hamilton financial index: july 2012
TRANSCRIPT
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The Hamilton Financial Index: !A semi-annual report on the sta
of our financial services industry
With a review of the upcoming
fiscal cliff !
July 2012!
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About this Report
The Partnership for a Secure Financial Future comprisesthe Consumer Bankers Association, Mortgage BankersAssociation, Financial Services Institute, and The Financial
Services Roundtable, which combined represent morethan 2,700 member companies across all organizations.
Hamilton Place Strategies is a consultancy based in Washington,DC with a focus at the intersection of business andgovernment. HPS Insight conducts in-depth analysis on public
policy issues.
About the Authors
Matt McDonald is a Partner at Hamilton Place Strategies. Heformerly worked on economic issues at the White House and isa former consultant with McKinsey and Company.
Steve McMillin is a Partner at US Policy Metrics, an economic and
public policy research firm serving asset managers, hedge fundsand the investor community. He is a former Deputy Director ofthe Office of Management and Budget and a former partner atHPS.
Patrick Sims directs research for HPS. He is a former leadresearch analyst in the financial institutions' group at SNLFinancial and is a former representative of CFA Institute.
Russ Grote is an Analyst at Hamilton Place Strategies specializing
in economic policy analysis and strategic communication.
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Executive Summary
The U.S. financial sector continues to make important changes to strengthen
itself against ongoing risks. As we document that improvement in this report,we also explore the tradeoffs inherent in todays higher capital levels, and theirimplications for economic growth.
The key findings of the report are:
The Hamilton Financial Index (HFI) rose seven points since the previousquarter and stands at 1.22 as of the end of the first quarter. Banks increase
in Tier 1 capital is driving the rise in the HFI. For the HFI to dip belowhistorical norms, systemic risk would have to increase five times thesecond quarter high. Conversely, if banks had not increased their Tier 1
Common Capital Ratio from the level of three years ago, the secondquarter high of systemic risk would have pushed the HFI below normallevels.
While the European debt crisis presents risks to the global economy, fromthe end of the first quarter of 2011 through the first quarter of 2012, U.S.
banks reduced exposure to the European periphery by over 16 percentand Europe as a whole by eight percent.
Lastly, our policy spotlight found that the upcoming fiscal cliff could bethe largest fiscal contraction in four decades, potentially causing a
significant drop in consumer demand and business investment. The fiscalcliff is further complicated by elevated U.S. debt and annual deficits, apolitically contentious debt ceiling debate, constraints on the Fed, and theslowing of the global economy.
There remain significant challenges to the U.S. and global economies. Despitethis, the financial sector is positioned to support stronger growth as theeconomy improves.
This report was commissioned by the Partnership for a Secure Financial Futureand the conclusions are that of the authors.
Matt McDonaldSteve McMillinPatrick SimsRuss Grote
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2 | The State of Our Financial Services!
CONTENTS
THE HAMILTON FINANCIAL INDEX3An index to measure both risk within the financial system andhow firms are dealing with that risk.
SAFETY AND SOUNDNESS .11A look at how our financial services sector has rebuilt after thecrisis and how they are meeting current challenges particularlyEuropean risk.
VALUE TO THE ECONOMY 20An examination of the everyday value that financial servicesbring to our lives, as well as an in-depth look at how thesector continues to supports the economy during therecovery.
POLICY SPOTLIGHT THE FISCAL CLIFF...38An explainer of the individual pieces of the fiscal cliff and itseconomic consequences in the context of a slowing globaleconomy, the debt ceiling, rising US deficits and the dispositionof the Federal Reserve.
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Hamilton Financial Index (HFI)In its second release, the HFI focuses on
the continued improvements in the financialservices industry and its ability to strengthenitself in economically challenging times. Italso incorporates the idea that tradeoffsexist and can have significant economicoutcomes.
The notion that decisions come withtradeoffs is nothing new. An economictradeoff can be compared to anopportunity cost, which represents thebenefits you could have received by takingan alternative action. The accumulation ofcapital involves an opportunity cost. Anyincrease in capital may indicate the industryis better able to absorb losses. But it isimportant to understand that capital held as abuffer is capital unused to fund important lending that would aid economic growth.
This tradeoff between economic safety and economic growth is why the aboveFederal Reserve quote is so meaningful capital has two purposes: it is used toabsorb unexpected losses andto lend businesses and consumers. A delicatebalance is needed to promote industry safety while encouraging healthy investmentand lending.
!
!
Key Findings Q112:
At 1.22, the Hamilton
Financial Index was 7
points higher than the
previous quarter and 22
percent above evennormal pre-crisis levels.
At current capital levels,
system level risks would
have to increase 5 times
the 2nd quarter high forthe HFI to dip below
historical norms.
Tier 1 Common Capital
increased to above $1.1
trillion, driving the Tier
1 Common Risk-Based
Ratio to 12.76 percent.
!
Capital is central to a
[banks] ability to absorb
unexpected losses and
continue to lend tocreditworthy businesses
and consumers.
- Federal Reserve CCAR
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The Hamilton Financial Index: A Snapshot of Firm and Systemic Risk
As of the first quarter of 2012, the HFI, a measure of both systemic risk and bankscapital levels, was valued at 1.22, 22 percent above the historical norm. The indexsvalue is up from its original release at 2011 year-end, attributing its rise to increasing
levels of capitalization and a reduction in system-wide volatility over the period(Exhibit 1).1
The HFI combines capital levels and financial stress to provide a snapshot of thefinancial sectors ability to handle risk. It uses two commonly accepted metrics:
1. The St. Louis Federal Reserve Financial Stress Index captures 18 marketindicators and is a well-established indicator of financial stress
2. Tier 1 Common Capital Ratio for commercial banks measures financialinstitutions ability to absorb unexpected losses in an adverse environment
In the first quarter of 2012, the St. Louis Federal Reserve Financial Stress Index fell,while the Tier 1 Common Capital Ratio for U.S. banks rose, causing the index toimprove. During the second quarter of 2012, events in Europe have caused stressin the system to rise. However, because U.S. banks have increased industrycapitalization, systemic stress would have to be significantly higher for the HFI to bein unsafe territory.
Exhibit!1 !
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
2010
All-Time High!1.24!
2011
2009
Crisis Low 0.46!
2008
IndexValue
0.50!
1.50!
1.00!
1.25!
0.75!
0.25!
Current !Release!
1.22!
2007
2006
2005
First Release!1.15!
THE HAMILTON FINANCIAL INDEX ROSE IN THE
FIRST QUARTER OF 2012!
Source: HPS Insight, St. Louis Federal Reserve, SNL Financial!
Hamilton Financial Index!
2012
The Hamilton Financial Index
rebounded to a level 22% above
normal after a small dip due to a
rise of financial stress in the fall.!
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Effectively, for the index to fall below normal levels, the level of systemic stresswould have to increase by five times the second quarter high. The economy hasnot seen that level of stress in three years. Conversely, if banks had not increased
their Tier 1 Common Capital Ratio from the level of three years ago, the secondquarter high of systemic risk would have pushed the HFI below normal levels. This
dramatic shift by U.S. banks over the past three years has better positioned them towithstand shocks from Europe and elsewhere (Exhibit 2).
Methodology
The index value is the difference between the quarterly averages of the FederalReserve of St. Louis Financial Stress Index and the quarterly Tier 1 Common CapitalRatio for the banking industry. All data points are indexed to 1994 levels and 1.00 is
the historical norm from 1994 to the present.
St. Louis Financial Stress Index
The first variable in the Hamilton Financial Index is the St. Louis Financial StressIndex, which combines 18 market variables segmented into three sections: interestrates, yields spreads and other indicators (Exhibit 3). Interest rates help determine
the markets assessment of risk across a number of different sectors. High interestrates represent an increase in financial stress. Yield spreads help determine relativerisk across time and geography. For example, the Treasury-Eurodollar (TED)spreads capture risk not just in the U.S., but also throughout the globe. Other
Exhibit!2 !THE HFI ROSE DUE TO SIGNIFICANTLY HIGHER CAPITAL
LEVELS AND SUBDUED FINANCIAL STRESS!
Source: FDIC, SNL Financial, St. Louis Federal Reserve, HPSInsight!Note:*Tier 1 Common Ratio is a %, St. Louis Financial Stress unit is an index value !
0
2
4
6
8
10
12
141.22
St. Louis
Financial
Stress Index!Tier 1
Common
Capital Ratio!
0
2
4
6
8
10
12
14
Units*
0.46
St. Louis
Financial
Stress Index!Tier 1
Common
Capital Ratio!
HFI During 2008 Crisis: Less
capital, high risk! Current HFI: More capital,moderated risk! Corresponding !HFI Value!14!12!10!8!6!4!2!0!
14!12!10!8!6!4!2!0!
For the index to dip
below its historical
average of 1, financial
stress would have to
increase five times its
Q212 high.!
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6 | The State of Our Financial Services!
indicators fill in important pieces not captured by interest rates or yields. Forexample, the Chicago Board Options Exchange Market Volatility Index captures themarkets expectation of volatility in the financial system. Each indicator captures anaspect of financial stress within the system with some overlap. Collectively, theyprovide a snapshot of systemic risk in financial markets.
