Diving Deeper

Consumer Loan Defaults: Should Banks Continue to Hold Elevated Reserves?


Allowing for loan losses during COVID: Banks prepared for delinquencies during COVID uncertainty, but the expected wave of losses has not come. Will it?

As states locked down, retail businesses were shuttered, and office workers who still had jobs learned to work from their kitchen tables via Zoom, credit analysts in the banking sector rushed to project the swell of consumer defaults on the horizon that would be driven by the COVID-19 pandemic.

The reality is that, nine months later, chargeoff rates are stable and delinquency rates are down more than 15%. If the anticipated defaults never materialize, the result would be a financial positive for the nation’s largest banks, supporting earnings growth in coming quarters as loss reserves are released.

With the unemployment rate now standing at 6.9%, is it possible, following record unemployment earlier this year, that we might never see a consumer credit default spike?

The Pandemic, Unprecedented Stimulus and Insulated Consumers

Passed and enacted in late March, the Coronavirus Aid, Relief, and Economic Security (CARES) Act provided $2.2 trillion of support via one-time checks to most Americans and expanded unemployment benefits, loans and grants to small businesses and aid to both large companies and state and local governments. Additional benefits included deferrals on federally insured student loans and a moratorium on foreclosure/evictions.

Months after those enhanced unemployment benefits ended, the banking industry still is observing stable credit trends. Early in the pandemic, most forecasters predicted material increases in delinquencies heading into 2021, but, as yet, they haven’t materialized. A combination of factors is likely effectively kicking the can down the road:

  • Record personal savings: The personal savings rate was at record levels for four months in a row beginning in April, according to the  St Louis Fed, allowing consumers to build up cash and pad their bank balances.
  • Forbearance on almost 6% of all mortgages: According to the Mortgage Bankers Association, this number – although a small percentage – translates into a meaningful portion of consumers who have paused their mortgage payments for six months and counting. Given that a mortgage is usually a family’s single largest monthly budget item, this represents substantial cash flow relief.
  • Halt on residential evictions: In September, the Centers for Disease Control and Prevention (CDC) issued an order halting evictions for covered tenants. Like mortgages, rent payments are usually the largest expense for many small households so bank balances could be bolstered by decisions not to pay rent. The order ends this month.
  • Deferrals on 99% of student loan debt: Based initially on the CARES Act and, later, an executive order, most federally insured student loans payments are on hold until at least February 2021. While these loan payments aren’t usually as large as mortgage payments, a broader group of consumers – including many renters – are better able to manage their monthly cash flow.

Just as banking analysts are scouring data for the delinquency trajectory, casual observers likely expect to see delinquencies rising. Instead, market research shows that consumers are temporarily insulated from default exposure through the combination of increased bank balances and reduced debt payments. But that won’t last forever. Already, bank account balances have begun to drop following the end of extended unemployment benefits, and loan forbearance and deferral programs will be ending in the next six months.

2021 and Beyond

With Pfizer, Moderna, and AstraZeneca in various stages of bringing vaccines to market, there is now hope for a resolution of this pandemic. However, a second stimulus package under debate in Congress is the lynchpin to avoiding a material surge in consumer loan defaults in early 2021.

At the moment, there is uncertainty regarding how a divided government in the midst of a disputed presidential election can pass legislation for additional stimulus. But both parties are aligned on certain core stimulus elements – including extended unemployment insurance, aid to both large companies and to states and localities, and another round of Payment Protection Program (PPP) lending for small businesses. With existing stimulus measures waning, the time is now.

A specific predicament for banks in the near term is the implication of the ongoing second round of 2020 stress testing, with results due by year-end. One of the hypothetical test scenarios assumes that unemployment rates rise to 12.5% by the end of 2021, while tightening net interest margins compress income.

In these stress tests, banks cannot explicitly assume that a vaccine or a government stimulus plan will mitigate losses in the coming year. It’s unknown what level of approval for excess capital deployment will be given based on recent guidance from the Federal Reserve Board prohibiting share repurchases and capping dividend payments. Those decisions will impact stock prices even if banks begin releasing their reserves.

The bottom line is that uncertainty remains for credit analysts responsible for forecasting future losses and determining financial reserves as the pandemic continues to complicate the economic world. Will stimulus get passed, how efficiently can vaccine programs provide inoculation to the population, and will there be sectoral losses even as the economy begins recovering from this pandemic? Many questions remain.

While we likely won’t see material changes to reserve levels in the short term, it remains entirely feasible that those reserves will ultimately prove to be nothing more than a security blanket for a scenario that will never come to pass.

Brett Ludden is president of Flying Phase, a consultancy that leverages state-of-the-art analytics and technology to help financial services firms solve their most difficult problems in credit, risk and lending.