Insider Information

Throughout the COVID shutdown, a lot of people - friends, family, clients - have been asking me for my views related to the prospects for the U.S. economy going forward. Some are concerned that this is worse than 2008-09. Some are concerned that it's worse than the Great Depression. Some are fearful that the economy will never recover.

I have tried to put those fears to rest through a combination of data analysis, macro trends, and anecdotal evidence. I've noted that when initial jobless claims peak (which they appear to have done seven weeks ago), we're near the point where the worst is over. And that when the unemployment rate peaks (which I suspect it might with the May data, which will be released June 5 and should come in around 22%), the worst is behind us.

I have explained the significant macro difference between those past severe downturns - both top-down events that eventually took out the rest of the economy - and this downturn, resulting from a bottom-up event, with the top of the economy still primarily intact in terms of employment and incomes. Which augurs well for demand.

And there is anecdotal evidence that demand remains extant. My lovely wife and I will celebrate our 25th year of her putting up with me in 2021. We enjoy cruising, having done so more than 20 times, and one of our more memorable trips was a cruise from Vancouver to Hawaii four years ago. Yesterday, I was researching cruises coming from Hawaii to the mainland. There are two such sailings next May on our preferred cruise line. The suites are sold out, nearly 12 months in advance. True, many of the bookings are being made using credits from cruises booked for this year that had to be canceled. But that doesn't disprove the demand argument - why book with cash when you have a credit for 125% of what you paid for this year's cruise, which many lines are offering?

I have a flight to visit a client next week. While the airlines have cut routes and are capping capacity to distance passengers on the planes, my return flight is sold out.

Since my home county re-opened last week, we have dined out twice. Both times, the restaurants were busy. At one of them, our waitress said that nearly all of the staff had been brought back. At both of them, our servers said they needed to hire more workers soon, because the same crews were prepping and serving both dine-in and still-brisk curbside/delivery customers, resulting in delays. (So if you dine out during this time, please show a little more forbearance than usual regarding wait times.) And a burger joint I drove by today had a sign out front saying that they're hiring.

There is other anecdotal evidence. But in this post, I want to share some "insider information" that points to this downturn being less severe than 2008-09.

I currently work as a risk management consultant for credit unions, which are like banks, but are owned by their depositors under a cooperative structure. I've worked with credit unions since 1992, and in this capacity since 2013. I've had clients in most U.S. states, and since this pandemic hit, I've been in contact with ongoing and former clients in 15 states. All of those states have different shutdown rules, and all have different re-opening plans and timeframes.

Regarding the various jurisdictional shutdown orders, the analogy I've been using with clients is this: we had to build the plane while we were flying it, and we had to get it up to altitude very quickly - with little, and often conflicting, guidance from air traffic control. Storms popped up everywhere, so we had to change course and altitude frequently. Now we have to plan for the descent, approach, and landing, again with little and often conflicting guidance. We have to figure out what parts we can remove, and when, and how. At the same time, we have to determine what parts may need to be put back on, and how and when and under what circumstances, as well as how we may need to change our flight plan, should the landing be aborted.

I've been impressed with how agile credit unions have been in doing all of this. Some have deployed nearly all of their work force remotely, including call centers, in a matter of days. Some have instead closed branches and deployed other personnel to that space to implement distancing across all facilities, and have deployed branch personnel to assist with the overwhelming volume seen by call centers and collections departments. Cash limits in ATMs have been increased to meet greater demand from that non-in-person channel. Plexiglas shields and floor markings have been put in place in branches. Millions of dollars of PPP loans have been extended to small businesses. Skip-payments and loan modifications have been proactively offered to keep borrowers from defaulting. HR departments have scrambled to deal with remote workforce deployment issues, CARES Act changes, and leave issues related to the pandemic.

But I'm not writing this just to congratulate the industry I serve. I'm writing it to report on what those institutions are projecting in terms of credit losses and other impacts to income, and the anecdotal evidence I hear from them. Let's tackle the anecdotal piece first.

Besides the mortgage refi business - which will help keep people whose incomes have been affected remain in their homes, and will put discretionary funds in the pockets of those who haven't been affected, so they can spend them - other business is picking up too. One client I spoke with very recently is in a state that has begun to re-open. That client, like most credit unions, is active in indirect auto lending. Under those arrangements, the credit union works with a network of dealers, and the dealers offer the credit union's auto financing at the dealership. The credit union provides the pricing (loan rate) and underwriting criteria. It's like having an outsourced auto lending business. Some credit unions do considerable volume in indirect lending, as much as 70% of total loan production.