Tier 1 Common Capital, Risk-Weighted Assets and Tier 1 Common Ratio
The second variable in the HFI is the Tier 1 Common Risk-Based Ratio, whichcaptures banks ability to absorb unexpected losses. The Tier One Common Risk-Based Ratio has ticked up to 12.76 percent as of the first quarter of 2012, anotherrecord (Exhibit 4).
The ratio is calculated by taking the industrys Tier 1 Common Capital (numerator)as a proportion of its Risk-Weighted Assets (denominator). Tier 1 Common Capitalacts as a cushion in case of unexpected losses. Therefore, any increase in Tier 1
Common Capital (numerator) improves safety and soundness, all else equal. Anydecreases in the holding of risky assets as measured by Risk-Weighted Assets(denominator) will improve a banks capital position.
Exhibit!3 !THE ST. LOUIS FINANCIAL STRESS INDEX
INCORPORATES 18 VARIABLES TO MEASURE STRESS!
Source: St. Louis Federal Reserve!
St. Louis Fed Financial Stress Index!Other Measures!
1. Effective federal funds rate !2. 2-year Treasury rate!3. 10-year Treasury rate!4. 30-year Treasury rate!5. Baa-rated corporate rate!6. Merrill Lynch High-Yield
Corporate Master II Index!7. Merrill Lynch Asset-Backed
Master BBB-rated!
8. 10-year Treasury minus 3-month Treasury!
9. Corporate Baa-rated bondminus 10-year Treasury !
10. Merrill Lynch High-YieldCorporate Master II Index
minus 10-year Treasury!11. 3-month LIBOR-OIS spread!12. 3-month (TED) spread !13. 3-month commercial paper
minus 3-month Treasury bill !!
14. J.P. Morgan Emerging MarketsBond Index Plus!!
15. Chicago Board OptionsExchange Market Volatility Index
(VIX)!!16. Merrill Lynch Bond Market
Volatility Index (1-month)!17. 10-year nominal Treasury yield
minus 10-year Treasury Inflation
Protected Security yield
(breakeven inflation rate)!18. Vanguard Financials Exchange-
Traded Fund (equities)!
Interest Rates! Yield Spreads!
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Capital levels have increased 38 percent since 2007 to more than $1.1 trillion. In
addition to higher capital levels, the first quarter of 2012 also saw a further declinein banks holdings of risky assets as a percentage of total assets. The fall from thepre-crisis highs calculates to a drop of 13 percent (Exhibit 5). The industrys ability
to shed problem assets and retool balance sheets is an important step. With areduction of risky assets, the financial industry can turn its focus to aiding theeconomy.2
Exhibit!4 !REGULATORY CAPITAL LEVELS HIT ANOTHER
ALL-TIME HIGH IN THE FIRST QUARTER OF 2012!
Source: FDIC, SNL Financial!
1.0!0.8!0.6!0.4!2!
14!
12!
10!
Tier1CommonCapital($T)
1.4!
0!Tier
1Common
Risk
-Base
dRa
tio
(%)
8!
6!
1.2!
Q112
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
Tier 1 Common Capital ($T)!Tier 1 Common Risk-Based Ratio (%)!
Tier 1 Common Capital and Tier 1 Common Risk-Based
Ratio for U.S. Banks!Tier 1 Common Capital
Ratio has risen 38%
since 2007 to an all-
time high.!
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A Tradeoff Between Capital and Lending
Crisis-era efforts from both government and the private sector proved successful inrestoring stability to the financial system. Much of this reflected a recapitalizationprocess, whereby capital was provided to individual firms with a promise to repay.
Without question, these injections of capital reduced financial stress, restoredconfidence and set the foundation for recovery.
However, setting the foundation for recovery is not recovery in itself. The U.S.economy depends on a firms ability to use its capital to grow profitability, therebyinvesting in new business and hiringadditional employees. Ultimately, a
tradeoff exists between increasingcapital as a buffer against future lossesand using capital to fund importantlending and aid economic growth.
Having too little capital is dangerous tothe system, leaving it crisis-prone. Toomuch capital and institutions do notfund growth and may becomeunprofitable. A delicate balancebetween stability and growth is needed.
Exhibit!5 !U.S. COMMERCIAL BANKS CONTINUE TO REDUCE
THEIR HOLDINGS OF RISK-WEIGHTED ASSETS!
Source: FDIC, SNL Financial!
63!
60!
-13%
Q112
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
Percent(%)
78!75!72!69!66!
Risk-Weighted Assets as a Percent of Total Assets for U.S. Banks!
!
Ultimately, a tradeoffexists between increasing
capital as a buffer againstfuture losses and using
capital to fund importantlending and aid economic
growth.
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The need to increase capital dominates the current political consensus around bankcapital levels with little discussion about the magnitude and impact of reducedlending. When banks convert maturing loan proceeds into capital rather than re-lending them into the economy, they increase the safety and soundness of thesystem at the expense of current economic growth. Over the long run, increased
safety and soundness may prevent crises and improve growth prospects. However,there are diminishing returns to each additional dollar of capital (Exhibit 6). At acertain point, higher capital standards could actually reduce growth. The magnitudeof this effect is uncertain, but the tradeoff is real and unfortunately under-recognized.
Calculating the Effects of Rising Capital Levels
Debate is rife about the impact of rising capital levels on the supply of loans, thecost of borrowing and, on a macro level, GDP growth. Unfortunately, studies thathave attempted to measure its impact have produced a wide-range of estimates.3
According to the Federal Reserve, for each percentage point of extra capital a bankmust hold, growth slows by about 0.09 percent a year, a modest impact onlending.4 On the other hand, the Basel Committee and the Bank for InternationalSettlements calculates that the damage is closer to one-third of the Feds value.5And while the OECD calculates the widest range,6 the Institute of InternationalFinance calculates that the impact could be up to 10 times bigger than all otherestimates.7
Exhibit!6 !
At what point are the gains from
increased safety and soundness
outweighed by less economic
growth? !
WHILE INCREASING SAFETY, INCREASED CAPITAL
REQUIREMENTS ALSO REDUCE LENDING!
Decision:!What to
do with
marginal
dollar?!
Less lending!
Re-loan into
the economy!
Higher!interest rates!
Less growth but!more safety!
Lower interest!rates! More growthbut less safety!
Increase !capital and !safety!
Decision Tree and Effects!
A higher capital ratio increases safety and soundness but may
reduce lending. At a certain point, the marginal increase to safetyand soundness may be outweighed by lower economic growth.!
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A study by American economist and former director of the Congressional BudgetOffice, Douglas Holtz-Eakin, states each dollar of capital supports between $7and $10 dollars of lending activity.8 McKinsey estimates that American banks aloneneed an additional $870 billion in capital to meet future regulatory standards.9These numbers imply that economic growth could take a major hit as a result of
significantly higher capital levels.
A more important aspect of requiring higher capital levels is that a banks ability toraise additional capital in economically challenging times would be more difficult
than doing so in periods of higher economic growth. To save in good times andthen spend in bad is traditional economic thought. Unfortunately, the regulatoryworld never seems to function in this manner. In requiring higher capitals now, thepossibility emerges that it could drive changes in lending activity and reduce
transparency.10
The Hamilton Financial Index Summary
Since the last release of the HFI in February of 2012, the index value has risenseven points. The industry continues to increase capital levels above required ratesmandated by federal regulators. Current levels of safety and soundness far surpass
the levels seen during the crisis and in the periods leading up to it. According to theindustrys Tier 1 Common Capital Ratio (12.76), higher levels of capital ($1.1
trillion) and a reduction in the ratio of risky assets to total assets by 13 percentfrom pre-crisis highs are driving the index higher. Because of the HFIs two-partapproach, a reduction in system-wide volatility additionally contributes to the indexincreased value.
It is important to note that an index value that constantly increases does notnecessarily point to an improving economy. Institutions that hold capital above theregulatory required rate could be less motivated by safety and more by policyuncertainty, expecting a higher required rate in the future and, therefore,dampening growth. Also, an industry that is over-capitalized may indicate aconstrained lending environment, representing high borrowing costs and tight creditconditions. Further, an over-capitalized industry may reflect a lack of demand frombusinesses and consumers. If borrowers are not requesting additional loans to fundgrowth, then capital will be left sitting in banks a scenario that fits the currenteconomic environment.
As the this section discussed, holding capital poses an economic tradeoff, as capital
is used as both a buffer to unexpected loss and to fund future growth. A questionwe posed in the first report can now be altered to include the tradeoff argument What is the appropriate capital level for a financial institution to hold to absorblosses resulting from unexpected shocks to the systemwhile ensuring an organic
and sustainable recovery?11
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Safety and Soundness:Balancing Risks in Uncertain Times
As the HFI shows, the level of safety andsoundness in the financial industry hassignificantly increased since the crisis. Inmany cases, the industry is in a much saferplace today than in periods before thecrisis. Moreover, the findings of the HFI arereinforced by improvements in otheraspects of safety and soundness such asliquidity, insurance companies Capital andSurplus, and performance measures.
