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Banking on households

| February 22, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Since the first sparks leading to the 2008 financial crisis started on household balance sheets, much of the effort to prevent a repeat has also focused on households. The effort has paid off. By some measures, consumers are better equipped to pay their debts than any time since 1980. And a new Fed paper suggests that households would fare much better than they did the last time if another sharp downturn came around again.  Taking credit risk on households continues to look better than the alternatives.

A stronger household balance sheet

A combination of household deleveraging, low interest rates and a tightening labor market have helped drive household debt service payments as a share of disposable personal income down to 9.82%, the lowest level since at least 1980 (Exhibit 1). The deleveraging wasn’t necessarily pretty. Some of it came from mortgage default, some from much tighter lending standards and some from lower consumer demand for debt. Outstanding single-family residential mortgage debt, the biggest liability on the average household balance sheet, dropped by $1.4 trillion between early 2008 and early 2014. And new federal rules requiring lenders to document borrowers’ ability to repay, which went into effect in 2014, has limited the rebound. Low interest rates have allowed a healthy majority of outstanding mortgage borrowers to refinance or take on debt at low rates. And a labor market that has taken unemployment from a crisis peak of 10% to 4% most recently, helping push real median household income toward record levels.

Exhibit 1: Debt service has dropped to a 38-year low as a share of income

Source: Federal Reserve

The average household asset base has also rebounded from crisis. Homeowners’ equity in real estate, the average household’s largest asset, is up 14.5% from its pre-crisis peak in early 2006. And a 12.8% average annual return on the S&P 500 since the start of 2010 has helped lift pensions, retirement accounts and other investment portfolios.

Exhibit 2: Homeowners’ equity is up 14.5% from its pre-crisis peak

Source: Federal Reserve

Stress testing household balance sheets

A recent study by analysts at the Fed entitled Stress Testing Household Debt applied home price and unemployment shocks from the Comprehensive Capital Analysis Review, or CCAR, to households and found more resiliency than pre-2008. The 2018 CCAR shocks applied to households at the county level showed lower levels of delinquency on debt than observed if the same shocks had occurred to households pre-crisis. A decline in household leverage and a shift in debt towards households with higher credit scores lay behind the better results. A major drop in home prices and a rise in unemployment would still push up delinquency and default, but less than observed after 2008.

Better than alternatives

Household balance sheets look strong not only compared to pre-crisis versions but also compared to the average corporate balance sheet. Corporate leverage has gone up at the same time that household leverage has generally gone down (see, for example, Rising risks from BBBs). Terms on corporate lending have also loosened, with plenty of concern about the risks if companies come under stress (see a recent S&P discussion of leveraged lending here). That’s left corporate credit much more vulnerable to any slowdown in the economy.

Although any drag on growth would affect both household and corporate credit, households seem better prepared to weather the impact. Mortgage credit, multi-family credit, asset-backed credit and other exposures to households broadly look like the better risk-return.

* * *

The view in rates

Very little changes on the rates front week-to-week almost by design. Rates look likely to drift in a narrow band for the foreseeable future. US growth looks likely to slow in 2019, and growth in Europe also looks challenged. With 10-year rates in Germany at 0.09, in Switzerland at -0.35 and Japan at -0.05, the US looks like a relative buy. Foreign flows could pull US rates below neutral.

The view in spreads

With the yield curve flat, rates steady, and those conditions likely to persist, carry matters more to fixed income returns. A stable Fed should keep encouraging carry trades and that should help performance of both corporate debt and MBS. MBS could widen a little this year if new bank liquidity rules reduce bank demand for MBS. Healthy MBS net supply could also weigh on spreads. But low volatility argues for MBS. MBS should still outperform corporate credit. Portfolios buying corporate debt should focus on names that show organic growth or use free cash flow or asset sales to pay down debt.

The view in credit fundamentals

Household balance sheets look strong, and corporate balance sheets look vulnerable. The ratio of household debt service to disposable income is at a record low, corporate leverage at a relative high. Of course, this all can continue for a long time if growth persists. The Fed has signaled that it stands ready to buffer any material softening in growth. Still, corporations may need to trim equity buybacks and reduce debt.

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