Turning a Corner on the Credit Crisis?

CUNA’s E-Scan Newsletter
July 7, 2010 | COMMENTS

The recent “Great Recession” led to the highest credit union loan delinquency and charge-off rates in over 25 years. Higher charge-offs were responsible for the record level of loan loss provisions in 2009. This, in turn, was the major contributing factor to the record low credit union return on assets—about 15 basis points for 2009.

The big question on the minds of many credit union executives is when will the credit crisis ebb? The answer depends on multiple factors including the condition of the labor market, the housing market situation, credit demand, and ultimately households' behavior. Let's take a look at each of these factors to determine the future of credit union credit quality.

First—and by far the most important—is the condition of the labor market. This is a good proxy for the amount of default risk to which your credit union is exposed. Default risk is concerned with a borrower's ability and willingness to pay back a loan. It's one of two components that make up credit risk, the other being collateral risk.

The unemployment rate in your state or local community is a good measure of your credit union's exposure to default risk. The Bureau of Labor Statistics has a useful Website to help you track your local unemployment rate.

On the national level, the unemployment rate fell to 9.7% in May 2010, down from its high of 10.2% in October of 2009. Even though the unemployment rate is considered a lagging indicator, in economic terms it appears to be a “coincident indicator” of credit quality among credit unions. The recent drop in delinquency rates occurred at about the same time as the turn in the labor market.

Also, there has been a close correlation between unemployment and delinquency rates over the past few years. Credit union loan delinquency rates began their recent ascent at roughly the same time as the rise in the unemployment rate. The recent drop in loan delinquency rates is even more surprising given that credit union loan balances have been falling for the past six months, which should be pushing up delinquency numbers.

It's no surprise that a rise in loan delinquency rates in one period will lead to a rise in charge-offs in the next. For the past 20 years, this ratio averaged around 0.5%, meaning credit unions charged off 50 cents for every $100 dollars of loans annually.

The charge-off ratio broke out of its historical range in 2008 and 2009 as home prices fell, the credit crisis spread, and job losses soared. In 2009, credit union net charge-off rates reached a record 1.21%. The improvement in the labor market today should mean a modest drop in charge-offs to 1.08% in 2010, with a bigger drop forecast for 2011.

Economics in action

One of the fundamental principles in economics is that variables revert to their mean values over time. So, the big question on the minds of many credit union executives is how much time it will take for credit union net charge-off rates to return to their 0.5% long run average. The answer will be a function of future job creation.

To understand the pace of job creation in the U.S., recall that a high point for employment came right before the onset of the Great Recession when the total number of jobs reached 138 million. The low point arrived in December 2009 when the number stood at only 129.5—a loss of 8.5 million jobs.

Recently, however, there has been some good news. The labor market stabilized in the fourth quarter of 2009. Since then, it has added 982,000 jobs. But it could take more than four years before the economy returns to its pre-recession number of jobs. This signals higher-than-average credit union loan delinquency rates, loan charge-offs rates, and loan loss provisions through 2015.

To understand the Herculean task the economy is facing to return to a pre-recession labor market, the U.S. economy must create 375,000 net new jobs per month over the next 60 months to bring the unemployment rate back down to 5% by June 2015. This is possible, but not probable.

That level of renewed employment seems implausible because the labor market is facing record long-term unemployment. As of May, 6.8 million Americans were unemployed for more than 26 weeks, the highest level on record since 1948, and up from a little over one million just before the Great Recession. It's this segment of the more than 15 million unemployed that is creating the bulk of credit union loan losses.

The record level of long-term unemployment also explains the significantly higher credit problems today as compared to past economic slowdowns. Many of the long-term unemployed are construction and manufacturing workers, and many of these jobs are not coming back anytime soon, if ever. Credit unions with members employed in the construction and manufacturing sectors will experience high loan delinquency rates for years to come.

The longer a person remains unemployed, the less employable they become. Their work skills deteriorate, their job market contacts fade away, and employers become wary of their work habits. For those who do return to work, many will earn significantly less than their previous jobs paid. New jobs might alleviate, but won't eliminate, the financial stress many of these workers face.

Collateral risk

The second component of credit risk is collateral risk, which deals with the market value of the collateral backing a loan. A good measure of this risk is the movement of home prices in your state or community. The Federal Housing Finance Agency (FHFA) has a useful Website to help you track local home price changes.

On a national level, home prices fell 1.9% in the first quarter of 2010 from the fourth quarter of 2009, according to FHFA's purchase-only house price index (HPI). This was the third biggest decline out of the 11 consecutive quarterly declines since the beginning of the housing bust. The HPI is calculated using home sales price information from mortgages acquired by Fannie Mae and Freddie Mac.

Home prices fell 3.1% from the first quarter of 2009 to the first quarter of 2010. This was the 10th consecutive quarterly year-over-year decline. With the prices of other goods and services rising 3.5% year over year, the inflation-adjusted price of homes fell approximately 6.3% over the past year, which is not a good sign.

The drop in home prices has caused one-quarter of home-mortgage holders to be underwater—facing home-loan amounts greater than home value. This led to a recent jump in “walk away” foreclosures, where homeowners decide to stop paying their mortgages even though they have the ability to make payments. In effect, they're exercising a “put option,” or the right to sell at a certain price. The homeowner is essentially receiving the loan amount for the house—by walking away and dumping the house on the lender—which is greater than the current market value.

The Great Recession has led to another perverse result—first mortgage loans now have a higher delinquency rate than consumer loans, which is unprecedented in credit union experience. Many members would rather make a payment on their credit cards before they make a payment on their underwater home loans.

The credit quality turnaround, however, is already showing up in credit union loan loss provisions. Credit unions expensed “only” 84 basis points (bp) of average assets, at an annualized rate, in the first quarter of this year. That's down from 118 bp in the fourth quarter of 2009 and 102 bp in the first quarter of 2009. Credit unions also are transitioning from building their loan loss allowance account to maintaining it at current elevated levels.

So will the economic principle of reversion to the mean apply to credit union earnings? Unfortunately, there's a countervailing principle from the world of physics, “hysteresis,” which is the notion that a variable might not return to its natural state even after some external shock has been removed.

For credit unions, the return-on-assets natural state is 100 bp—its long-run average before the recession. The external shock was the Great Recession. So even though the recession is technically over, the number of long-term unemployed may have permanently shifted to a higher level, along with credit union charge-offs and loan loss provisions.

All this implies credit unions earnings might have shifted permanently lower. Only time will tell which principle wins out.

Steve Rick is senior economist in CUNA's economics and statistics department. Reach him at 608-231-4285 or srick@cuna.coop. This article originally appeared in CUNA's E-Scan Newsletter. Reprinted with permission.