Much like capital levels, the bankingindustrys liquidity levels are at historichighs, meaning that the industry is betterable to meet any potential funding needs
than at any time in the past. Another
important signal of safety, insurercapitalization, is also at all-time highs,indicating that the broader financial servicesindustry is also better capitalized. Asindustry profitability continues to bounceback from crisis lows, it is important thatwe note the current global economy facesmany challenges.
This section will examine these metrics tocomplement the HFI such as liquidity,
insurance capital levels and performancemeasures. The section will also look at theEuropean crisis and its potential impact on theU.S. financial sector as well as the broader economy.
!
Key Findings Q112:
Bank liquidity measures
show that banks aremore liquid than anytime before and thus
better able to meetfunding needs.
Total capital and surplusfor the P&C and Life &
Health industries rose to
$576 billion and $314
billion, respectively.! U.S. financial institutions
exposure to the
European periphery fell16 percent over the past
year.!
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A Highly Liquid Industry
Liquidity, a measure of the ability to fund ongoing operations, is a financialinstitutions lifeblood, especially in times of crisis when funds may not be readilyavailable from outside participants. The same can be said for consumers and non-
bank businesses; their ability to pay expenses, make on-time payments and use cashin other ways is vital for financial success. Banking industry liquidity is high relative to
the levels seen over the past decade, which indicates that the industry is safer,though the economy is growing at a slower pace.
To assess bank liquidity, we examined two ratios: the Loans-to-Deposits (LTD)ratio and the Cash Ratio. The LTD ratio looks at the amount banks are lendingrelative to the amount of deposits that banks hold. While deposits are consideredcore funding for a bank, loans measure risk-taking and potential profitability;
therefore, the ratio captures risk relative to funding. As of the first quarter of 2012,the LTD Ratio was valued at 72 percent an all-time low, meaning that the banking
industry is holding more core-funding for their loans than they have at any time inthe past decade (Exhibit 7).
Exhibit!7 !
Percent(%)
100!90!80!70!60!50!
-21%!
THE U.S. BANKING SYSTEM IS MORE LIQUID NOW
THAN AT AN ANY TIME IN THE PAST!
Source: FDIC, SNL Financial!
Total Loans as a Percent of Total Deposits for U.S. Banks!
Cash & Cash Equivalents as a Percent of Liabilities for U.S. Banks !Both ratios show that the
industry is more liquid today
that at any time in the past.!
2010
10!5!0!
Q112
2011
Percent(%)
25!20!15!
2004
2003
2002
2001
2000
2009
2008
2007
2006
2005
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The second ratio, known as theCash Ratio, is Cash and CashEquivalents-to-Liabilities. It alsogauges liquidity; however, itrepresents cash on-hand and other
assets easily converted to cash,which can then be used to pay anyfinancial obligations. As of the firstquarter of 2012, the Cash Ratio wasvalued at 23 percent (Exhibit 7).The Cash Ratio is nearly three-
times the level it was the year before the crisis and is at an all-time high. Both ratiosindicate an extremely liquid banking industry.
While the banking industry has a high level of liquidity, indicating a less risky market,a high level of liquidity also represents less profitable lending opportunities andlower demand for loans in the economy. When the economy returns to higherlevels of growth, the banking industrys liquidity will be reduced as lending increases.Therefore, increased liquidity may be a sign that the economy is still in recovery.
Insurers Capital & Surplus (C&S) Continues to Climb
The financial services industry is made up of a diverse set of sectors and companies.Each has a role in supporting the U.S. and global economies. As the crisis reflected aloss of confidence in institutions ability to meet their financial obligations, much like
the banking sector, the insurance sector has built a sizeable capital cushion for anyfuture unexpected losses.
Both U.S. Property & Casualty (P&C) andLife & Health insurers have increasedcapitalization by greater than 16 percentsince the crisis low in the first quarter of2009. As of the first quarter of 2012, totalCapital and Surplus for the P&C and Life& Health industries were $576 billion and$314 billion, respectively (Exhibit 8).Similar to banks, insurers use capital to investin new business and customers. While banks base their operations around lending,insurers invest the premiums obtained by policyholders, pay policyholders for any
losses and further reward stakeholders in the form of dividends.
!
Much like the banking
sector, the insurance
sector has built a
sizeable capital cushionfor any future
unexpected losses.
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Performance Metrics Rise to Pre-Crisis Highs
Banking industry profitability stands at its highest level since the second quarter of2007, and according to the FDICs quarterly banking profile, more than two-thirdsof all institutions reported year-over-year improvements in earnings. Few firms,
roughly 10 percent, reported losses, which is also a promising indication theeconomy has stabilized.
Since the crisis, the industry has taken painstaking steps to repair loan portfolios andhelp address borrower-refinancing needs. Like most businesses, a banks ability tomake a profit signals a healthy economy. Increased profitability for the bankingsector indicates businesses and consumers can access credit and keep up withpayments.
As new rules are released for increased capital levels, it is important that thebanking sector remains profitable.12 Profits often heavily correlate with borrowing
costs; greater profits for the industry translate to an increased supply of credit andlower costs to borrowing. Profits also are used for investing in new products andservices that end up benefiting the consumer. Lastly, profits can be used to add toan institutions capital cushion. Profitability is at its highest point since the crisis,
totaling $35.3 billion for U.S. commercial banks, as of the first quarter of 2012(Exhibit 9).
Exhibit!8 !P&C AND LIFE INSURERS CAPITAL AND SURPLUS
CONTINUES TO RISE SINCE THE CRISIS!
Source: NAIC, SNL Financial!
200
300
400
500
600
20
24
28
32
36
40
C&S as a Percent of Assets (%)!Surplus as Regards to Policyholders ($B) !40!36!32!28!24!20!
150
200
250
300
350
8!9!
6!
2008
Q112
2006
2009
7!
2011
10!
2007
2010
5!
2005
2004
2003
2002
2001
CapitalandSurplusasa
PercentofAssets(%) C
apital&
Surplus($B)
Life Insurers!
P&C Insurers!600!500!400!300!200!350!300!250!200!150!
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The U.S P&C insurance industry posted healthy profits in the first quarter of 2012,as net income rose to $12.2 billion, up from $11.2 billion just a quarter prior(Exhibit 10). During the crisis, much of the loss suffered by the P&C industry related
to loss on investment income via the market crash. However, losses also can occurfrom catastrophic events. This was seen in the second quarter of 2011 when
several natural disasters occurred throughout the world. Fortunately, a largenumber of individuals and businesses had insurance plans with many U.S.institutions, triggering massive payouts to plan owners.
Increased profits for the P&C industry are a promising sign, as income now can beused to invest, lower premium costs for buyers and as savings to absorb anyunexpected losses that occur in the future.
While the P&C industry saw healthy profits in the first quarter of 2012, the Lifeinsurance industry witnessed its most profitable quarter since the crisis. Net Incomerose from $4.4 billion in the last quarter of 2011 to $14.9 billion as of March 30,
2012 (Exhibit 10). To put this in perspective, the Life insurance industry sawmassive losses in the last half of 2008 of more than $51 billion. The large gainsassociated with the recent quarterly data strongly indicate that U.S. financialinstitutions are supporting a growing economy. The industry is still in recoverystages, as profitability is volatile from quarter to quarter. Future earnings willdetermine if the recovery is sustainable.
Exhibit!9 !BANK PERFORMANCE MEASURES ARE STILL STRONG
IN Q112!
Source: FDIC, SNL Financial!
Net Income and Return on Average Assets and !Equity for U.S. Banks!
-40
-30
-20
-10
0
10
20
30
40
-15
-10
-5
0
5
10
15
Percent(%)
Dollars($B)
Q112
Q411
Q311
Q211
Q111
Q410
Q310
Q210
Q110
Q409
Q309
Q209
Q109
Q408
Q308
Q208
Q108
Net Income ($B)!ROAE (%)!ROAA (%)!
15!10!5!0!-5!-10!
-15!
40!30!20!10!0!
-10!-20!-30!-40!
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Economic Challenges Lie Ahead European Distress
The financial industrys resilience has been on display since the recovery began.Many unknowns existed at the markets lowest point, and many still do, but theindustry has managed to provide the support needed to place the U.S. on a more
sustainable path. The following section will spotlight some of these key problemsfacing Europe, and then provide clarity around the potential impact it could have onU.S. banks and the broader economy.
A Crisis of Growth
It is apparent that what started out as a crisis of debt has morphed into a crisis ofgrowth. The loss of investor confidence is bearing down on governments asinvestors continue to question their ability to pay back debt. Though steps havebeen taken to cut government spending, increasing austerity without morestructural reforms has provided little assurance that future growth will be large
enough to resolve the issue.
Megan Greene of Roubini Global Economics writes that the trade-off betweenausterity and growth was crystal clear in Ireland in late 2010No matter what theIrish government did, it could not regain market confidence, and Ireland was forcedinto an EU/IMF bailout within weeks. She states further that Eurozone leadershave not learnt their lesson.13 To date, governments around Europe havecontinued to replicate what occurred in Ireland, only to see themselves in the same
Exhibit!10 !P&C AND LIFE INSURERS PERFORMANCE SHOWS
STRONG GROWTH IN Q112!