This particular client reported that, during the shutdown, they were doing about three indirect loans a day, which is abysmal. Now that things have re-opened - just partially, mind you - their end-of-day queue - the loans they couldn't get approved that day just due to sheer volume - is 60 to 70 loans. (And they have a sizable indirect lending department.) Their dealers are reporting that May will be a record month for them in terms of sales. This makes sense: new light vehicle sales had been trending around 17 million units, annualized, as of February. In March, they fell to just over 11 million, the lowest since 2010. In April, sales fell to about 8.5 million units - the lowest ever.  That's a lot of pent-up demand to pick up, and to be financed at record-low rates. And the dealerships are implementing innovations like contactless sales and delivery to make it easier to buy for those still leery about kicking tires and slamming doors at the dealership.

My primary contact at this client also told me that she and her husband had been furniture shopping recently, and the store told them that it too was looking at an all-time record sales month in May. This illustrates that demand for big-ticket items is still there. And folks - this credit union is located in America's factory belt, where unemployment rates already were systemically above the national rate by about a percentage point.

On to the data. A key measure of financial institutions' profitability is return on assets (ROA), defined as net income divided by average annual assets. Another definition we need in hand for this discussion is "basis points." One basis point is equal to 1/100th of a percent; 100 basis points (bp) equals one percent.

All of the credit unions I've spoken with are projecting about a 40-45bp hit to ROA this year. To put that in perspective, that would knock out about half a year's earnings for the average credit union with assets of $500 million or more (my clients range in asset size from about $200 million to nearly $10 billion, with the average north of a billion). In other words, industry average ROA would be about 45bp.

In 2009, the industry average ROA was 29bp. In other words, earnings were about 36% lower than what's projected this year. Many credit unions, especially those in the "sand states" where home price declines were more severe, had negative earnings in 2009.

Our firm works with over 100 credit unions, and we have validated the estimated 45bp hit to ROA through analysis of our clients' aggregate risk assessment data. The losses will come in part from charge-offs of loans that default. However, they'll also come from reduced investment income because interest rates have plummeted (credit unions can only invest in bonds, which pay interest). And from reduced loan income as auto loan demand disappeared for the two months that dealerships were shut down across most of the nation (but that demand is coming back as dealerships open, especially with loan rates this low). And from reduced interchange income (the income earned on credit and debit card swipes) during the two months that people weren't shopping, dining out and traveling (most of that demand will come back also; we'll see how contactless payment affects it). And from reduced income from wealth management services as those clients have stopped investing. And from increased expenses from the technology costs of deploying workers remotely, installing Plexiglas shields, buying hand sanitizer, and other responses to the pandemic.

So it's not just credit losses, and that suggests that credit losses won't be that widespread. Again, clients are reporting that they're proactively offering loan modifications and rate reductions to keep borrowers in their loans. As hiring in the service sectors picks up, those loans will remain current. They're also modifying business loans to keep those borrowers from failing and defaulting, as well as extending the PPP loans to keep them afloat.

And mortgage refinancings are exploding at today's record-low rates, so they're booking a lot more of those loans. True, the loans are at low rates, but most institutions are selling those loans into the secondary market (where they're packaged and sold to investors), earning fees for originating and selling the loans, as well as for servicing the loan payments. So that is helping to offset lost income. Only one of my clients is not seeing record mortgage refi volume, and they're located in a COVID hotspot.

In terms of the anticipated loan losses alone, the hit to ROA is projected to be about 20bp - roughly half the total hit, and on the order of a fairly mild recession. This has also been validated by looking at aggregate data across all of our clients.

If credit unions thought that demand wasn't coming back, and that most businesses would fail, and unemployment would continue to go up for months, they'd be reserving more for loan losses. They tend to be very conservative in establishing their loan loss reserves. And their regulator hits them hard if they don't, so the regulator isn't anticipating widespread business failures and continuously increasing unemployment, either. Reports from the banking industry tell a similar story.

So don't just take my word for it. America's financial institutions - who lend to the businesses and individuals who are affected by the shutdown, as well as those who aren't - are telling a story of a short recession overall, and a return to more normal times in 2021. The anecdotal evidence corroborates that, as do the projections by the majority of credible economists, including our current Fed Chairman.