavirus Aid, Relief, and Economic Security Act forbearance provisions and thus might not reflect an improvement in the overall credit quality of households. Other contributing factors to this acceleration included income support programs. See Sarena Goodman, Geng Li, Alvaro Mezza, and Lucas Nathe (2021), "Developments in the Credit Score Distribution over 2020," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, April 30), https://www.federalreserve.gov/econres/notes/feds-notes/developments-in-the-credit-score-distribution-over-2020-20210430.html. Return to text

 6. Nonqualified mortgages are mortgages that do not satisfy the Ability-to-Repay/Qualified Mortgage Rule, which requires a creditor to make a reasonable, good faith determination of a consumer's ability to repay a residential mortgage according to its terms. For more details, see Consumer Financial Protection Bureau (2022), "What Is a Qualified Mortgage?" webpage, https://www.consumerfinance.gov/ask-cfpb/what-is-a-qualified-mortgage-en-1789. Return to text

 7. Securitized credit card outstanding balances amounted to $50 billion in the second quarter of 2022, compared with $330 billion reached during the 2007–09 financial crisis, which likely limits the effects of consumer credit delinquencies on financial stability. In addition, delinquency rates in securitized credit card pools remained lower than in the aggregate. For auto loans, securitized outstanding balances stood around $250 billion in the second quarter of 2022, above the $200 billion peak reached right before the 2007–09 financial crisis. That said, the current amount represents less than 20 percent of total outstanding balances, whereas it represented 25 percent before the 2007–09 financial crisis. Additionally, only $70 billion are classified as subprime auto asset-backed securities. Return to text