Source: NAIC, SNL Financial!
-15
-10
-5
0
5
10
15
-10
-5
0
5
10
15
Net Income ($B)!ROAA (%)!ROAE (C&S) (%)!
!!!!!!!!!
15!10!5!0!-5!-10!-15!
-30
-20
-10
0
10
20
-60
-40
-20
0
20
40
Q112
Q411
Q311
Q211
Q111
Q410
Q310
Q210
Q110
Q409
Q309
Q209
Q109
Q408
Q308
Q208
Q108
Percent(%) D
ollars($B)
P&C Insurers!
Life Insurers!
Net Income and Return on Average Assets and Equity!
20!10!0!
-10!-20!-30!
15!10!5!0!-5!-10!40!20!0!
-20!-40!-60!
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troubling situation. Investors have focused on a select number of countries,particularly Greece, Ireland, Italy, Portugal and Spain. According to the EconomistIntelligence Unit, GDP growth rates for 2012 among the distressed Europeanperiphery members are estimated to be the lowest in all of Europe. 14
U.S. Bank Exposure to Europe
It is no coincidence that low GDPgrowth rates are linked withratings downgrades. Yet, U.S.banks have aligned their portfolioswith countries that are rated safer(Exhibit 11). In fact, more than 72percent of all risk claims areassociated with countries with aAAA rating.15
U.S. banks exposure to the European periphery declined over 16 percent in thepast 12 months. Moreover, exposure to Europe on the whole has declined by eightpercent during that time period. (Exhibit 12). The peripheral countries of Greece,Italy, Ireland, Portugal and Spain represent less than $200 billion in risk claims, andare less than 10 percent of total exposure (Exhibit 13).16
Exhibit!11 !U.S. BANKS EUROPEAN EXPOSURE IS CONCENTRATED IN
COUNTRIES WITH HIGH CREDIT RATINGS!
Source: FFIEC, HPSInsight!
S&PCreditRating
Risk Claims ($B)!
$785.9B!
$53.8B!
U.S. banks total exposure to
Greek risk claims is less than 1%
of UK risk claims. Exposure to
peripheral countries is less than
10% of total European exposure.!
$351.4B!
$5.8B!
Total Risk Claims by Country and National S&P Ratings!
!
!"##$#%! "!"#$!"#$%&'()! "!"#$!"#$%&! ! "!"#$!"#$%&! ! "!"#$!"#$%&'(! "!"##!"#$%&'()*&(+%","-./0(!"#$%%&'$"($)*"
!"#$%&'!
!"#$!%&'()$*+,-+.
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18 | The State of Our Financial Services!
Exhibit!12 !
Percent(%)
50!40!30!20!10!0!
-10!-20!-30!-40!-50!-60!
Total
Europe!Swiss!UK!France!Germany!Italy!Portugal!Ireland!Spain!Greece!
U.S. FINANCIAL INSTITUTIONS HAVE REDUCED EXPOSURE TO
THE PERIPHERY BY OVER 16%!
Source: FFIEC, HPSInsight!
Percent Change of Country Risk Claims from Q111 to Q112!Over the course of the last 12 months, U.S.banks have reduced exposure to the
periphery from $216 billion to $181 billion
and to Europe as a whole by eight percent.!
Exhibit!13 !U.S. BANKS ARE MOST EXPOSED TO THE U.K.,
GERMANY AND FRANCE!
Source: FFIEC, HPSInsight!
< 10!10 - 100!
> 500!100 - 500!
Risk Claims ($B)!
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The continued turmoil around Europes debt problems has contributed to marketinstability. However, no U.S. bank has reported significant losses tied to the issue asof the date of this report. While it is worth noting that financial contagion effectsare an unfortunate reality and European countries with investment grade ratings
today could lose them in the future, U.S. banks have reduced exposure to Europe
and total direct exposure to the periphery is modest.
Potential Impacts on the U.S. Economy
The threat of financial contagion is ongoing. Although a major public fear is tied toU.S. banks exposure to Europe, there are other important threats to the U.S.economy that are not linked to the U.S. banking sector. For instance, manyemerging markets obtain funding for imports from European banks. If their sourceof funding is cut off, exports to these countries could dry up. This could have a largeimpact on U.S. GDP, since emerging market economies have represented a largeshare of U.S. export growth over the last several years. In fact, U.S. exports to Brazilalone have increased 70 percent since 2007. Although total exports only accountfor roughly 14 percent of U.S. GDP, the increase in exports represents nearly halfof GDP growth in the U.S., according to RBC Capital Markets chief U.S. economist,Tom Porcelli.17
Further distress in Europe could also lead to other issues for the U.S. economy,including direct exports to Europe, U.S. banking losses tied to European debt, andsupply-chain issues involving U.S. multinational firms. When compiling the potentialimpact of emerging market exports with other factors, a Euro break-up could haveserious consequences for the U.S. economy.
Summary
The financial services industry as whole continues to increase levels of safety andsoundness shown through both capitalization and liquidity measurements, althoughincreased levels of capitalization and liquidity are no free lunch as a tradeoff existsbetween these measurements and economic growth. Higher levels of liquidity arealso being driven by a low demand for loans, rather than a low supply. Thisindicates that while the financial sector has quickly repositioned itself since the crisis,other parts of the U.S. economy are recovering at a slower pace. If the economyreturns to higher levels of growth, then liquidity and capitalization will decrease.Therefore, the balance between safety and growth is a delicate one.
As the industry faces global economic challenges, i.e. crises in Europe, its currentlevels of capitalization and liquidity will contribute to, rather than reduce, systemwide stability. Even though banks are continually adjusting to safeguard themselvesagainst catastrophe, the trouble in Europe could potentially impact the U.S.economy via emerging market exports and other links. To an extent, the negativeeffects on the U.S. economy from a further deepening of the European crisis are inmany ways unavoidable.
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20 | The State of Our Financial Services!
Value to the Economy:Increasing Loans During the Recovery
The diversity of institutions in the U.S.financial sector enables individuals andbusinesses to meet all of their financialneeds efficiently. Insurance companiesinsure individuals and businesses against
catastrophes, accidents and unforeseencrises. Community banks provide loans tolocal restaurants and help set-up a highschool students first bank account, while
the largest U.S. banks supply capital,foreign exchange and trade financing tohelp Americas companies sell productsworldwide.
As the winter HFI detailed, U.S. banksprovided financial shelter during the
recession. As a result, commercial bankdeposits increased 25 percent andconsumer credit card loans rose 70percent. When the recovery began, U.S.banks quickly increased loans tobusinesses, including a six percentincrease in 2011.
In the first half of 2012, U.S. economicgrowth decelerated, householdscontinued to deleverage, and uncertainty
about the fate of the Eurozonepermeated the economic climate. Bankscontinued to play the dual role of financial shelter for investors seeking refuge fromvolatile markets and supporter of the recovery for businesses looking to expand.Meanwhile, insurers whose services are less tied to the state of the economycontinue to aid individuals and businesses.
!
Key Findings Q112:
Total loans and leases
rose to $6.8 trillion.
Domestic business loans
rose above $2 trillion
and small business
owners borrowingsatisfaction continues to
improve.
P&C and Life Insurerspaid out $338 billion and
$493 billion in benefits,
respectively.
The total U.S.retirement market
reached $17.9 trillion,
an all-time high.
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The National Economy and Individuals Balance Sheets
After a strong fourth quarter in which the economy grew at a three percentannualized rate, U.S. economic growth decelerated, only expanding at a modest 1.9percent annual rate in the first quarter of 2012. Similarly, job growth, while strong
throughout the winter, fell below 100,000 in April and May. Spring retail salesflatlined, job openings declined and the unemployment rate ticked up. These pastsix months exhibit the economys continued fragility three years after the recessionofficially came to an end (Exhibit 14).
With slower economic growth, consumers continued to deleverage in 2012(Exhibit 15). According to the New York Federal Reserves Quarterly HouseholdCredit and Debit Report, households have reduced total debt burdens by 10percent since the crisis and total household debt is down to $11.43 trillion, a level
not seen since late 2006. Mortgage and home-equity debt fell one percent and 2.4percent respectively, while auto and student loan debt rose slightly.
Deleveraging places households on sounder financial footing for the future.However, it can also potentially drag economic growth. Typically, deleveraging isdiscussed as a temporary phenomenon with the expectation that householdseventually will gain confidence and increase spending. New evidence, though,suggests that households may have adjusted to a new normal.
Exhibit!14 !
RealGDPGrowthPercentage(Annualized)(%)
8!6!4!2!0!-2!-4!-6!-8!-10!
Q112
Q411
Q311
Q211
Q111
Q410
Q310
Q210
Q110
Q409
Q309
Q209
Q109
Q408
Q308
Q208
Q108
No
nfarm
PayrollMonthlyChange(InThousands)
800!600!400!200!
