Hamilton Financial Index: July 2012

July 2012!
The Hamilton Financial Index: ! A semi-annual report on the state of our nancial services industry! ! With a review of the upcoming scal cliff !
About this Report The Partnership for a Secure Financial Future comprises the Consumer Bankers Association, Mortgage Bankers Association, Financial Services Institute, and The Financial Services Roundtable, which combined represent more than 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 and government. HPS Insight conducts in-depth analysis on public policy issues. About the Authors Matt McDonald is a Partner at Hamilton Place Strategies. He formerly worked on economic issues at the White House and is a 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 funds and the investor community. He is a former Deputy Director of the Office of Management and Budget and a former partner at HPS. Patrick Sims directs research for HPS. He is a former lead research analyst in the financial institutions' group at SNL Financial 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.
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 their implications for economic growth. The key findings of the report are: The Hamilton Financial Index (HFI) rose seven points since the previous quarter 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 below historical norms, systemic risk would have to increase five times the second quarter high. Conversely, if banks had not increased their Tier 1 Common Capital Ratio from the level of three years ago, the second quarter high of systemic risk would have pushed the HFI below normal levels. While the European debt crisis presents risks to the global economy, from the 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 percent and Europe as a whole by eight percent. Lastly, our policy spotlight found that the upcoming fiscal cliff could be the largest fiscal contraction in four decades, potentially causing a significant drop in consumer demand and business investment. The fiscal cliff is further complicated by elevated U.S. debt and annual deficits, a politically contentious debt ceiling debate, constraints on the Fed, and the slowing of the global economy.
There remain significant challenges to the U.S. and global economies. Despite this, the financial sector is positioned to support stronger growth as the economy improves. This report was commissioned by the Partnership for a Secure Financial Future and the conclusions are that of the authors. Matt McDonald Steve McMillin Patrick Sims Russ Grote
Hamilton Place Strategies | 1
CONTENTS
THE HAMILTON FINANCIAL INDEX3 An index to measure both risk within the financial system and how firms are dealing with that risk. SAFETY AND SOUNDNESS .11 A look at how our financial services sector has rebuilt after the crisis and how they are meeting current challenges particularly European risk. VALUE TO THE ECONOMY 20 An examination of the everyday value that financial services bring to our lives, as well as an in-depth look at how the sector continues to supports the economy during the recovery. POLICY SPOTLIGHT THE FISCAL CLIFF...38 An explainer of the individual pieces of the fiscal cliff and its economic consequences in the context of a slowing global economy, the debt ceiling, rising US deficits and the disposition of the Federal Reserve.
2 | The State of Our Financial Services
Hamilton Financial Index (HFI)

In its second release, the HFI focuses on the continued improvements in the financial services industry and its ability to strengthen itself in economically challenging times. It also incorporates the idea that tradeoffs exist and can have significant economic outcomes.
Key Findings Q112: At 1.22, the Hamilton Financial Index was 7 points higher than the previous quarter and 22 percent above even normal pre-crisis levels. At current capital levels, system level risks would have to increase 5 times the 2nd quarter high for the HFI to dip below historical norms.
Capital is central to a [banks] ability to absorb unexpected losses and continue to lend to creditworthy businesses and consumers. - Federal Reserve CCAR
!
The notion that decisions come with Tier 1 Common Capital tradeoffs is nothing new. An economic increased to above $1.1 tradeoff can be compared to an opportunity cost, which represents the trillion, driving the Tier benefits you could have received by taking 1 Common Risk-Based an alternative action. The accumulation of Ratio to 12.76 percent. capital involves an opportunity cost. Any increase in capital may indicate the industry ! ! is better able to absorb losses. But it is important to understand that capital held as a buffer is capital unused to fund important lending that would aid economic growth. This tradeoff between economic safety and economic growth is why the above Federal Reserve quote is so meaningful capital has two purposes: it is used to absorb unexpected losses and to lend businesses and consumers. A delicate balance is needed to promote industry safety while encouraging healthy investment and lending.
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 banks capital levels, was valued at 1.22, 22 percent above the historical norm. The indexs value 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
Exhibit!1 !
THE HAMILTON FINANCIAL INDEX ROSE IN THE FIRST QUARTER OF 2012!

Hamilton Financial Index!
1.50!
1.25!
The Hamilton Financial Index rebounded to a level 22% above normal after a small dip due to a rise of nancial stress in the fall.!
All-Time High! 1.24!
Current ! Release! 1.22!
Index Value!
1.00!
First Release! 1.15!
0.75!
0.50!
Crisis Low 0.46!
0.25!
1994!
1995!
1996!
1997!
1998!
1999!
2000!
2001!
2002!
2003!
2004!
2005!
2006!
2007!
2008!
2009!
2010!
2011!
Source: HPS Insight, St. Louis Federal Reserve, SNL Financial!
The HFI combines capital levels and financial stress to provide a snapshot of the financial sectors ability to handle risk. It uses two commonly accepted metrics: 1. 2. The St. Louis Federal Reserve Financial Stress Index captures 18 market indicators and is a well-established indicator of financial stress Tier 1 Common Capital Ratio for commercial banks measures financial institutions 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 to improve. During the second quarter of 2012, events in Europe have caused stress in the system to rise. However, because U.S. banks have increased industry capitalization, systemic stress would have to be significantly higher for the HFI to be in unsafe territory.
2012!
Effectively, for the index to fall below normal levels, the level of systemic stress would have to increase by five times the second quarter high. The economy has not 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 second quarter 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 to withstand shocks from Europe and elsewhere (Exhibit 2).
Exhibit!2 !
THE HFI ROSE DUE TO SIGNIFICANTLY HIGHER CAPITAL LEVELS AND SUBDUED FINANCIAL STRESS!
HFI During 2008 Crisis: Less capital, high risk!
14! 14 12! 12
Current HFI: More capital, moderated risk!

14! 14 12! 12 1.22
Corresponding ! HFI Value!
10 10!
Units*!
0.46
10! 10 8!8 6!6 4!4 2!2 0!0
8 8! 6 6! 4 4! 2 2! 0 0!
Tier 1 Common Capital Ratio! St. Louis Financial Stress Index!
For the index to dip below its historical average of 1, nancial stress would have to increase ve times its Q212 high.!
Tier 1 St. Louis Common Financial Capital Ratio! Stress Index!
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!
Methodology
The index value is the difference between the quarterly averages of the Federal Reserve of St. Louis Financial Stress Index and the quarterly Tier 1 Common Capital Ratio 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 Stress Index, which combines 18 market variables segmented into three sections: interest rates, yields spreads and other indicators (Exhibit 3). Interest rates help determine the markets assessment of risk across a number of different sectors. High interest rates represent an increase in financial stress. Yield spreads help determine relative risk 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 !
indicators fill in important pieces not captured by interest rates or yields. For example, the Chicago Board Options Exchange Market Volatility Index captures the markets expectation of volatility in the financial system. Each indicator captures an aspect of financial stress within the system with some overlap. Collectively, they provide a snapshot of systemic risk in financial markets.
Exhibit!3 !
THE ST. LOUIS FINANCIAL STRESS INDEX INCORPORATES 18 VARIABLES TO MEASURE STRESS!
St. Louis Fed Financial Stress Index! Interest Rates!
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! 9. Corporate Baa-rated bond minus 10-year Treasury ! 10. Merrill Lynch High-Yield Corporate 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 ! !
Yield Spreads!
8. 10-year Treasury minus 3month Treasury!
Other Measures!
14. J.P. Morgan Emerging Markets Bond Index Plus! ! 15. Chicago Board Options Exchange Market Volatility Index (VIX)! ! 16. Merrill Lynch Bond Market Volatility Index (1-month)! 17. 10-year nominal Treasury yield minus 10-year Treasury Ination Protected Security yield (breakeven ination rate)! 18. Vanguard Financials ExchangeTraded Fund (equities)!
Source: St. Louis Federal Reserve!
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, which captures banks ability to absorb unexpected losses. The Tier One Common RiskBased Ratio has ticked up to 12.76 percent as of the first quarter of 2012, another record (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 Capital acts as a cushion in case of unexpected losses. Therefore, any increase in Tier 1 Common Capital (numerator) improves safety and soundness, all else equal. Any decreases in the holding of risky assets as measured by Risk-Weighted Assets (denominator) will improve a banks capital position.
Capital levels have increased 38 percent since 2007 to more than $1.1 trillion. In addition to higher capital levels, the first quarter of 2012 also saw a further decline in banks holdings of risky assets as a percentage of total assets. The fall from the pre-crisis highs calculates to a drop of 13 percent (Exhibit 5). The industrys ability to shed problem assets and retool balance sheets is an important step. With a reduction of risky assets, the financial industry can turn its focus to aiding the economy.2
Exhibit!4 !
REGULATORY CAPITAL LEVELS HIT ANOTHER ALL-TIME HIGH IN THE FIRST QUARTER OF 2012!
Tier 1 Common Capital and Tier 1 Common Risk-Based Ratio for U.S. Banks! 14! Tier 1 Common Capital ($T)! Tier 1 Common Risk-Based Ratio (%)! Tier 1 Common Capital Ratio has risen 38% since 2007 to an alltime high.! 1.4! 1.2!
Tier 1 Common Risk-Based Ratio (%)!
12!
Tier 1 Common Capital ($T)!
1.0! 10! 0.8! 0.6! 8! 0.4! 2! 0!
6!
1991!
1992!
1993!
1994!
1995!
1996!
1997!
1998!
1999!
2000!
2001!
2002!
2003!
2004!
2005!
2006!
2007!
2008!
2009!
2010!
2011!
Source: FDIC, SNL Financial!
Q112!
Exhibit!5 !
U.S. COMMERCIAL BANKS CONTINUE TO REDUCE THEIR HOLDINGS OF RISK-WEIGHTED ASSETS!

