The Big Idea

Banks’ benign view of consumer credit

Steven Abrahams | June 7, 2024

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. This material does not constitute research.

Banks regularly report to the Fed on the probability of default in a wide range of loans, including mortgage and other consumer exposures. At the end of 2023, banks’ view of mortgage credit risk was among the most benign of the last 10 years, and the same was true for credit card and auto loans. Only in unsecured consumer and student loans had risk materially ticked up. Although views may have changed a bit since, banks paint a picture of a strong consumer. Consumer exposures continue to look like better relative value than comparable corporate ones.

Bank default expectations on mortgage loans

Banks with roughly $10 billion or more in total assets report quarterly to the Fed on the probability of default in the next two years for a wide range of loans. The Fed uses the information to manage credit concentration risk, but access to good and timely information on borrowers’ ability and willingness to pay makes these bank estimates valuable for a broader audience holding similar credit risk.

Banks’ view on default risk in residential mortgage loans at the end of 2023 was among the most benign in at least 10 years. Banks at that point expected 6.7% of their $21 billion in junior liens to default in the next two years, 5.6% of their $287 billion in non-traditional loans—loans with interest-only periods, pay options, negative amortization or similar features—to default, 3.8% of their $1.5 trillion in first liens and 3.4% of their $208 billion in home equity lines of credit (Exhibit 1).

Exhibit 1: Banks’ expected residential mortgage defaults have steadily declined

Note: Reporting banks at 4Q23 held $1,529B in first liens, $287B in non-traditional, $208B in HELOC, $21B in junior liens. Aggregate default risk estimated by taking the mid-point of the probability-of-2Y-default categories reported, multiplying them by the share in each category at each quarter and summing the resulting products. Source: Federal Reserve, Santander US Capital Markets

More important for the broader market than the absolute levels is the trend. These estimates all are at the low end of expectations for the last 10 years. More importantly, all of these estimates had declined from the end of 2019, the last pre-Covid mark. And compared to the end of 2021, the last pre-Fed-tightening mark, expected defaults on first liens had declined by 0.3% and on HELOCs by 0.2% while expectations for non-traditional loans had increased by 0.2% and on second liens by 0.1%.

To put these estimates in the context of the broader mortgage market, banks reporting to the Fed at the end of 2023 held slightly more than $2 trillion in par residential mortgage balances. That amounted to 79% of all residential mortgage loans held by banks since only banks with roughly $10 billion or more in total assets report expected defaults. It also amounted to roughly 15% of all residential mortgages outstanding with agency MBS accounting for 65%, private MBS for 3% and others accounting for the rest.

The credit risk in first liens held by banks is likely most similar to the risk in agency MBS and less risky than loans in private securitizations. Banks’ non-traditional loans are likely comparable to loans in pre-GFC legacy securitizations. Bank HELOCs are likely less risky than HELOCs in private securitizations.

Relative risk matters because riskier loans held away from banks could show different trends. But it seems unlikely that expected levels of defaults across tiers of mortgage loan risk could be entirely independent. All loans are affected by trends in home prices and the strength of consumer balance sheets, both of which have been going strong since 2020 and likely explain banks’ benign view. The view from banks’ balance sheet suggests consumer mortgage credit is strong.

Bank default expectations on consumer loans

Banks also weigh in on consumer loans, and there the picture is more mixed but still benign for the biggest consumer exposures. At the end of 2023, banks expected 9.1% of their $338 billion in other unsecured consumer loans to default in the next two years, 6.1% of their $1.0 trillion in credit cards, 4.0% of their $50 billion in student loans and 3.3% of their $481 billion in auto loans (Exhibit 2).