0!-200!-400!-600!-800!
-1,000!
First and second quarter
GDP and job growth iscontinuing to slow down
through the summer.!
THE ECONOMIC RECOVERY DECELERATED IN THE
FIRST HALF OF 2012!
Source: BEA, BLS!
Nonfarm Payroll Monthly Change and Real GDP Growth! GDP Growth (%)!Payroll Growth!
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22 | The State of Our Financial Services!
Household deleveraging continues despite Federal Reserve data demonstrating thatmonthly financial obligations are at lows not seen sine the early 1990s. On average,households allocate about 16 percent of their income to meet their monthlyfinancial obligations, which include debt service, rent for tenant-occupied
households, automobile leases, homeowners insurance and property taxes. This issignificantly lower than the 19 percent they spent before the recession.
Continued deleveraging despite low monthly financial obligations is consistent withlow growth expectations. In fact, the expected increase in inflation-adjusted familyincome has plummeted since the recession according to data from the ThomsonReuters/University of Michigan Survey of Consumers. After 20 years of reportingexpectations of a two-to-three percent increase in family income over the next 12months, households have foreseen less than a 0.5 percent increase, the lowestmedian level on record. These data points suggest that rather than deleveraging tohelp pay current bills, households may be using their excess income as insurance tohandle future financial shocks.
Moreover, the fall in housing prices erased a significant amount of wealth thatallowed people to borrow and spend more. Therefore, with the baby boomersretiring, it is welcome news to see retirement accounts rebounding strongly from
the crisis. In fact, in the first quarter of 2012, the total value of the U.S. retirementmarket reached a record high of $17.9 trillion (Exhibit 16). According to theInvestment Company Institute (ICI), as of the third quarter of 2011, retirement
Exhibit!15 !
Total Q112 Change: ! - 0.9%! Mortgage debt: ! - 1.0%! HE Revolving:! ! - 2.4%! Auto Loans: ! ! +0.3%! Credit Card: ! ! - 3.6%! Student loan debt: ! +3.4%!
7!
12!
9!10!
8!
6!Mortgage!
HE Revolving*!Auto Loan!Credit Card!Student Loan!Other!
Q111
Q110
Q109
Q108
Q107
Q106
Q112
Dollars($T)
11!
13!
HOUSEHOLDS ARE CONTINUING TO REDUCE
DEBT BURDENS IN 2012!
Source: The Federal Reserve Bank of New York, !*Home Equity!
Total Household Debt by Type!
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savings comprised 36 percent of all household financial assets. Current and soon-to-be retirees lost a significant amount of wealth due to the plunge in home prices, but
the recent gains in the retirement market have helped provide more financialsecurity to individuals.
Financial Shelter
Given the fragility of the recovery in the first half of 2012, the U.S. financial sectorcontinues to serve as a safe haven in times of economic crisis. In the first quarter of2012, the U.S. financial industry continued to play the role of safe keeper asdeposits continued to rise, topping out at $9.46 trillion. Moreover, core deposits,which are comprised of accounts holding $250,000 or less, excluding brokereddeposits, and are considered highly liquid, continued to rise. As a percent of totalliabilities, they now stand at 76.2 percent, the highest level since 1993 (Exhibit 17).This level of core deposits provides a large and stable base to fund loans.
Not only did the level of deposits rise, but also the growth rate was faster than theprevious several periods. From the fourth quarter of 2011 through the first quarterof 2012, the growth rate of deposits increased from 9.2 percent to10.3 percent.
As noted earlier, the LTD ratio for U.S. commercial banks continued to fall andnow sits below 70 percent. While the drop represents a more liquid bankingsystem, it also reflects an increased flight to safety as individuals and companies look
to avoid volatility in the markets.
Exhibit!16 !THE TOTAL RETIREMENT MARKET REACHED AN ALL-
TIME HIGH OF $17.9 TRILLION AT THE END OF 2011!
Source: Investment Company Institute!2001
2000
2002
14!16!
Dolla
rs($T) 12!
10!8!6!4!2!
+13%!
IRAs!
DC Plans!
Private DB Plans!
18!Federal Pension Plans!Annuities!
2011
2010
2009
2008
2007
2006
2005
2004
2003
State and Local !Government Pension Plans!
Total U.S. Retirement Market!
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24 | The State of Our Financial Services!
Providing Credit
Despite the economic slowdown and continued movement toward safety, U.S.commercial banks still increased loans to the economy. Total loans and leases in the
first quarter of 2012 rose to $6.8 trillion, slightly below the all-time high set in 2008(Exhibit 18). The increase in loans was driven by rises in real estate lending.
While still increasing, loan growth has slowedin 2012. In the third and fourth quarter of2011, loans grew at 11.4 and 9.3 percent,respectively. During that time, the loangrowth rate outpaced the deposit growthrate. However, in the first quarter of 2012,
the loan growth rate slowed to 4.55 percent.The underlying dynamics show an economy
in flux where consumers pull back from creditneeds, businesses continue to expand at a moderate pace and the housing marketshows signs of life.
Exhibit!17 !DEPOSITS CONTINUED TO CLIMB THROUGHOUT THE
RECESSION AND RECOVERY!
Source: FDIC, SNL Financial!
30
40
50
60
70
80
90
100
TotalDeposits($T)
10!9!8!7!6!5!4!3!2!
CoreDeposits/TotalDeposits(%)
+24%!
Q112
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
Total Deposits and Total Core Deposits!
as a Percent of Total for U.S. Commercial Banks! Total Deposits ($T)!Core Deposits/Total Deposits (%)!100!90!80!70!60!50!
40!
30!
!
Total loans and leases in
the first quarter of 2012
rose to $6.8 trillion,slightly below the all-
time high set in 2008.
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Loans to Businesses
The rise in total loans and leaseswas driven by increasedcommercial and industrial loans.
Commercial and industrial loansincreased to $1.3 trillion in thefirst quarter of 2012. Thisgrowth offset the fall inconsumer loans, which wasdriven by a reduction in creditcard loans (Exhibit 19). U.S.commercial banks alsocontinued to increase loans to
businesses in the first quarter of 2012 by three percent. Total loan volume nowtops $2 trillion, the second-highest level on record. Since the end of 2010, domestic
business loans have risen almost 10 percent (Exhibit 20).
Exhibit!18 !TOTAL LOANS AND LEASES ROSE TO $6.8
TRILLION IN THE FIRST QUARTER OF 2012!
Source: FDIC, SNL Financial!
Total Loans from U.S. Commercial Banks!
Dollars($T)
7!
6!
5!
4!
3!Q112
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
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26 | The State of Our Financial Services!
Exhibit!19 !COMMERCIAL AND INDUSTRIAL LOANS HAVE DRIVEN
INCREASES IN NON-REAL ESTATE LOANS IN 2012!
Source: FDIC, SNL Financial!
Dollars($T)
2.8!2.4!2.0!1.6!1.2!0.8!0.4!0.0!
Q112
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
Consumer Loans and Commercial and Industrial Loans !for U.S. Banks! Consumer Loans ($T)!
Commercial & Industrial Loans ($T)!
Exhibit!20 !TOTAL DOMESTIC BUSINESS LOANS HAVE
INCREASED IN Q112 TO $2 TRILLION!
Source: FDIC, SNL Financial!
Dollars($T)
2.5!
2.0!
1.5!
1.0!Q112
$2 Trillion!
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
Total Domestic Business Loans ($T)!Total Domestic Business Loans for U.S. Banks!
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While total domestic business loans continued to increase, their rate of growth
decelerated from six percent to three percent. This change more than likely reflectsreduced demand for loans as economic growth decelerated.
Commenting on the drop in small businessloans, Paynet founder Bill Phelan said,"These businesses are cautiousThey'reholding back on new investments andexpansions in their businesses, and that'sreally a result of the view of uncertainty in
the marketplace."18 The Federal ReserveSenior Loan Officer survey found that from
January to April 2012, a majority of banks easedstandards on Commercial and Industrial loans. The NFIB Small Business Optimismsurvey tells a similar story, as small-business owners are not signaling reduced loanavailability or lower levels of borrower satisfaction from the previous year (Exhibit21). Moreover, only three percent of small-business owners cite financing as theirlargest problem.19 Businesses that need funding are becoming more likely to receiveloans from banks than several years ago.
!
!
Spotlight: U.S. Bank Support for Metropolitan Transportation
Tashitaa Tufaas bus company, Metropolitan Transportation Network Inc., is on course tohave its best year yet in the Minneapolis-St. Paul metropolitan area. The company plans to
add between 60-80 new buses to its fleet of 300 for the school year that begins this fall,and it already has added 60 new jobs this year. Its strong growth earned the company aspot on the Minneapolis-St. Paul Business Journals l ist of top 50 fastest-growing companiesin the area.
Tufaas success did not come easy. The company hit a rough patch in the midst of therecession as school districts cut costs wherever possible. Tufaa weathered the storm until2011 by self-financing and continually putting money back into the business. That year, hesought counsel from U.S. Bank.