Risk-Weighted Assets as a Percent of Total Assets for U.S. Banks! 78! 75! 72! -13%
Percent (%)!
69! 66! 63! 60!
2001!
2002!
2003!
2004!
2005!
2006!
2007!
2008!
2009!
2010!
2011!
A Tradeoff Between Capital and Lending

Crisis-era efforts from both government and the private sector proved successful in restoring stability to the financial system. Much of this reflected a recapitalization process, whereby capital was provided to individual firms with a promise to repay. Without question, these injections of capital reduced financial stress, restored confidence 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, thereby investing in new business and hiring additional employees. Ultimately, a Ultimately, a tradeoff tradeoff exists between increasing exists between increasing capital as a buffer against future losses capital as a buffer against and using capital to fund important lending and aid economic growth. future losses and using Having too little capital is dangerous to capital to fund important the system, leaving it crisis-prone. Too lending and aid economic much capital and institutions do not fund growth and may become growth. unprofitable. A delicate balance ! between stability and growth is needed.
Q112!
The need to increase capital dominates the current political consensus around bank capital levels with little discussion about the magnitude and impact of reduced lending. When banks convert maturing loan proceeds into capital rather than relending them into the economy, they increase the safety and soundness of the system 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 a certain point, higher capital standards could actually reduce growth. The magnitude of this effect is uncertain, but the tradeoff is real and unfortunately underrecognized.
Exhibit!6 !
WHILE INCREASING SAFETY, INCREASED CAPITAL REQUIREMENTS ALSO REDUCE LENDING!

A higher capital ratio increases safety and soundness but may reduce lending. At a certain point, the marginal increase to safety and soundness may be outweighed by lower economic growth.! Decision Tree and Effects! Re-loan into the economy! Decision:! What to do with marginal dollar?! Increase ! capital and ! safety! Lower interest! rates! At what point are the gains from increased safety and soundness outweighed by less economic growth? ! Less lending! Higher ! interest rates! Less growth but! more safety! More growth but less safety!
Calculating the Effects of Rising Capital Levels

Debate is rife about the impact of rising capital levels on the supply of loans, the cost of borrowing and, on a macro level, GDP growth. Unfortunately, studies that have 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 bank must hold, growth slows by about 0.09 percent a year, a modest impact on lending.4 On the other hand, the Basel Committee and the Bank for International Settlements calculates that the damage is closer to one-third of the Feds value.5 And while the OECD calculates the widest range,6 the Institute of International Finance calculates that the impact could be up to 10 times bigger than all other estimates.7
A study by American economist and former director of the Congressional Budget Office, Douglas Holtz-Eakin, states each dollar of capital supports between $7 and $10 dollars of lending activity.8 McKinsey estimates that American banks alone need an additional $870 billion in capital to meet future regulatory standards.9 These 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 to raise additional capital in economically challenging times would be more difficult than doing so in periods of higher economic growth. To save in good times and then spend in bad is traditional economic thought. Unfortunately, the regulatory world never seems to function in this manner. In requiring higher capitals now, the possibility 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 risen seven points. The industry continues to increase capital levels above required rates mandated 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 the industrys 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 percent from pre-crisis highs are driving the index higher. Because of the HFIs two-part approach, a reduction in system-wide volatility additionally contributes to the index increased value. It is important to note that an index value that constantly increases does not necessarily point to an improving economy. Institutions that hold capital above the regulatory required rate could be less motivated by safety and more by policy uncertainty, expecting a higher required rate in the future and, therefore, dampening growth. Also, an industry that is over-capitalized may indicate a constrained lending environment, representing high borrowing costs and tight credit conditions. Further, an over-capitalized industry may reflect a lack of demand from businesses and consumers. If borrowers are not requesting additional loans to fund growth, then capital will be left sitting in banks a scenario that fits the current economic 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 question we 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 absorb losses resulting from unexpected shocks to the systemwhile ensuring an organic and sustainable recovery?11
Safety and Soundness:

As the HFI shows, the level of safety and soundness in the financial industry has significantly increased since the crisis. In many cases, the industry is in a much safer place today than in periods before the crisis. Moreover, the findings of the HFI are reinforced by improvements in other aspects of safety and soundness such as liquidity, insurance companies Capital and Surplus, and performance measures. Much like capital levels, the banking industrys liquidity levels are at historic highs, meaning that the industry is better able to meet any potential funding needs than at any time in the past. Another important signal of safety, insurer capitalization, is also at all-time highs, indicating that the broader financial services industry is also better capitalized. As industry profitability continues to bounce back from crisis lows, it is important that we note the current global economy faces many challenges.
Balancing Risks in Uncertain Times

Key Findings Q112: Bank liquidity measures show that banks are more liquid than any time before and thus better able to meet funding needs.
Total capital and surplus for the P&C and Life & Health industries rose to $576 billion and $314 billion, respectively.! U.S. financial institutions exposure to the European periphery fell 16 percent over the past year.!
This section will examine these metrics to complement the HFI such as liquidity, insurance capital levels and performance ! measures. The section will also look at the European crisis and its potential impact on the U.S. financial sector as well as the broader economy.
A Highly Liquid Industry

Liquidity, a measure of the ability to fund ongoing operations, is a financial institutions lifeblood, especially in times of crisis when funds may not be readily available from outside participants. The same can be said for consumers and nonbank businesses; their ability to pay expenses, make on-time payments and use cash in 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 lending relative to the amount of deposits that banks hold. While deposits are considered core 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 in the past decade (Exhibit 7).
Exhibit!7 !
THE U.S. BANKING SYSTEM IS MORE LIQUID NOW THAN AT AN ANY TIME IN THE PAST!
Total Loans as a Percent of Total Deposits for U.S. Banks! 100!
Percent (%)!
90! 80! 70! 60! 50! Both ratios show that the industry is more liquid today that at any time in the past.! -21%!
Cash & Cash Equivalents as a Percent of Liabilities for U.S. Banks! 25!
Percent (%)!
20! 15! 10! 5! 0!
Q1 12!
2000!
2001!
2002!
2003!
2004!
2005!
2006!
2007!
2008!
2009!
2010!
2011!
The second ratio, known as the Cash Ratio, is Cash and Cash Equivalents-to-Liabilities. It also gauges liquidity; however, it represents cash on-hand and other assets easily converted to cash, which can then be used to pay any financial obligations. As of the first quarter of 2012, the Cash Ratio was valued at 23 percent (Exhibit 7). The Cash Ratio is nearly threetimes the level it was the year before the crisis and is at an all-time high. Both ratios indicate 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 and lower demand for loans in the economy. When the economy returns to higher levels 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 a loss 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 any future unexpected losses. Both U.S. Property & Casualty (P&C) and sector, the insurance Life & Health insurers have increased sector has built a capitalization by greater than 16 percent since the crisis low in the first quarter of sizeable capital cushion 2009. As of the first quarter of 2012, total for any future Capital and Surplus for the P&C and Life unexpected losses. & Health industries were $576 billion and $314 billion, respectively (Exhibit 8). ! Similar to banks, insurers use capital to invest in new business and customers. While banks base their operations around lending, insurers invest the premiums obtained by policyholders, pay policyholders for any losses and further reward stakeholders in the form of dividends.
Much like the banking
Exhibit!8 !
P&C AND LIFE INSURERS CAPITAL AND SURPLUS CONTINUES TO RISE SINCE THE CRISIS!
Surplus as Regards to Policyholders ($B) ! C&S as a Percent of Assets (%)!
40 40! 36 36! 32 32!