Exhibit 2: Banks’ expected defaults on consumer loans are mixed

Note: Reporting banks at 4Q23 held $1,086B in credit card loans, $481 in auto loans, $338B in other consumer loans and $50B in student loans. Aggregate default risk estimated by taking the mid-point of the probability-of-2Y-default categories reported, multiplying them by the share in each category at each quarter and summing the resulting products. Source: Federal Reserve, Santander US Capital Markets

Again, the trend is more important for the broader markets than the absolute levels of expected default. Over the last 10 years, except for other unsecured consumer loans, default expectations have steadily trended lower. Compared to the end of 2019, bank expectations dropped in all loan categories except other unsecured consumer loans. And compared to the end of 2021, expectations dropped in credit cards, remained unchanged in auto and other consumer loans rose in student loans.

As was the case for mortgage loans, the same caveats apply for generalizing bank trends to other parts of these consumer loan markets. Private securitizations of credit card, auto and unsecured consumer loans likely include riskier loans more sensitive to small changes in wealth and income, among other factors. But these loans on or off bank balance sheets reflect common factors, so the direction of travel in one place—if not the magnitude—is likely reflected everywhere.

The big picture of the consumer and relative value

Some circumstances have changed since the end of 2023, notably the market’s assumption about the immediate direction of Fed policy. It may be that revised expectations about the pace of Fed easing would lead banks to notch up their expectations for consumer defaults. On the other hand, home equity, investment portfolios and pension plans have continued to perform well and the labor market has remained relatively strong. There are a lot of competing factors, so the next round of bank estimates will be valuable.

For investors, spreads in consumer exposures generally stand wide of competing corporate credits. Residential mortgage credit and consumer ABS have looked like good value relative to corporate credit. Banks view of credit risk in their own exposures suggests the same.

* * *

The view in rates

Fed funds futures price roughly 36 bp of easing this year as of the Friday close, roughly the same number for the last six weeks. The market sees a 44% chance of September and a 68% chance of December. It’s still all about sticky inflation. In the aftermath of the last FOMC, implied rate volatility continues to trend lower, although recently bouncing off the lows of the year.

Other key market levels:

Fed RRP balances closed Friday at $395 billion. RRP balances have bounced between $400 billion and $500 billion since the start of March. That range has held despite yields on most Treasury bills running well above the RRP’s 5.30% rate.
Setting on 3-month term SOFR closed Friday at 533 bp, down 1 bp in the last week.
Further out the curve, the 2-year note closed Friday near 4.89%, up 2 bp in the last week. The 10-year note closed at 4.43%, down 7 bp in the last week.
The Treasury yield curve closed Friday afternoon with 2s10s at -45, flatter by 8 bp in the last week. The 5s30s closed Friday at 9 bp, flatter by 5 bp over the same period
Breakeven 10-year inflation traded Friday at 230 bp, down 6 bp in the last week. The 10-year real rate finished the week at 214 bp, down 1 bp in the last week.

The view in spreads

A trend to lower volatility should create more room for spreads in all risk assets to tighten a little further. Credit still has the most momentum with a strong bid from insurers and mutual funds, the former now seeing some of the strongest premium and annuity inflows in two decades and the later getting strong inflows in 2024. The broad trend to higher Treasury supply also helps in the background to squeeze the spread between risk and riskless.

The Bloomberg US investment grade corporate bond index OAS closed Friday at 89 bp, wider by 3 bp in the last two weeks. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 143 bp, unchanged in the last week. Par 30-year MBS TOAS closed Friday at 37 bp, tighter by 2 bp in the last week. Both nominal and option-adjusted spreads on MBS look rich.

The view in credit

Higher interest rate should raise concerns about the credit quality of the most leveraged corporate balance sheets and commercial office properties. Most investment grade corporate and most consumer sheets have fixed-rate funding and look relatively well protected against higher interest rates—even if Fed easing comes late this year. Healthy stocks of cash and liquid assets also allow these balance sheets to absorb a moderate squeeze on income. Consumer balance sheets also benefit from record levels of home equity and steady gains in real income. Consumer delinquencies show no clear signs of stress, with most metrics renormalizing back to late 2019 levels. Less than 7% of investment grade debt matures in 2024, so those balance sheets have some time. But other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. US banks nevertheless have a benign view of credit in syndicated loans. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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