U.S. Bank examined Metropolitan Transportation and determined how it could help thecompany become more profitable and grow. The bank proposed that the companyconsolidate its multiple sites into one location to save time and travel. The company took
the advice and a year later has added employees and equipment. Tufaa expects revenueto rise to record levels.
Consolidating the worksites allowed the company to purchase larger fuel tanks, which hasprovided major savings in the high fuel-cost environment. The new garage is top of theline and makes others want to learn from us, says Tufaa. U.S. Bank helped us controlunnecessary costs and made the consolidation process easy.
Businesses that need
funding are becomingmore likely to receive
loans from banks thanseveral years ago.
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28 | The State of Our Financial Services!
Loans to IndividualsBeyond loans to businesses, banks lend to consumers to help finance consumerspending. Overall, consumer loans have fallen since last quarter, led by a slight dropin credit-card loans. However, as we saw in the winter HFI, credit-card loans
increased 70 percent during the crisis as consumers looked to finance purchases intough times. Therefore, a gradual reduction of these loans is unsurprising in theshort-term. Consumers have continued to increase their holdings of automobiledebt to finance car purchases for the fifth consecutive quarter. May auto sales wereup 17.4 percent from 12 months earlier. The largest type of loan to individuals, real-estate loans, has started to tick up for the first time since the crisis. Total real-estateloans rose to $3.6 trillion in the first quarter of 2012 (Exhibit 22).
Exhibit!21 !SMALL-BUSINESSES LOAN AVAILABILITY AND BORROWER
SATISFACTION REMAINED UP SINCE THE END OF 2011!
Source: NFIB Small Business Optimism Survey!
3-Month Rolling Average of Net Small-Business Owners Responding Loan
Availability is Increasing vs. Decreasing and That Borrowing Needs AreSatisfied!
BorrowingNeedsSatisfied(%)
45!40!35!30!25!20!15!10!5!0!
LoanAvailability(%)
0!
-10!
2012
2011
2010
2009
2008
2007
2006
-5!
-15!
Borrowing Needs Satisfied!Availability of Loans!
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!
Spotlight: Fifth Third Bank Support for Square 1 Art
In 1999, Andrew Reid, a former businessman, and his wife Martha, a former elementaryschool art teacher, received a small loan from Ballston Spa National Bank to combine
their passions and start their own business, Square 1 Art. The company reproduceschildrens art onto shirts, mugs and other products and shares the profits of their saleswith schools. The product affirms students artistic achievements, gives parentskeepsakes of their childrens art and provides schools a fundraising option in difficultbudget times.
After several years of impressive 20 percent annual growth, Square 1 Art had theopportunity to expand. Andrew and Martha moved the operation from Upstate NewYork to Atlanta. They recently acquired 84,000 square feet of warehouse space toincrease production, employment and opportunities for schools throughout the country.Tired of expensive leases, they found a partner in Fifth Third bank. It representedSquare 1 Art to the Small Business Administration for a loan guarantee. The couplereceived a larger line of credit that allowed them to make critical purchases and meet
the up-and-down cost requirements of a highly seasonal business.
Fifth Third is known as a bank with a hands-on approach. Andrew, for one, needed toknow what will a bank do for you todayandwhat will they do for you tomorrow. Hefound a bank ready to tackle his financing needs while giving his wife and him the
confidence to take advantage of growth opportunities down the road. Not only isSquare 1 Art the realization of the American Dream for them, it has also become thatfor their adult children, Travis and Jane, who are now members of the leadership team.Square 1 Arts continued growth will mean the passing down of the family business
thanks to two caring banks.!
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30 | The State of Our Financial Services!
Throughout the recovery, many analysts predicted a housing bottom and, according
to CoreLogic data, housing prices increased month-over-month in both March andApril, thus showing signs of stabilization. Housing starts also increased significantlyfrom last year according to data from theDepartment of Commerce. In May, year-over-
year total privately owned housing unit startswere up 28 percent at a 708,000 seasonallyadjusted annual rate. With inventories
tightening in many markets, especially in themultifamily sector, Americas housing sectorshowed promise of making a comeback andpropelling the recovery. In fact, residentialinvestment increased 19.3 percent in the first quarter of 2012. Despite recent gains,
the housing market remains in recovery given the low levels of starts. Thefundamentals of the market still point to slow but improving growth in the near-
term.
Every year from 1992 to 2006, more than 1 million single-family homes werestarted, more than double the current rate of 492,000. The annual pace ofmultifamily home construction, which is up over 100 percent from 2009 lows, is still17 percent below the average from 1990 to 2008 (Exhibit 23).
Exhibit!22 !REAL-ESTATE LOANS HAVE INCREASED IN THE
FIRST QUARTER OF 2012!
Source: SNL Financial, FDIC!2001
2005
2011
2010
2009
2006
2007
2008
Q112
2000
2002
2003
2004
Dollars($T)
1!
4!
2!
3!
U.S. Commercial Bank Real Estate Loans!
!
In May, year-over-year privately ownedhousing unit starts
were up 28 percent.!
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While overbuilding occurred prior to the recession, low levels of construction in thelate 2000s brought household construction more in line with household formationin the 2000s (Exhibit 24). Demand for housing has slowed for two reasons:household formation has declined significantly since the crisis; and consumers
tenuous credit situations make mortgage lending more risky.
Household formation since the crisis is 57 percent below trend growth, equating tothree million missing households (Exhibit 25). More specifically, the high rate ofyouth unemployment combined with rising student debt levels may have led tosignificantly less household formation among recent college graduates. According to
the Census CPS/HVS survey, more men and women aged 24 to 30 years old areliving with their parents now than in the past 20 years. Nineteen percent of menand 10 percent of women in this age group currently live with their parents,compared to 14 and nine percent pre-recession. Moreover, the entire dropoffcomes from family household formation as opposed to groups.
Exhibit!23 !WHILE INCREASING THIS YEAR, NEW HOUSING
STARTS ARE WELL BELOW NORMAL LEVELS !
Source: Census CPS/HVS!
0.2!
0.8!
1.8!1.6!
1.0!
0.6!
1.2!
2.2!
0.4!
1.4!
0.0!2012
2011
2010
2009
2008
2007
2006
2.0!
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
Multifamily! Single Unit!Single Unit and Multifamily Starts!
Millions
Multifamily starts have
increased while single
unit starts continue to
lag!
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32 | The State of Our Financial Services!
Exhibit!24 !RELATIVE TO HOUSEHOLD FORMATION, THE 2000S DID
NOT SEE SIGNIFICANT OVERBUILDING IN HOUSING!
Source: Census Decennial, CPS/HVS, HPS Insight!
Starts(Thousands)
18!17!16!15!14!13!12!11!10!9!8!7!
HouseholdsAdded(InMillions)
17!16!15!14!13!12!11!10!9!8!7!
2000s!1990s!1980s!1970s!1960s!
New Households!Starts!Pace of 2000-2007!Housing Starts and Household Formation!
There was a boom in the
early 2000s. We were on
pace to build more houses
in that decade than any
since the 1950s while
having a very low level of
household formation. !!However, the bust over the
past four years brings the
total to normal levels.
Moreover, low levels of
construction in 2011
continues to reduce supply
issues.!!
Exhibit!25 !SINCE 2007, HOUSEHOLD FORMATION IS ROUGHLY 3
MILLION HOUSEHOLDS BELOW TREND!
Source: Census CPS/HVS, HPS Insight!
Households(InMillions)
125!
120!
115!
110!
105!2012
2010
2008
2006
2004
2002
2000
3 million
households!
Household Formation!Household formation
is 53% below trend
since 2007.!The reduction in
household formation puts
downward pressure on
prices and reduces the
incentive to build new
single and multifamily
units.!!However, if household
formation snaps back to
trend, inventories will
tighten, putting upward
pressure on prices. Higher
prices will incentivize
more housing starts. !
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This data suggests that new families are putting off moving into their own home. Inaddition to young people moving in with parents, a decline in immigration hasreduced household formation during the crisis.
Beyond slower household formation, high debt levels and poor credit further
constrain growth in the housing market. The main method for deleveraging hasbeen foreclosing on houses. According to The McKinsey Institute, two-thirds ofhousehold deleveraging has been through foreclosures and defaults on consumercredit.20 While this reduces debt burdens, the negative effect on credit scoresmakes mortgage lending less attractive. Real-estate assets, while improving forbanks, still have high non-performing rates (Exhibit 26).
Banks have responded to these dynamics by tightening lending standards for lesscreditworthy borrowers - 90 percent of all new mortgages last year went toborrowers with high credit scores compared to 50 percent several years ago.21 Thishas helped banks improve their balance sheets, but it also results in less lending and
lower growth in the sector.
Despite headwinds, the fundamentals show signs of improvement. Home prices arebeginning to stabilize, inventories are shrinking, debt burdens are falling and real-estate loan performance is improving. With the improved bank balance sheets asdetailed in Section 2 of the report, banks should be in a prime position to support asustained housing recovery. In the near-term, the fundamentals point to an increasein multifamily housing, as the vacancy rate is historically low and rental prices have
Exhibit!26 !
Source: SNL Financial, FDIC!