Capital and Surplus as a Percent of Assets (%)!
P&C Insurers!
600 600!
500! 500 400! 400
28 28! 24 24!
20! 20 10! 9! 8! 7! 6! 5! Life Insurers!
Capital & Surplus ($B)!
300! 300 200! 200
350 350! 300 300!

250! 250 200! 200 150! 150
2001!
2002!
2003!
2004!
2005!
2006!
2007!
2008!
2009!
2010!
2011!
Source: NAIC, SNL Financial!
Performance Metrics Rise to Pre-Crisis Highs

Banking industry profitability stands at its highest level since the second quarter of 2007, and according to the FDICs quarterly banking profile, more than two-thirds of all institutions reported year-over-year improvements in earnings. Few firms, roughly 10 percent, reported losses, which is also a promising indication the economy has stabilized. Since the crisis, the industry has taken painstaking steps to repair loan portfolios and help address borrower-refinancing needs. Like most businesses, a banks ability to make a profit signals a healthy economy. Increased profitability for the banking sector indicates businesses and consumers can access credit and keep up with payments. As new rules are released for increased capital levels, it is important that the banking sector remains profitable.12 Profits often heavily correlate with borrowing costs; greater profits for the industry translate to an increased supply of credit and lower costs to borrowing. Profits also are used for investing in new products and services that end up benefiting the consumer. Lastly, profits can be used to add to an 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).
Q1 12!
Exhibit!9 !
BANK PERFORMANCE MEASURES ARE STILL STRONG IN Q112!

Net Income and Return on Average Assets and ! Equity for U.S. Banks! ROAA (%)! ROAE (%)! Net Income ($B)! 40! 40 30! 30 20! 20
15 15! 10 10! 5 5! 0 0!
-5! -5 -10! -10 -15! -15
Percent (%)!
10! 10 0! 0 -10! -10 -20! -20 -30! -30 -40! -40
Dollars ($B)!
Q108!
Q208!
Q308!
Q408!
Q109!
Q209!
Q309!
Q409!
Q110!
Q210!
Q310!
Q410!
Q111!
Q211!
Q311!
Q411!
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 occur from catastrophic events. This was seen in the second quarter of 2011 when several natural disasters occurred throughout the world. Fortunately, a large number 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 be used to invest, lower premium costs for buyers and as savings to absorb any unexpected losses that occur in the future. While the P&C industry saw healthy profits in the first quarter of 2012, the Life insurance industry witnessed its most profitable quarter since the crisis. Net Income rose 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 saw massive losses in the last half of 2008 of more than $51 billion. The large gains associated with the recent quarterly data strongly indicate that U.S. financial institutions are supporting a growing economy. The industry is still in recovery stages, as profitability is volatile from quarter to quarter. Future earnings will determine if the recovery is sustainable.
Q112!
Exhibit!10 !
P&C AND LIFE INSURERS PERFORMANCE SHOWS STRONG GROWTH IN Q112!

Net Income and Return on Average Assets and Equity! P&C Insurers! 15 15! ROAE (C&S) (%)! ROAA (%)! Net Income ($B)! 15! 15 10! 10 5! 5
10 10! 5 5! 0 0!
Percent (%)!
15! 12! 9! 6! 3! 0! -3! -6! -9! -12!
-5 -5! -10 -10!

40! 40 20! 20 0! 0 -20! -20 -40! -40 -60! -60 Life Insurers!
0 0! -5 -5! -10 -10! -15 -15!

20 20! 10 10! 00! -10 -10!
-20! -20 -30! -30
Dollars ($B)!
Q108!
Q208!
Q308!
Q408!
Q109!
Q209!
Q309!
Q409!
Q110!
Q210!
Q310!
Q410!
Q111!
Q211!
Q311!
Q411!
Source: NAIC, SNL Financial!
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 the industry 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 problems facing Europe, and then provide clarity around the potential impact it could have on U.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 of growth. The loss of investor confidence is bearing down on governments as investors continue to question their ability to pay back debt. Though steps have been taken to cut government spending, increasing austerity without more structural 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 between austerity and growth was crystal clear in Ireland in late 2010No matter what the Irish government did, it could not regain market confidence, and Ireland was forced into an EU/IMF bailout within weeks. She states further that Eurozone leaders have not learnt their lesson.13 To date, governments around Europe have continued to replicate what occurred in Ireland, only to see themselves in the same
Q112!
troubling situation. Investors have focused on a select number of countries, particularly Greece, Ireland, Italy, Portugal and Spain. According to the Economist Intelligence Unit, GDP growth rates for 2012 among the distressed European periphery members are estimated to be the lowest in all of Europe. 14 U.S. Bank Exposure to Europe It is no coincidence that low GDP growth rates are linked with ratings downgrades. Yet, U.S. banks have aligned their portfolios with countries that are rated safer (Exhibit 11). In fact, more than 72 percent of all risk claims are associated with countries with a AAA rating.15 !"#$%&'! !"#$!%&'()$*+,-+.
!"##$#%! "!"#$ !"#$%&'()! "!"#$ !"#$%&! ! "!"#$ !"#$%&! ! "!"#$ !"#$%&'(! "!"## ! !"#$%&'()*&(+%","-./0(!"#$%%&'$"($)*"&#
U.S. banks exposure to the European periphery declined over 16 percent in the past 12 months. Moreover, exposure to Europe on the whole has declined by eight percent during that time period. (Exhibit 12). The peripheral countries of Greece, Italy, Ireland, Portugal and Spain represent less than $200 billion in risk claims, and are 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!
Total Risk Claims by Country and National S&P Ratings!
$351.4B!
$785.9B!
S&P Credit Rating!
$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.! $5.8B! Risk Claims ($B)!
Source: FFIEC, HPSInsight!
Exhibit!12 !
U.S. FINANCIAL INSTITUTIONS HAVE REDUCED EXPOSURE TO THE PERIPHERY BY OVER 16%!
Percent Change of Country Risk Claims from Q111 to Q112! 50! 40! 30! 20! Over the course of the last 12 months, U.S. banks have reduced exposure to the periphery from $216 billion to $181 billion and to Europe as a whole by eight percent.!
Percent (%)!
10! 0! -10! -20! -30! -40! -50! -60! Greece! Spain! Ireland! Portugal! Italy! Germany! France! UK! Swiss! Total Europe!
Exhibit!13 !
U.S. BANKS ARE MOST EXPOSED TO THE U.K., GERMANY AND FRANCE!
Risk Claims ($B)! < 10! 10 - 100! 100 - 500! > 500!
The continued turmoil around Europes debt problems has contributed to market instability. However, no U.S. bank has reported significant losses tied to the issue as of the date of this report. While it is worth noting that financial contagion effects are 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 to U.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, many emerging markets obtain funding for imports from European banks. If their source of funding is cut off, exports to these countries could dry up. This could have a large impact on U.S. GDP, since emerging market economies have represented a large share of U.S. export growth over the last several years. In fact, U.S. exports to Brazil alone have increased 70 percent since 2007. Although total exports only account for roughly 14 percent of U.S. GDP, the increase in exports represents nearly half of 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, and supply-chain issues involving U.S. multinational firms. When compiling the potential impact of emerging market exports with other factors, a Euro break-up could have serious consequences for the U.S. economy.
Summary
The financial services industry as whole continues to increase levels of safety and soundness shown through both capitalization and liquidity measurements, although increased levels of capitalization and liquidity are no free lunch as a tradeoff exists between these measurements and economic growth. Higher levels of liquidity are also being driven by a low demand for loans, rather than a low supply. This indicates 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 economy returns 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 current levels of capitalization and liquidity will contribute to, rather than reduce, system wide stability. Even though banks are continually adjusting to safeguard themselves against catastrophe, the trouble in Europe could potentially impact the U.S. economy via emerging market exports and other links. To an extent, the negative effects on the U.S. economy from a further deepening of the European crisis are in many ways unavoidable.
Value to the Economy:

The diversity of institutions in the U.S. financial sector enables individuals and businesses to meet all of their financial needs efficiently. Insurance companies insure individuals and businesses against catastrophes, accidents and unforeseen crises. Community banks provide loans to local restaurants and help set-up a high school students first bank account, while the largest U.S. banks supply capital, foreign exchange and trade financing to help Americas companies sell products worldwide. As the winter HFI detailed, U.S. banks provided financial shelter during the recession. As a result, commercial bank deposits increased 25 percent and consumer credit card loans rose 70 percent. When the recovery began, U.S. banks quickly increased loans to businesses, including a six percent increase in 2011.
Increasing Loans During the Recovery

Key Findings Q112: Total loans and leases rose to $6.8 trillion. Domestic business loans rose above $2 trillion and small business owners borrowing satisfaction continues to improve. P&C and Life Insurers paid out $338 billion and $493 billion in benefits, respectively. The total U.S. retirement market reached $17.9 trillion, an all-time high.
In the first half of 2012, U.S. economic growth decelerated, households continued to deleverage, and uncertainty ! about the fate of the Eurozone permeated the economic climate. Banks continued to play the dual role of financial shelter for investors seeking refuge from volatile markets and supporter of the recovery for businesses looking to expand. Meanwhile, insurers whose services are less tied to the state of the economy continue to aid individuals and businesses.
The National Economy and Individuals Balance Sheets

After a strong fourth quarter in which the economy grew at a three percent annualized rate, U.S. economic growth decelerated, only expanding at a modest 1.9 percent 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 sales flatlined, job openings declined and the unemployment rate ticked up. These past six months exhibit the economys continued fragility three years after the recession officially came to an end (Exhibit 14).
Exhibit!14 !
THE ECONOMIC RECOVERY DECELERATED IN THE FIRST HALF OF 2012! Payroll Growth!
Nonfarm Payroll Monthly Change and Real GDP Growth! GDP Growth (%)!
Nonfarm Payroll Monthly Change (In Thousands)!
800! 600! 400! 200! 0! -200! -400! -600! -800! -1,000!
First and second quarter GDP and job growth is continuing to slow down through the summer.!
8!
Real GDP Growth Percentage (Annualized) (%)!
6! 4! 2! 0! -2! -4! -6! -8! -10!
Q1 08!
Q2 08!
Q3 08!
Q4 08!
Q1 09!
Q2 09!
Q3 09!
Q4 09!
Q1 10!
Q2 10!
Q3 10!
Q4 10!
Q1 11!
Q2 11!
Q3 11!
Q4 11!
Source: BEA, BLS!
With slower economic growth, consumers continued to deleverage in 2012 (Exhibit 15). According to the New York Federal Reserves Quarterly Household Credit and Debit Report, households have reduced total debt burdens by 10 percent 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 2.4 percent 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 is discussed as a temporary phenomenon with the expectation that households eventually will gain confidence and increase spending. New evidence, though, suggests that households may have adjusted to a new normal. !
Q1 12!
Household deleveraging continues despite Federal Reserve data demonstrating that monthly financial obligations are at lows not seen sine the early 1990s. On average, households allocate about 16 percent of their income to meet their monthly financial obligations, which include debt service, rent for tenant-occupied households, automobile leases, homeowners insurance and property taxes. This is significantly lower than the 19 percent they spent before the recession. Continued deleveraging despite low monthly financial obligations is consistent with low growth expectations. In fact, the expected increase in inflation-adjusted family income has plummeted since the recession according to data from the Thomson Reuters/University of Michigan Survey of Consumers. After 20 years of reporting expectations of a two-to-three percent increase in family income over the next 12 months, households have foreseen less than a 0.5 percent increase, the lowest median level on record. These data points suggest that rather than deleveraging to help pay current bills, households may be using their excess income as insurance to handle future financial shocks.
Exhibit!15 !
HOUSEHOLDS ARE CONTINUING TO REDUCE Total Q112 Change: ! - 0.9%! DEBT BURDENS IN 2012! Mortgage debt: ! - 1.0%!
Total Household Debt by Type! 13! 12! 11! Other! Student Loan! Credit Card! Auto Loan! HE Revolving*! 8! 7! 6! Mortgage! HE Revolving:! Auto Loans: ! Credit Card: ! Student loan debt: ! - 2.4%! ! +0.3%! ! - 3.6%! ! +3.4%!
Dollars ($T)!
10! 9!
Q106!
Q107!
Q108!
Q109!
Q110!
Q111!
Source: The Federal Reserve Bank of New York, ! *Home Equity!
Moreover, the fall in housing prices erased a significant amount of wealth that allowed people to borrow and spend more. Therefore, with the baby boomers retiring, 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. retirement market reached a record high of $17.9 trillion (Exhibit 16). According to the Investment Company Institute (ICI), as of the third quarter of 2011, retirement
Q112!
savings comprised 36 percent of all household financial assets. Current and soon-tobe 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 financial security to individuals.
Exhibit!16 !
THE TOTAL RETIREMENT MARKET REACHED AN ALLTIME HIGH OF $17.9 TRILLION AT THE END OF 2011!
Total U.S. Retirement Market! 18! 16! 14! +13%! Annuities! Federal Pension Plans! State and Local ! Government Pension Plans! Private DB Plans!
Dollars ($T)!
12! 10! 8! 6! 4! 2!
DC Plans!
IRAs!
2001!
2002!
2003!
2004!
2005!
2006!
2008!
2009!
2010!
2000!
Source: Investment Company Institute!
Financial Shelter
Given the fragility of the recovery in the first half of 2012, the U.S. financial sector continues to serve as a safe haven in times of economic crisis. In the first quarter of 2012, the U.S. financial industry continued to play the role of safe keeper as deposits continued to rise, topping out at $9.46 trillion. Moreover, core deposits, which are comprised of accounts holding $250,000 or less, excluding brokered deposits, and are considered highly liquid, continued to rise. As a percent of total liabilities, 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 the previous several periods. From the fourth quarter of 2011 through the first quarter of 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 and now sits below 70 percent. While the drop represents a more liquid banking system, it also reflects an increased flight to safety as individuals and companies look to avoid volatility in the markets. !
2007!
2011!
Exhibit!17 !
DEPOSITS CONTINUED TO CLIMB THROUGHOUT THE RECESSION AND RECOVERY!

