The US financial system appears resilient overall, albeit non-financial corporations debt remains at a historical high amid ultra-low interest rates
According to the Federal Reserve, asset valuations (equities, corporate bonds, commercial real estate prices, house prices) remain above their long-term medians relative to income streams. However, taking into account the ultra-low level of Treasury yields, relative valuations appear less excessive. At the same time, corporate debt has increased to record levels.
Regarding the major asset classes, the price-to-rent ratio for residential real estate (estimated market value of $37.3 tn or 175% of GDP) has stabilized recently and currently stands only slightly above (103.79) its long-term normalized trend value of 100 (September 2019). On the other hand, prices for commercial real estate (CRE: estimated market value of $20 tn or 94% of GDP) appear high compared with rents. Indeed, capitalization rates (the annual rental income relative to prices for recently purchased commercial properties), stand at historically low levels (6.13% in September). Nevertheless, the premium that investors require versus safe alternative investments (i.e. Treasury Securities) remains well above the long-term median (see graph below).
The price-to-earnings ratio for equities (estimated market value of $35.6 tn or 167% of GDP) is slightly above its median over the past 30 years (17.9x versus 15.5x). However, investors’ willingness to assume risk on top of risk-free assets (Equity Risk Premium) does not appear excessive by historical standards (see graph 1, page 3). Regarding other (smaller sized) asset classes, the Fed observed potential pockets of vulnerability stemming from leveraged loans, for which demand remains strong, albeit easing recently. Furthermore, some signs of excessive risk taking were also observed in corporate bonds, with the yield spreads versus US treasury securities in the high-yield spectrum standing below the long-term median (see Markets section). Investors’ pricing of corporate bonds relative to the perceived risk of default (i.e. the gap between bond spreads and expected credit losses) appears benign compared with the norm (see graph 2, page 3).
Regarding debt burdens, household debt has risen in line with incomes. Moreover, quality has improved, as households with high credit scores accounted for most of the growth. Households with prime ratings, which represent half of total borrowers, hold about ⅔ of total loan balances ($15.5 tn or 73% of US GDP). Regarding mortgage loans, the major category of household debt (⅔ of total), delinquencies as a percentage of total mortgages stand at 3.97% (as of Q3:19), the lowest rate since Q1:1995. Finally, the ratio of outstanding mortgage debt to the aforementioned FRB estimate for the market value of residential real estate property, stands at a healthy 27.9%, suggesting sufficient collateral for mortgage loans, and thus increased lenders’ protection against potential credit losses.
On the other hand, pockets of vulnerability are evident vis-à-vis business debt. Specifically, debt in the non-financial business sector is at a record high (74% of GDP). Moreover, according to Fed calculations, gross leverage -- defined as the ratio of firms' book value of total debt to the book value of total assets -- stood at 35.5% in Q2:2019, also a record high. Furthermore, the balance of new debt generation has been tilted towards relatively riskier firms in recent years, as indicated by the high net issuance of high-yield bonds and institutional leveraged loans (see graph 3, page 3). It should be noted, however, that the median ratio of earnings (before interest and taxes) to interest payments (interest coverage ratio) stands at a relatively resilient 2.94%. This highlights the importance (for financial stability) of maintaining accommodative financial conditions.