NONCURRENT REAL-ESTATE LOANS ARE IMPROVING,
BUT ARE STILL ABOVE HISTORICAL NORMS!
20!10!0!
2012
!2011
!2010
!2009
!2008
!2007
!2006
!2005
!2004
!2003
!
15!
10!5!0!
10!5!0!6!4!2!0!
Noncurrent Total
Real Estate vs Non
Real Estate (%)!
Noncurrent 1-4Unit Family Loans
(%)!
NoncurrentMultifamily Unit
Loans (%)!
Noncurrent Land
Dev/ Construction
Loans (%)!
Noncurrent Non-Real Estate Loans (%)!Noncurrent Real Estate Loans (%)!!
Noncurrent Non-Real Estate loans
have fallen unlike
Real Estate Loans! Noncurrent 1-4
Unit Family Loans
remain very high!! Noncurrent
Multifamily and
Land Dev/
Construction
Loans have fallen
but remain high!
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skyrocketed (Exhibit 27). Most recently, Reis data shows the rental vacancy ratedropping to 4.7 percent, the lowest point in a decade.22 It is not surprising to see
that U.S. banks have increased multifamily loans by six percent as of the first quarterof 2012.
Insurance: P&C and Life
While the volume of bank deposits and loans are affected by the state of themacroeconomy, individuals and businesses rely on insurers for support regardless of
the state of the economy. The main categories of insurance are personal auto,which accounted for 39 percent of total premiums, and home and farm ownership,which comprised 15 percent of all premiums. The broad categories listed aboveobscure the actual scope of insurance in the United States. State fairs, food trucks,even hot air balloons, require insurance for business owners to provide their serviceat a reasonable price for consumers. By pooling risks, insurance companies offerindividuals and businesses a low cost way to hedge against catastrophes.
In the first quarter of 2012, P&C insurance premiums, the dollar value paid to theinsurance company in exchange for coverage, continued to rise from 2009 lows,reaching $449 billion. Meanwhile, payouts, which set an all-time record in 2011,dipped slightly in the first quarter of 2012 to $338 billion (Exhibit 28).
Exhibit!27 !THE FUNDAMENTALS POINT TO EXPANSION IN
MULTIFAMILY MARKET!
Source: Census CPS/HVS, St. Louis Federal Reserve !
100
150
200
250
300
350
400
450
V
acancyRate(%)
12!11!10!9!8!7!6!
RentPriceInd
ex
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
V
acancyRate(%)
3!
2!
1!
0!Case-S
hillerPriceIndex
220!200!180!160!140!120!100!80!60!
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
Rental Vacancy Rate !and Price Index!Home Vacancy Rate and !Case-Shiller Price Index! Vacancy Rate (%)!
Rent Price Index!Vacancy Rate!Case-Shiller Index!
Homeowning market vacancy rates remain elevated
and prices continue to fall!Rental vacancy rates are falling and prices are risingrapidly!
450!400!350!300!250!200!150!100!
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Exhibit!28 !P&C PREMIUMS AND PAYOUTS REMAINED
STEADY THROUGHOUT THE RECESSION!
Source: FDIC, SNL Financial !*Premiums are annualized and Loan & Loss Adjusted Expenses are calculated on a Last-Twelve Months basis!
100
200
300
400
500P&C Insurers Net Premiums Written!500!
400!300!200!100!
100
200
300
400
2008
2011
Q112*
2009
2010
2007
2006
2005
2004
2003
2002
2001
2000
Dollars($B)
P&C Insurers Loan & Loss Adjusted Expense (Payouts)!400!
300!
200!
100!
!
Spotlight: Allstate Support for the Gasmans
Dustin and Jill Gasman were driving to the airport to start a relaxing summer vacation inMexico when they noticed their car was having issues. Dustin discovered the catalyticconverter, a device designed to reduce harmful emissions released from a vehiclesexhaust, was sawed off. With no choice but to leave them unresolved before takeoff,Dustin quickly filed a claim and notified their Allstate agent Scott Burlet. Understandinghis clients situation, Scott notified Allstate claims adjuster Mike Nelson and, together,
they worked diligently to ensure the Gasmans had a vacation free of worries about theircar.
Nelson traveled to the Gasmans car, crawled under it to take pictures and arranged fora nearby mechanic to make the necessary repairs. He also arranged a rental car for theGasmans when he realized the repairs wouldnt be finished in time.
The Gasmans were very appreciative. All the parts had been ordered, so all I needed todo was pick our car up from the hotel and drop it off [at the dealership, said Dustin.
Burlet credits mechanic Nelson for his service. He did the extra footwork and arrangedeverything, said Burlet. For Nelson, though, helping the Gasmans wasnt a big deal. Itwent without saying that we needed to do what we could to get the problem resolved,he explains.!
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The Life industry had Premiums, Consideration and Deposits (a comparable metricto Net Premiums for the P&C industry) of $627 billion in the first quarter of 2012,a record high. In the first quarter of 2012, payouts for the industry amounted to$493 billion (Exhibit 29). Life insurance payouts are measured in the form ofBenefits and Surrenders. Benefits include death benefits, matured endowments,
annuity benefits, accident & health benefits, guarantees, group conversions, and lifecontingent contract pay. Surrender benefits and withdrawals for life contractsinclude all surrender or other withdrawal benefit amounts incurred in connectionwith contract provisions for surrender or withdrawal.
As stated above, insurance companies main role is to pool risk to help individualsand companies hedge against unexpected losses. To ensure they can cover lossesadequately, P&C and Life insurers charge premiums. However, one method tolower premiums or provide better benefits to customers is to invest premiums instock markets, bonds and other asset classes. These investments not only helpinsurers better service their customers, but also contribute to economic growth by
turning idle savings into capital for growing companies. As a whole, the insuranceindustry held cash and investments of $4.74 trillion in the first quarter of 2012, ofwhich Life insurers have $3.38 trillion in investments and P&C insurers have $1.36
trillion.
Exhibit!29 !LIFE INSURERS PREMIUMS AND PAYOUTS REMAIN
AT ELEVATED LEVELS!
Source: FDIC, SNL Financial!*Premiums are annualized and Payouts, Surrenders and Benefits are calculated on Last-Twelve Month basis!!
700!600!500!400!300!200!100!
Net Premiums, Considerations and Deposits for Life Insurance!
0
100
200
300
400
500
600
Benefits ($B)!
Surrenders ($B)!
Q112*
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
Dollars($B)
Life Insurance Payouts, Surrenders and Benefits!600!500!400!300!200!100!
0!
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Summary
Despite the deceleration of economic growth, financial services still played a vital role as afinancial shelter, supporter of the recovery and insurer against risk. As detailed in the firstsection, the financial sectors efforts to increase the level of safety and soundness may lead
to reduced lending in the short run. Meanwhile, economic uncertainty has reduced theamount of leverage that households and businesses are willing to undertake. However, byraising capital levels now, banks will be in a better position to contribute sustainably toeconomic growth as the economy continues to improve.
!
Spotlight: Wells Fargo Support for Green Technology and Enfinity
Wells Fargo views solar energy as a viable source of power for the future. Recently, itaffirmed its commitment to environmentally friendly business opportunities by pledgingan additional $30 billion of support by 2020. In the past seven years alone, Wells Fargohas provided more than $11.7 billion in capital across their environmental portfolio,
which includes investments in green buildings, green businesses, and renewable energyprojects. As Jason Kaminsky, vice president of its Environmental Finance group, explains,Wells Fargo is committed to meeting the financial needs of both small and largecompanies integral to the growth of the solar industry."
One Wells Fargo relationship is with Enfinity, among the worlds largest solar developerswith over 390 megawatts of worldwide installed solar capacity. Enfinity provides solarenergy directly to commercial and government customers to provide electricity savings.!David Shipley, Chief Financial Officer for Enfinity in the Americas, says that Enfinityis extremely bullish about the opportunities for growth in distributed solar generation,but we need partners like Wells Fargo to make it happen. Initially, Enfinity relied on
Wells Fargo to provide foreign-exchange services to manage its international operation.More recently, it has invested directly into Enfinity projects.
Describing the relationship between the two companies, David says, Enfinity works withinvestment partners like Wells Fargo that have the appetite and mission to invest in solarassets. Their relationship illustrates how banks and businesses can work together tobring innovative new services to the market.
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Policy Spotlight:The Economic Impact of the Fiscal Cliff
Without legislative action, on January1, 2013, federal tax and spendingpolicy will change so drastically that
the U.S. economy will undergo thelargest year-over-year fiscalcontraction in the past 40 years(Exhibit 30). While partially unwinding
the effects of the fiscal expansion in
2009, the staggering magnitude of thisfiscal adjustment and the severity of itsconsequences have earned thisphenomenon the nickname the fiscalcliff. Without action to avoid thefiscal cliff, the U.S. could be at risk offalling into a recession in 2013.
Moreover, the fiscal cliff only adds toexisting economic concerns such as
the Chinese economy showing signs
of a slowdown and the fate of theEurozone remaining in doubt.Meanwhile, the U.S. is also expected
to hit the debt ceiling in early 2013,meaning Congress will have tostruggle with both the fiscal cliff and
the debt ceiling debate potentiallyamidst a global slowdown.
