The FDIC panel considered the effects of a possible recession, not because they think one is likely, but only because it’s part of their what-if and forecasting planning. Attendees were from the FDIC, OCC, and private firms.
In conclusion, while there are areas of concern, they are minor, everything is rosy, banks have never done better. Their conclusion on the housing bubble: it could burst. “However, little is known as yet about the effects these credit-market changes might have on the dynamics of boom-bust cycles, making them promising areas for future research.”
Apparently they didn’t have time for too much research, because they released another paper, which basically said that they need more research to determine the effects of exotic lending, and time will tell how it all plays out. They can’t possibly be a bunch of bumbling fools, can they now????
END OF SUMMARY
In a follow-up paper on the Housing Boom/Bust scenario, they conclude with:
“However, the broadening of the U.S. housing boom during 2004 may imply a growing role for national factors–including mortgage credit conditions–in explaining recent home price trends. More research is needed to establish exactly what role, if any, changes in the cost and availability of mortgage credit played in the expansion of the U.S. housing boom in 2004. But to the extent that credit conditions are driving home price trends, the implication would be that a reversal in mortgage market conditions–where interest rates rise and lenders tighten their standards–could contribute to an end of the housing boom. While our analysis shows that boom does not necessarily lead to bust, it remains to be seen to what degree the current situation might differ from our previous experience in U.S. housing markets.”
Back to excerpts from the summary of their meeting:
The Economy is Strong
Rising business profit growth and investment, booming home prices, and favorable fiscal and monetary policies are in place. Despite the overall strong appraisal, real GDP growth decelerated sharply, to a 1.6 percent annualized rate during fourth quarter 2005. Although fourth quarter GDP growth was weak, recent signs point to a resurgence early in 2006. For instance, job growth has picked up and the unemployment rate fell to 4.8 percent as of February. Manufacturing purchaser index is up.
Despite a favorable outlook, there are at least three widely acknowledged areas of near-term concern that could pose risks to the economy going forward: a spike in energy prices, a decline in home prices, and a retrenchment in consumer spending arising from record consumer indebtedness.
Energy Shocks
Because global excess crude oil production and refining capacity are limited, the risk of supply-side energy shocks remains high.
Housing
The risk of a housing slowdown is another area of concern going forward. The recent housing boom has been unprecedented in modern U.S. history. It is very likely that housing wealth has been a significant factor behind growth in consumer spending. There are concerns, however, that changes in the structure of mortgage lending [exotic loans]could pose new risks to housing. Because of the importance of mortgage lending to bank and thrift earnings, the large-scale changes that have taken place in this sector will clearly have implications for the banking outlook. Bank exposure to mortgage and home equity lending is now at peak levels.
Consumer Debt and Lack of Savings
Just as there has been a positive wealth effect from soaring home prices in recent years, the concern is that an end to the housing boom could result in a slowdown in consumer spending growth. However, it is important to keep in mind that such an outcome would likely play out over several years, as happened during the boom.
Banking Industry is Well Positioned for the Next Recession Richard Brown, FDIC:Historically, the fortunes of the banking business have varied with economic cycles, but the worst of times in recent memory were not predominantly the result of recession. [His chart shows that bank failures did not occur in each recession, and the 1980’s S&L failure, as well as the ROA and ROE of all FDIC insured commercial banks occured outside of a recession period – very interesting….] There were a lot of factors involved in this wave of bank failures, including risk management problems, fraud, and self-dealing. But probably the biggest single economic factor related to boom and bust cycles in real estate.
Another case in point is the experience of the last five years, from 2001 through 2005. We saw trillions of dollars in stock market losses starting in 2000 with the failure of hundreds of publicly traded companies, including Enron and WorldCom, followed by a very slow recovery in job growth over the next couple of years.
How did all of that affect FDIC-insured institution? They earned record profits every year from 2001 through 2004. Year-end results are not in yet, but 2005 also looks like it could well be another record year.
Part of the reason the industry was able to post this strong performance was the response of monetary policy to the recession itself. Low nominal interest rates and a steep yield curve helped the industry boost its net interest income and realize gains on the sale of securities that offset the increase in credit losses.
I think the main lesson here is that the boom and bust cycles, or the particular sectoral incidence of a cyclical downturn, are more important than recession itself in determining which institutions are affected…. the number of problem institutions has fallen to historically low levels, in order of magnitude less than they were 15 years ago. Given its strong current financial position, the banking industry appears to be generally well positioned to meet the challenges of the next recession.
From footnotes:
Although this paper demonstrates that relatively few metro area housing booms have ended in busts, there are reasons to think that history might be an imperfect guide to the present situation. Foremost among these are changes in credit markets that are pushing homeowners—and housing markets—into uncharted territory…. An increased incidence of default and foreclosure could, in turn, contribute to downward pressure on home prices as distressed properties are liquidated by lenders. However, little is known as yet about the effects these credit-market changes might have on the dynamics of boom-bust cycles, making them promising areas for future research.
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