Total Deposits and Total Core Deposits ! as a Percent of Total for U.S. Commercial Banks! 100! 100 Core Deposits/Total Deposits (%)! Total Deposits ($T)! 10! 9! 8!
Core Deposits/Total Deposits (%)!
90! 90
80 80!
70! 70 60! 60 50! 50 40! 40 30! 30 +24%!
Total Deposits ($T)!
7! 6! 5! 4! 3!
2000!
2001!
2002!
2003!
2004!
2005!
2006!
2007!
2008!
2009!
2010!
2011!
2!
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 slowed Total loans and leases in in 2012. In the third and fourth quarter of 2011, loans grew at 11.4 and 9.3 percent, the first quarter of 2012 respectively. During that time, the loan rose to $6.8 trillion, growth rate outpaced the deposit growth slightly below the allrate. However, in the first quarter of 2012, the loan growth rate slowed to 4.55 percent. time high set in 2008. The underlying dynamics show an economy ! in flux where consumers pull back from credit needs, businesses continue to expand at a moderate pace and the housing market shows signs of life.
Q1 12!
Exhibit!18 !
TOTAL LOANS AND LEASES ROSE TO $6.8 TRILLION IN THE FIRST QUARTER OF 2012!
Total Loans from U.S. Commercial Banks! 7!
6!
Dollars ($T)!
5!
4!
2000!
2001!
2002!
2003!
2004!
2005!
2006!
2007!
2008!
2009!
2010!
2011!
3!
Loans to Businesses
The rise in total loans and leases was driven by increased commercial and industrial loans. Commercial and industrial loans increased to $1.3 trillion in the first quarter of 2012. This growth offset the fall in consumer loans, which was driven by a reduction in credit card loans (Exhibit 19). U.S. commercial banks also continued to increase loans to businesses in the first quarter of 2012 by three percent. Total loan volume now tops $2 trillion, the second-highest level on record. Since the end of 2010, domestic business loans have risen almost 10 percent (Exhibit 20).
Q1 12!
Exhibit!19 !
COMMERCIAL AND INDUSTRIAL LOANS HAVE DRIVEN INCREASES IN NON-REAL ESTATE LOANS IN 2012!
Consumer Loans and Commercial and Industrial Loans ! for U.S. Banks! 2.8! 2.4! 2.0! Consumer Loans ($T)! Commercial & Industrial Loans ($T)!
Dollars ($T)!
1.6! 1.2! 0.8! 0.4! 0.0!
2000!
2001!
2002!
2003!
2004!
2005!
2006!
2007!
2008!
2009!
2010!
2011! 2011! Q1 12!
Exhibit!20 !
TOTAL DOMESTIC BUSINESS LOANS HAVE INCREASED IN Q112 TO $2 TRILLION!

Total Domestic Business Loans for U.S. Banks! 2.5! Total Domestic Business Loans ($T)!
$2 Trillion!
Dollars ($T)!
2.0!
1.5!
2000!
2001!
2002!
2003!
2004!
2005!
2006!
2007!
2008!
2009!
2010!
1.0!
Q1 12!
Spotlight: U.S. Bank Support for Metropolitan Transportation Tashitaa Tufaas bus company, Metropolitan Transportation Network Inc., is on course to have 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 a spot on the Minneapolis-St. Paul Business Journals list of top 50 fastest-growing companies in the area. Tufaas success did not come easy. The company hit a rough patch in the midst of the recession as school districts cut costs wherever possible. Tufaa weathered the storm until 2011 by self-financing and continually putting money back into the business. That year, he sought counsel from U.S. Bank. U.S. Bank examined Metropolitan Transportation and determined how it could help the company become more profitable and grow. The bank proposed that the company consolidate 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 revenue to rise to record levels. Consolidating the worksites allowed the company to purchase larger fuel tanks, which has provided major savings in the high fuel-cost environment. The new garage is top of the line and makes others want to learn from us, says Tufaa. U.S. Bank helped us control unnecessary costs and made the consolidation process easy. !
While total domestic business loans continued to increase, their rate of growth decelerated from six percent to three percent. This change more than likely reflects reduced demand for loans as economic growth decelerated. Commenting on the drop in small business Businesses that need loans, Paynet founder Bill Phelan said, "These businesses are cautiousThey're funding are becoming holding back on new investments and more likely to receive expansions in their businesses, and that's loans from banks than really a result of the view of uncertainty in 18 the marketplace." The Federal Reserve several years ago. ! Senior Loan Officer survey found that from January to April 2012, a majority of banks eased standards on Commercial and Industrial loans. The NFIB Small Business Optimism survey tells a similar story, as small-business owners are not signaling reduced loan availability or lower levels of borrower satisfaction from the previous year (Exhibit 21). Moreover, only three percent of small-business owners cite financing as their largest problem.19 Businesses that need funding are becoming more likely to receive loans from banks than several years ago.
Exhibit!21 !
SMALL-BUSINESSES LOAN AVAILABILITY AND BORROWER SATISFACTION REMAINED UP SINCE THE END OF 2011!
3-Month Rolling Average of Net Small-Business Owners Responding Loan Availability is Increasing vs. Decreasing and That Borrowing Needs Are Satised! 0! Availability of Loans! Borrowing Needs Satised! 45! 40!
Borrowing Needs Satised (%)!
35!
Loan Availability (%)!
-5!
30! 25! 20!
-10!
15! 10! 5!
-15!
0!
2006!
2007!
2008!
2009!
2010!
2011!
Source: NFIB Small Business Optimism Survey!
Loans to Individuals
Beyond loans to businesses, banks lend to consumers to help finance consumer spending. Overall, consumer loans have fallen since last quarter, led by a slight drop in 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 in tough times. Therefore, a gradual reduction of these loans is unsurprising in the short-term. Consumers have continued to increase their holdings of automobile debt to finance car purchases for the fifth consecutive quarter. May auto sales were up 17.4 percent from 12 months earlier. The largest type of loan to individuals, realestate loans, has started to tick up for the first time since the crisis. Total real-estate loans rose to $3.6 trillion in the first quarter of 2012 (Exhibit 22).
2012!
Spotlight: Fifth Third Bank Support for Square 1 Art In 1999, Andrew Reid, a former businessman, and his wife Martha, a former elementary school 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 reproduces childrens art onto shirts, mugs and other products and shares the profits of their sales with schools. The product affirms students artistic achievements, gives parents keepsakes of their childrens art and provides schools a fundraising option in difficult budget times. After several years of impressive 20 percent annual growth, Square 1 Art had the opportunity to expand. Andrew and Martha moved the operation from Upstate New York to Atlanta. They recently acquired 84,000 square feet of warehouse space to increase production, employment and opportunities for schools throughout the country. Tired of expensive leases, they found a partner in Fifth Third bank. It represented Square 1 Art to the Small Business Administration for a loan guarantee. The couple received 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 to know what will a bank do for you today and what will they do for you tomorrow. He found 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 is Square 1 Art the realization of the American Dream for them, it has also become that for 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. ! !
Exhibit!22 !
REAL-ESTATE LOANS HAVE INCREASED IN THE FIRST QUARTER OF 2012!

U.S. Commercial Bank Real Estate Loans! 4!
Dollars ($T)!
3!
2!
1!
Source: SNL Financial, FDIC!
Throughout the recovery, many analysts predicted a housing bottom and, according to CoreLogic data, housing prices increased month-over-month in both March and April, thus showing signs of stabilization. Housing starts also increased significantly from last year according to data from the Department of Commerce. In May, year-overIn May, year-overyear total privately owned housing unit starts were up 28 percent at a 708,000 seasonally year privately owned adjusted annual rate. With inventories housing unit starts tightening in many markets, especially in the were up 28 percent.! multifamily sector, Americas housing sector showed promise of making a comeback and ! propelling the recovery. In fact, residential investment 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. The fundamentals of the market still point to slow but improving growth in the nearterm. Every year from 1992 to 2006, more than 1 million single-family homes were started, more than double the current rate of 492,000. The annual pace of multifamily home construction, which is up over 100 percent from 2009 lows, is still 17 percent below the average from 1990 to 2008 (Exhibit 23).
Q1 12!
2000!
2001!
2002!
2003!
2004!
2005!
2006!
2007!
2008!
2009!
2010!
2011!
Exhibit!23 !
WHILE INCREASING THIS YEAR, NEW HOUSING STARTS ARE WELL BELOW NORMAL LEVELS !
Single Unit and Multifamily Starts! 2.2! 2.0! 1.8! 1.6! 1.4! Multifamily starts have increased while single unit starts continue to lag! Multifamily! Single Unit!
Millions!
1.2! 1.0! 0.8! 0.6! 0.4! 0.2! 0.0!
1990!
1991!
1992!
1993!
1994!
1995!
1996!
1997!
1998!
1999!
2000!
2001!
2002!
2003!
2004!
2005!
2006!
2007!
2008!
2009!
2010!
2011!
Source: Census CPS/HVS!
While overbuilding occurred prior to the recession, low levels of construction in the late 2000s brought household construction more in line with household formation in 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 to three million missing households (Exhibit 25). More specifically, the high rate of youth unemployment combined with rising student debt levels may have led to significantly less household formation among recent college graduates. According to the Census CPS/HVS survey, more men and women aged 24 to 30 years old are living with their parents now than in the past 20 years. Nineteen percent of men and 10 percent of women in this age group currently live with their parents, compared to 14 and nine percent pre-recession. Moreover, the entire dropoff comes from family household formation as opposed to groups.
2012!
Exhibit!24 !
RELATIVE TO HOUSEHOLD FORMATION, THE 2000S DID NOT SEE SIGNIFICANT OVERBUILDING IN HOUSING!
Housing Starts and Household Formation! 17! 16! Pace of 2000-2007! 18! 17! 16! 15! 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.! ! Starts! New Households!
Households Added (In Millions)!
15! 14! 13! 12! 11! 10! 9! 8! 7! 1960s! 1970s! 1980s! 1990s! 2000s!
Starts (Thousands)!
14! 13! 12! 11! 10! 9! 8! 7!
Source: Census Decennial, CPS/HVS, HPS Insight!
Exhibit!25 !
SINCE 2007, HOUSEHOLD FORMATION IS ROUGHLY 3 MILLION HOUSEHOLDS BELOW TREND!