However, despite the hyperbole of itsnickname, the fiscal cliff represents aset of choices with tradeoffs in theshort and long run. This section of thereport seeks to explain the manyaspects of the fiscal cliff while properlycontextualizing the issue within thedebt ceiling debate, the U.S.precarious fiscal position and thedisposition of the Federal Reserve.
!
Key Findings:
The fiscal cliff
represents the potential
for the largest year-
over-year fiscalcontraction in fourdecades.
66% of the fiscal cliff is
revenue increases.
The debt ceiling willneed to be raised early
in 2013. Last yearsdebate caused
significant turmoil in the
markets.
Monetary policy canoffset some of the fiscal
cliff, but new Fed action
would yield diminishing
returns and is
constrained by inflationconcerns.
!
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One expiring tax that has received too little attention is the 2007 MortgageForgiveness Debt Relief Act and Debt Cancellation. Normally, if a person owes$100,000 and the lender forgives 20 percent, the borrower must report $20,000 as
taxable income. This provision excludes mortgage debt forgiveness from taxation.Without action, this provision will expire, reducing the effectiveness of foreclosure
prevention efforts for struggling homeowners.
On the spending side, automatic spending cuts or sequestration under the BudgetControl Act (BCA) accounts for $65 billion, or 64 percent of total spending cuts.Also, the expiration of extended unemployment insurance benefits will reduce totalpayments by $26 billion in 2013.
The BCA was passed in the summer of 2011 as a part of bipartisan compromise toraise the debt ceiling. Sequestration was imposed as a backstop to ensure thatdeficit reduction promised by the law would be achieved. These spending cutsprimarily affect defense and nondefense discretionary spending, which together
make up roughly one-third of the budget. The remainder of federal spending islargely made up of entitlements, which are barely affected by the BCA. Forexample, the maximum cut to Medicare is only 2 percent. Meanwhile, Medicaid, S-Chip and SNAP (food stamps) are exempt.
Most analysis of the impending fiscal cliff focuses on the collective impact of allthese decisions on aggregate demand in the national economy. However, eachaspect of the fiscal cliff impacts a specific part of the U.S. economy.
Exhibit!31 !
BillionsofDollars($B)
700!600!500!400!300!200!100!
0!Fiscal Cliff!
$607 B!
Continuation
of other
existing
policies!
Cut in
Medicares
payment!Unemploy-!
ment
Benefits!Budget
Control Act!AffordableCare Act!Other*!Payroll!Income andEstate!Source: Congressional Budget Office !*The main provision expiring is the partial expensing of investment properties, !
66% OF THE $607 BILLION FISCAL CLIFF IS REVENUE
INCREASES!
$399 B in Tax Hikes!$105 B in Spending Cuts!
Fiscal Cliff Breakdown!Total fiscal adjustment is about5% of GDP in CY 2013 and the
U.S. would fall into a recession.!
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What Are The Near-Term Economic Consequences?
The Congressional Budget Office (CBO) estimatesthat if the fiscal cliff is not avoided, the shock to the
economy will likely cause the U.S. economy tocontract deep enough to be judged a recession.They project the economy will contract in the firsthalf of 2013 by 1.3 percent and, compared to aneconomy where all provisions were extended, near
term GDP growth would be reduced by fourpercentage points in 2013 (Exhibit 32).
The CBOs findings are echoed by analysts for Goldman Sachs, who estimates afour percent reduction in growth25, and David Greenlaw of Morgan Stanley, whoargues that even with ultraconservative multipliers, it seems almost certain the U.S.
would enter into a recession next year if the fiscal cliff is not avoided. Moreover,38 of 39 top economists surveyed by the University of Chicago Booth BusinessSchool agreed that output would be lower than the alternate fiscal scenario (whichavoids most of the fiscal cliff) if no action were taken.26
The economic analyses cited above are concerned that the fiscal cliff willsignificantly reduce aggregate demand in the economy. If the fiscal cliff is notavoided, all households would see an immediate reduction in cash as payroll taxes
Exhibit!32 !THE FISCAL CLIFF MAY REDUCE GDP GROWTH BY 4% IN
2013 AND CAUSE A RECESSION IN THE FIRST HALF OFTHE YEAR!
Source: Congressional Budget Office!
Percent(%)
4.5!4.0!3.5!3.0!2.5!2.0!1.5!1.0!0.5!0.0!
2013!
-4%!
2012!2011!2010!
2.5!2.0!1.5!1.0!0.5!0.0!
-0.5!
-1.0!-1.5!
Second half!2013!First half!2013!
With Cliff!Without Cliff!Real GDP Growth! Without avoiding the fiscalcliff, the U.S. would fall into
a recession in the first half
of 2013 !
!
!If the fiscal cliff isnot avoided, the
shock to the
economy increases
the risk of a U.S.
recession.!
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rise. And while income tax hikes willnot be paid until 2014, people will cutspending immediately to save for theirfuture tax bills. Spending program cutswould directly impact government-
dependent jobs, while reducingunemployment assistance will impactconsumer spending. With less after-taxincome, spending will decline.
Moreover, according to research byChristina and David Romer of theUniversity of California at Berkeley, the effectof tax hikes on demand for goods and services is magnified as businesses reducedgrowth expectations translate into lower investment. In total, they find a taxincrease of one percent of GDP reduces inflation-adjusted GDP by roughly threepercent.27 In the intervening time period, uncertainty around policy could putbusiness investment on hold, further stifling growth.
Is The Fiscal Cliff All Bad?
While falling off the fiscal cliff could cause a recession in 2013, it would alsodrastically reduce the federal governments debt concerns in the medium term andwould actually increase output in the long-term. Focusing on the magnitude of theyear-over-year fiscal contraction conceals the fact that last year we spent 24.1percent of GDP while only collecting 15.4 percent of GDP in revenues. According
to Office of Management and Budget data, historically, those averages are 19.7percent and 17.7 percent, respectively. This current imbalance is simplyunsustainable and fiscal contraction is both necessary and inevitable. The question iswhether the contraction is achieved rationally over a period of years or abruptly via
the fiscal cliff.
If there is no action taken to avoid the fiscal cliff, the tax hikes and spending cutswould push federal debt as a percentage of GDP down from 73 percent to 61percent by 2022. Meanwhile, the CBOs alternative fiscal scenario, which avoidsmost of the fiscal cliff without addressing lingering deficits, would increase this ratiofrom 73 percent to 93 percent by 2022 (Exhibit 33).
Reducing government debt, while most likely very painful in the short-run, will
actually raise economic growth over the next decade. As the economy fullyrecovers, higher deficits will crowd out private investment; therefore, by reducingour debt now, higher levels of investment will finance faster growth over the courseof the decade. While a trade-off exists between short-run deficit-financed tax cutsand spending and long-run growth, they are not mutually exclusive if legislation tomitigate the fiscal cliff includes provisions to reduce deficits in future years.
!
Moreover, 38 of 39 top
economists surveyed by the
University of Chicago
Booth Business Schoolagreed that output would
be lower than the alternate
fiscal scenario if no action
were taken.!
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Complications: The Debt Ceiling
The fiscal cliff is not the only political stand-off over Americas fiscal position. Thedebt ceiling, which represents the legal borrowing limit of the U.S. Treasury, willneed to be raised in early in 2013 to avoid
defaulting on payments (Exhibit 34). WhileSecretary Tim Geithner possesses the tools
to defer some borrowing from internalgovernment funds in order to continuespending, his efforts merely delay the crisis.Only Congress can raise the debt ceiling toenable the Treasury to continue to fund allauthorized government obligations, includingservicing existing debt. Without discussing thespecifics behind the politics of the debt ceiling, experience from last summersuggests there is very little reason to be optimistic that a lasting and timely
agreement will be reached. And more importantly, the experience last summersuggests that uncertainty surrounding the debt ceiling can produce harmfuleconomic effects.
Exhibit!33 !THE FISCAL CLIFF WOULD SIGNIFICANTLY LOWER THE
DEFICIT IN THE MEDIUM-RUN!
Source: Congressional Budget Office!
Percent(%)
100!
90!
80!
70!
60!
50!2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
Alternative Fiscal Scenario!Current Law!Debt Held by the Public as a Percent of GDP!
31.9%
of GDP !
According to CBO
analysis, increasing debt
levels will raise interest
rates, reducing growth
over the decade.!!While cuts will hurt in the
short-run, over the next
decade they can be
positive for economic
growth.!!Through this lens, the
fiscal cliff represents a
trade-off between the
short-run and long-run. !
!
Currently, the U.S. is
on pace to exhaust
its borrowingauthority in early
2013.
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While the effect of uncertainty around economic policy has been a polarizing topicin the political debate, research attempting to quantify the effects of uncertaintysuggests it may be highly detrimental to the economy. One attempt to quantify theeffect was the development of The Economic Policy Uncertainty Index byeconomists Scott R. Baker, Nicholas Bloom and Steve Davis, which showed its
larg