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Credit's Check Up - May 7, 2019

“Large Increases in Risky Forms of Debt”

 The Fed released its latest assessment of the financial system’s health, and like many of the data series we follow, the results are mixed. The May Financial Stability Report has both good and bad news from the Fed. On the good side of the ledger, private credit has “advanced roughly in line with economic activity” and households appear to be in good shape. Household borrowing has only “grown modestly relative to incomes” and while there are some potentially odd dynamics in auto loans, “there has been an ongoing shift in the composition of household debt toward borrowers with higher credit scores”. Borrowers with prime credit scores have continued to increase their loan balances since 2013 and now have debts that “exceed their pre-crisis levels”.

In stark contrast, Business Debt appears to be a potential ‘bull in a china shop’. Debt owed by businesses has “expanded more rapidly than output for the past several years”, pushing its debt to GDP ratio to “historically high levels”. What has the Fed worried is that business debt growth “has been characterized by large increases in risky forms of debt extended to firms with poorer credit profiles or that already had elevated levels of debt”. In fact, the share of leveraged loans issued to companies with a debt-to-EBITDA ratio of greater than six has now passed “previous peak levels observed in 2007 and 2014”. The good news is there is currently no sign of problems in leveraged loans, with the default rate “down in the most recent data to a level near the low end of its historical. The Fed does, however, warn that there are “vulnerabilities” associated with elevated business debt. In addition to posing a risk to themselves, a highly indebted business sector increases “the downside risk to broader economic activity”.

Additional credit data was released in the Fed’s April Senior Loan Officer Opinion Survey. Respondents reported that, regarding loans to businesses, “on balance, they left their standards basically unchanged”. At the same time, they reported “weaker demand for C&I loans”. For consumers, Banks reported “that standards on credit card loans tightened” while auto loans and real estate loans “remained basically unchanged”. There were some points of weakness as banks took “steps to mitigate risk of loan losses” from firms exposed to “developments in Asia or Europe”. No significant signs of trouble yet, but we will be watching for problems and any ensuing ripples.