Household Formation! 125! Household formation is 53% below trend since 2007.! The reduction in household formation puts downward pressure on prices and reduces the 3 million incentive to build new households! 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. !
Households (In Millions)!
120!
115!
110!
2000!
2002!
2004!
2006!
2008!
2010!
Source: Census CPS/HVS, HPS Insight!
2012!
105!
This data suggests that new families are putting off moving into their own home. In addition to young people moving in with parents, a decline in immigration has reduced 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 has been foreclosing on houses. According to The McKinsey Institute, two-thirds of household deleveraging has been through foreclosures and defaults on consumer credit.20 While this reduces debt burdens, the negative effect on credit scores makes mortgage lending less attractive. Real-estate assets, while improving for banks, still have high non-performing rates (Exhibit 26).
Exhibit!26 !
NONCURRENT REAL-ESTATE LOANS ARE IMPROVING, BUT ARE STILL ABOVE HISTORICAL NORMS!
! Noncurrent NonReal 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! 15!
Noncurrent Total Real Estate vs Non Real Estate (%)!
10! 5! 0! 10! 5! 0! 6! 4! 2! 0! 20!
Noncurrent Real Estate Loans (%)! Noncurrent Non-Real Estate Loans (%)!
Noncurrent 1-4 Unit Family Loans (%)!
Noncurrent Multifamily Unit Loans (%)!
Noncurrent Land Dev/ Construction Loans (%)!
10! 0!
2003!
2004!
2005!
2006!
2007!
2008!
2009!
2010!
2011!
Source: SNL Financial, FDIC!
Banks have responded to these dynamics by tightening lending standards for less creditworthy borrowers - 90 percent of all new mortgages last year went to borrowers with high credit scores compared to 50 percent several years ago.21 This has 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 are beginning to stabilize, inventories are shrinking, debt burdens are falling and realestate loan performance is improving. With the improved bank balance sheets as detailed in Section 2 of the report, banks should be in a prime position to support a sustained housing recovery. In the near-term, the fundamentals point to an increase in multifamily housing, as the vacancy rate is historically low and rental prices have
2012!
skyrocketed (Exhibit 27). Most recently, Reis data shows the rental vacancy rate dropping 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 quarter of 2012.
Exhibit!27 !
THE FUNDAMENTALS POINT TO EXPANSION IN MULTIFAMILY MARKET!

Rental vacancy rates are falling and prices are rising rapidly! Home Vacancy Rate and ! Case-Shiller Price Index! 220! Case-Shiller Index! Vacancy Rate! 3! Homeowning market vacancy rates remain elevated and prices continue to fall! Rental Vacancy Rate ! and Price Index! Rent Price Index! Vacancy Rate (%)! 12! 11!
450 450! 400 400!

Rent Price Index!
Case-Shiller Price Index!
200! 180! 160! 140! 120! 100! 80! 60! 0! 1! 2!
350 350! 300 300! 250 250! 200 200! 150 150! 100 100!
2000! 2001! 2002! 2003! 2004! 2005! 2006! 2007! 2008! 2009! 2010! 2011!
Vacancy Rate (%)!
Vacancy Rate (%)!
10! 9! 8! 7! 6!
Source: Census CPS/HVS, St. Louis Federal Reserve!
Insurance: P&C and Life

While the volume of bank deposits and loans are affected by the state of the macroeconomy, 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 above obscure 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 service at a reasonable price for consumers. By pooling risks, insurance companies offer individuals 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 the insurance 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).
2000! 2001! 2002! 2003! 2004! 2005! 2006! 2007! 2008! 2009! 2010! 2011!
Spotlight: Allstate Support for the Gasmans Dustin and Jill Gasman were driving to the airport to start a relaxing summer vacation in Mexico when they noticed their car was having issues. Dustin discovered the catalytic converter, a device designed to reduce harmful emissions released from a vehicles exhaust, 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. Understanding his 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 their car. Nelson traveled to the Gasmans car, crawled under it to take pictures and arranged for a nearby mechanic to make the necessary repairs. He also arranged a rental car for the Gasmans 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 to do 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 arranged everything, said Burlet. For Nelson, though, helping the Gasmans wasnt a big deal. It went without saying that we needed to do what we could to get the problem resolved, he explains. ! !
Exhibit!28 !
P&C PREMIUMS AND PAYOUTS REMAINED STEADY THROUGHOUT THE RECESSION!

500! 500 400! 400 300! 300 200! 200 P&C Insurers Net Premiums Written!
Dollars ($B)!
100 100!
400! 400 300! 300 200! 200 100! 100
P&C Insurers Loan & Loss Adjusted Expense (Payouts)!
2000!
2001!
2002!
2003!
2004!
2005!
2006!
2007!
2008!
2009!
2010!
2011!
Source: FDIC, SNL Financial ! *Premiums are annualized and Loan & Loss Adjusted Expenses are calculated on a Last-Twelve Months basis!
Q1 12*!
The Life industry had Premiums, Consideration and Deposits (a comparable metric to 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 of Benefits and Surrenders. Benefits include death benefits, matured endowments, annuity benefits, accident & health benefits, guarantees, group conversions, and life contingent contract pay. Surrender benefits and withdrawals for life contracts include all surrender or other withdrawal benefit amounts incurred in connection with contract provisions for surrender or withdrawal. As stated above, insurance companies main role is to pool risk to help individuals and companies hedge against unexpected losses. To ensure they can cover losses adequately, P&C and Life insurers charge premiums. However, one method to lower premiums or provide better benefits to customers is to invest premiums in stock markets, bonds and other asset classes. These investments not only help insurers better service their customers, but also contribute to economic growth by turning idle savings into capital for growing companies. As a whole, the insurance industry held cash and investments of $4.74 trillion in the first quarter of 2012, of which 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!

Net Premiums, Considerations and Deposits for Life Insurance! 700! 600! 500! 400! 300!
Dollars ($B)!
200! 100! 600! 600 Life Insurance Payouts, Surrenders and Benets!
500 500! 400 400!

300! 300 Surrenders ($B)!
200 200!
100! 100 Benets ($B)!
0 0!
2000! 2001! 2002! 2003! 2004! 2005! 2006! 2007! 2008! 2009! 2010! 2011! Q1 12*!
Source: FDIC, SNL Financial! *Premiums are annualized and Payouts, Surrenders and Benets are calculated on Last-Twelve Month basis! !
Summary
Despite the deceleration of economic growth, financial services still played a vital role as a financial shelter, supporter of the recovery and insurer against risk. As detailed in the first section, 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 the amount of leverage that households and businesses are willing to undertake. However, by raising capital levels now, banks will be in a better position to contribute sustainably to economic 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, it affirmed its commitment to environmentally friendly business opportunities by pledging an additional $30 billion of support by 2020. In the past seven years alone, Wells Fargo has provided more than $11.7 billion in capital across their environmental portfolio, which includes investments in green buildings, green businesses, and renewable energy projects. As Jason Kaminsky, vice president of its Environmental Finance group, explains, Wells Fargo is committed to meeting the financial needs of both small and large companies integral to the growth of the solar industry." One Wells Fargo relationship is with Enfinity, among the worlds largest solar developers with over 390 megawatts of worldwide installed solar capacity. Enfinity provides solar energy directly to commercial and government customers to provide electricity savings.! David Shipley, Chief Financial Officer for Enfinity in the Americas, says that Enfinity is 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 with investment partners like Wells Fargo that have the appetite and mission to invest in solar assets. Their relationship illustrates how banks and businesses can work together to bring innovative new services to the market. !
Policy Spotlight:
The Economic Impact of the Fiscal Cliff
Without legislative action, on January 1, 2013, federal tax and spending policy will change so drastically that the U.S. economy will undergo the largest year-over-year fiscal contraction in the past 40 years (Exhibit 30). While partially unwinding the effects of the fiscal expansion in 2009, the staggering magnitude of this fiscal adjustment and the severity of its consequences have earned this phenomenon the nickname the fiscal cliff. Without action to avoid the fiscal cliff, the U.S. could be at risk of falling into a recession in 2013. Moreover, the fiscal cliff only adds to existing economic concerns such as the Chinese economy showing signs of a slowdown and the fate of the Eurozone remaining in doubt. Meanwhile, the U.S. is also expected to hit the debt ceiling in early 2013, meaning Congress will have to struggle with both the fiscal cliff and the debt ceiling debate potentially amidst a global slowdown. However, despite the hyperbole of its nickname, the fiscal cliff represents a set of choices with tradeoffs in the short and long run. This section of the report seeks to explain the many aspects of the fiscal cliff while properly contextualizing the issue within the debt ceiling debate, the U.S. precarious fiscal position and the disposition of the Federal Reserve.
Key Findings: The fiscal cliff represents the potential for the largest yearover-year fiscal contraction in four decades. 66% of the fiscal cliff is revenue increases. The debt ceiling will need to be raised early in 2013. Last years debate caused significant turmoil in the markets. Monetary policy can offset some of the fiscal cliff, but new Fed action would yield diminishing returns and is constrained by inflation concerns.
! !
Exhibit!30 !
THE FISCAL CLIFF REPRESENTS A 4% FISCAL CONTRACTION IN THE 2013 FISCAL YEAR!
Net Year-Over-Year Fiscal Adjustment! 7! 6! 5! 4! 3! 2! 1! 0! -1! -2! -3! -4! -5! The total scal adjustment represents the net effects of tax and spending increases/ decreases. ! A four percent scal contraction is unprecedented and would equal the single largest scal contraction in the past four decades.!
Expansion! Contraction!
Percent of GDP!
1977!
1979!
1981!
1983!
1985!
1987!
1989!
1991!
1993!
1995!
1997!
1999!
2001!
2003!
2005!
2007!
2009!
2011!
1973!
Source: CBO, HPSInsight!
What Is The Fiscal Cliff?

The fiscal cliff represents the net change in federal revenues and spending yearover-year. Including the effects the tax hikes and spending cuts will have on economic activity, the U.S. fiscal position will contract by $607 billion dollars, or four percent of GDP.23 This fiscal adjustment will occur in just nine months, as the fiscal year ends in September. For the 2013 calendar year, the fiscal contraction is closer to five percent of GDP.24 Under current law, changes in policies currently in effect will result in $399 billion in tax hikes, $105 billion in spending cuts, while the continuation of existing policies result in an additional $104 in additional fiscal restraint. Increased taxes represents 66 percent of the fiscal cliff (Exhibit 31). On the tax side, 55 percent of the increase in revenues reflects the expiration of the 2001 and 2003 tax cuts, as well as the indexing of the Alternative Minimum Tax to inflation. The 2001 and 2003 tax cuts reduced taxes on income, capital gains and dividends, and estates. Additionally, the termination of the two percent payroll tax cut in effect since 2010, accounts for another 24 percent of new revenues. The remaining revenue comes from other expiring provisions (21 percent of the total), such as expensing property investment.
1975!
2013!
Exhibit!31 !
66% OF THE $607 BILLION FISCAL CLIFF IS REVENUE INCREASES! Total scal adjustment is about
Fiscal Cliff Breakdown!
700! $105 B in Spending Cuts! 600! $399 B in Tax Hikes! $607 B! 5% of GDP in CY 2013 and the U.S. would fall into a recession.!
Billions of Dollars ($B)!
500! 400! 300! 200! 100! 0! Income and Estate! Payroll! Other*! Affordable Budget Unemploy-! Cut in Continuation Fiscal Cliff! of other Care Act! Control Act! ment Medicares Benets! payment! existing policies!
Source: Congressional Budget Ofce ! *The main provision expiring is the partial expensing of investment properties, !
One expiring tax that has received too little attention is the 2007 Mortgage Forgiveness 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 Budget Control Act (BCA) accounts for $65 billion, or 64 percent of total spending cuts. Also, the expiration of extended unemployment insurance benefits will reduce total payments by $26 billion in 2013. The BCA was passed in the summer of 2011 as a part of bipartisan compromise to raise the debt ceiling. Sequestration was imposed as a backstop to ensure that deficit reduction promised by the law would be achieved. These spending cuts primarily affect defense and nondefense discretionary spending, which together make up roughly one-third of the budget. The remainder of federal spending is largely made up of entitlements, which are barely affected by the BCA. For example, the maximum cut to Medicare is only 2 percent. Meanwhile, Medicaid, SChip and SNAP (food stamps) are exempt. Most analysis of the impending fiscal cliff focuses on the collective impact of all these decisions on aggregate demand in the national economy. However, each aspect of the fiscal cliff impacts a specific part of the U.S. economy.
What Are The Near-Term Economic Consequences?

The Congressional Budget Office (CBO) estimates that if the fiscal cliff is not avoided, the shock to the economy will likely cause the U.S. economy to contract deep enough to be judged a recession. They project the economy will contract in the first half of 2013 by 1.3 percent and, compared to an economy where all provisions were extended, near term GDP growth would be reduced by four percentage points in 2013 (Exhibit 32).
Exhibit!32 !
If the fiscal cliff is ! not avoided, the shock to the economy increases the risk of a U.S. recession.! !
THE FISCAL CLIFF MAY REDUCE GDP GROWTH BY 4% IN 2013 AND CAUSE A RECESSION IN THE FIRST HALF OF THE YEAR!
Real GDP Growth! 4.5! 4.0! 3.5! 2.5! 2.0! 1.5! -4%! 1.0! 0.5! 0.0! -0.5! -1.0! -1.5! First half! 2013! Second half! 2013! Without Cliff! With Cliff! Without avoiding the scal cliff, the U.S. would fall into a recession in the rst half of 2013 !
Percent (%)!
3.0! 2.5! 2.0! 1.5! 1.0! 0.5! 0.0! 2010! 2011! 2012! 2013!
Source: Congressional Budget Ofce!
The CBOs findings are echoed by analysts for Goldman Sachs, who estimates a four percent reduction in growth25, and David Greenlaw of Morgan Stanley, who argues 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 Business School agreed that output would be lower than the alternate fiscal scenario (which avoids most of the fiscal cliff) if no action were taken.26 The economic analyses cited above are concerned that the fiscal cliff will significantly reduce aggregate demand in the economy. If the fiscal cliff is not avoided, all households would see an immediate reduction in cash as payroll taxes
rise. And while income tax hikes will not be paid until 2014, people will cut spending immediately to save for their future tax bills. Spending program cuts would directly impact governmentdependent jobs, while reducing unemployment assistance will impact consumer spending. With less after-tax income, spending will decline.
Moreover, according to research by Christina and David Romer of the ! University of California at Berkeley, the effect of tax hikes on demand for goods and services is magnified as businesses reduced growth expectations translate into lower investment. In total, they find a tax increase of one percent of GDP reduces inflation-adjusted GDP by roughly three percent.27 In the intervening time period, uncertainty around policy could put business investment on hold, further stifling growth.
Moreover, 38 of 39 top economists surveyed by the University of Chicago Booth Business School agreed that output would be lower than the alternate fiscal scenario if no action were taken.!
Is The Fiscal Cliff All Bad?

While falling off the fiscal cliff could cause a recession in 2013, it would also drastically reduce the federal governments debt concerns in the medium term and would actually increase output in the long-term. Focusing on the magnitude of the year-over-year fiscal contraction conceals the fact that last year we spent 24.1 percent of GDP while only collecting 15.4 percent of GDP in revenues. According to Office of Management and Budget data, historically, those averages are 19.7 percent and 17.7 percent, respectively. This current imbalance is simply unsustainable and fiscal contraction is both necessary and inevitable. The question is whether 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 cuts would push federal debt as a percentage of GDP down from 73 percent to 61 percent by 2022. Meanwhile, the CBOs alternative fiscal scenario, which avoids most of the fiscal cliff without addressing lingering deficits, would increase this ratio from 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 fully recovers, higher deficits will crowd out private investment; therefore, by reducing our debt now, higher levels of investment will finance faster growth over the course of the decade. While a trade-off exists between short-run deficit-financed tax cuts and spending and long-run growth, they are not mutually exclusive if legislation to mitigate the fiscal cliff includes provisions to reduce deficits in future years.
Exhibit!33 !
THE FISCAL CLIFF WOULD SIGNIFICANTLY LOWER THE DEFICIT IN THE MEDIUM-RUN!
Debt Held by the Public as a Percent of GDP! 100! Current Law! Alternative Fiscal Scenario! According to CBO analysis, increasing debt levels will raise interest rates, reducing growth over the decade.! ! 31.9% While cuts will hurt in the of GDP ! short-run, over the next decade they can be positive for economic growth.! ! Through this lens, the scal cliff represents a trade-off between the short-run and long-run. !
2013! 2014! 2015! 2016! 2017! 2018! 2019! 2020! 2021! 2022!
90!
Percent (%)!
80!
70!
60!
Source: Congressional Budget Ofce!
Complications: The Debt Ceiling

The fiscal cliff is not the only political stand-off over Americas fiscal position. The debt ceiling, which represents the legal borrowing limit of the U.S. Treasury, will need to be raised in early in 2013 to avoid defaulting on payments (Exhibit 34). While Currently, the U.S. is Secretary Tim Geithner possesses the tools to defer some borrowing from internal on pace to exhaust government funds in order to continue its borrowing spending, his efforts merely delay the crisis. authority in early Only Congress can raise the debt ceiling to enable the Treasury to continue to fund all 2013. ! authorized government obligations, including servicing existing debt. Without discussing the specifics behind the politics of the debt ceiling, experience from last summer suggests there is very little reason to be optimistic that a lasting and timely agreement will be reached. And more importantly, the experience last summer suggests that uncertainty surrounding the debt ceiling can produce harmful economic effects.
2012!
50!
Exhibit!34 !
WITHOUT LEGISLATIVE ACTION, THE DEBT CEILING MAY BE REACHED IN EARLY 2013!
Total Outstanding Debt Subject to Debt Limit! 17! Current debt ceiling is $16..4 trillion ! 16! Without any actions by Secretary Geithner, the U.S. Treasury will hit the debt ceiling in early 2013.! ! Actions to delay hitting the debt ceiling are only temporary solutions.!
Dollars ($T)!
15!
Debt ceiling crisis last Summer!
Potential timeline for debt ceiling reach with Treasury actions to buy more time!
14!
Source: HPSInsight, United States Treasury!
While the effect of uncertainty around economic policy has been a polarizing topic in the political debate, research attempting to quantify the effects of uncertainty suggests it may be highly detrimental to the economy. One attempt to quantify the effect was the development of The Economic Policy Uncertainty Index by economists Scott R. Baker, Nicholas Bloom and Steve Davis, which showed its largest spike during the debt ceiling debate last summer. In fact, the level of economic policy uncertainty rose 92 percent during the debt ceiling debate and peaked 18 percent higher than the month Lehman Brothers failed (Exhibit 35). 28 Furthermore, analysis by Baker, Bloom and Davis found that a rise in uncertainty equal to the change from 2006 to 2011 resulted in large and persistent drops in output with peak declines of 3.2 percent of real GDP and 2.3 million fewer jobs. The rise in policy uncertainty also correlated with significant downward shifts in other economic indicators.29 After five months of averaging 72 points, consumer confidence plunged 16 points to 55.8 in the summer of 2011, a level not seen since the fall of 2008. The S&P 500 steadily climbed 255 points for the 12 months leading up to the debt ceiling debate. During the three-month debt ceiling debate, the S&P 500 plummeted 152 points. Employment gains suffered as well. On average, 176,000 jobs were created each month from January through May. However, during the three-month debt ceiling debate, job growth slowed to just 88,000 jobs created per month. All three of these indicators recovered to previous levels quickly after the crisis, further
Jan-11! Feb-11! Mar-11! Apr-11! May-11! Jun-11! Jul-11! Aug-11! Sep-11! Oct-11! Nov-11! Dec-11! Jan-12! Feb-12! Mar-12! Apr-12! May-12! Jun-12! Jul-12! Aug-12! Sep-12! Oct-12! Nov-12! Dec-12! Jan-13!
13!
suggesting that increased uncertainty caused by the debt ceiling had a measurable effect on the economy.30
Exhibit!35 !
DEBT CEILING DEBATE PUSHED ECONOMIC POLICY UNCERTAINTY TO AN ALL-TIME HIGH!

Economic Policy Uncertainty Index! 270! 240! 210! 180! 9/11! Iraq War! Stimulus Debate! 150! 120! 90! 60! 30! Debt Ceiling Debate! Lehman Failure/TARP! During three-month spike in uncertainty last summer:! ! Consumer Condence fell from 74.3 to 55.8! ! Nonfarm Payroll growth only averaged 88k per month, down from previous 4month average of 190k! S&P 500 fell 152 point!
Index Value!
2000!
2001!
2002!
2003!
2004!
2005!
2006!
2007!
2008!
2009!
2010!
2011!
Source: "Measuring Economic Policy Uncertainty", (2012), Scott R. Baker, Nicholas Bloom and Steve Davis, St. Louis Federal Reserve!
The most striking aspect of the debt ceiling debates effect on the economy was that the debt ceiling was raised in time to avoid defaulting on any payments. If the federal government were to default on payments of interest and principal, the effect on the global economy cannot be overstated, as so much economic activity is dependent on the U.S. Treasury paying its debt. Even the deferral of other nondebt obligations (Social Security, federal salaries, payments to contractors) would have an unpredictable effect on market confidence.
Can the Federal Reserve Offset the Fiscal Cliff?

The fiscal cliff would affect our economy by rapidly pulling significant aggregate demand out of the U.S. economy. Yet, the Federal Reserve typically works to offset drops or quell spikes in aggregate demand in the private sector to keep the economy growing on a sustainable basis. The Fed still has tools to ease monetary policy and provide other forms of support to stimulate demand, although it is unlikely that the Fed can fully offset the fiscal cliff. Normally, the Fed stimulates the economy by reducing interest rates, enabling individuals and businesses to borrow more cheaply to invest and spend. However, the Feds conventional tools are not available as the Fed Funds rate is already essentially zero. Interest rates on bonds, loans and mortgages are historically low, !
2012!
0!
and the struggles in the housing market make it more difficult for the Fed to gain traction by lowering long-term rates.
The Federal Reserve can still ease monetary policy by conveying to market participants that it will do everything in its power to maintain aggregate demand. The Fed can do this by conducting another round of ! quantitative easing. It can also turn this into a communications policy by announcing expected quantitative easing purchases on a monthly or even weekly basis. More radically, the Fed could signal it is willing to tolerate a higher level of inflation. A price level targeting approach would try to average two percent inflation over time, thus signaling it would temporarily tolerate higher inflation in order to get the economy moving. In practice, this reduces peoples demand for holding money, as they expect rising nominal income, increasing spending and stimulating the economy. The Fed has tools to mute the effects of the fiscal cliff, but they are atypical actions that still face one major constraint: inflation. The Feds preferred inflation target is the Personal Consumption Expenditure (PCE deflator) price index, without food and energy prices. Essentially, the Fed purchases a representative basket of goods and tracks the rate at which the price of the basket of goods rise. Food and energy prices are excluded because they are volatile, making targeting them difficult. The PCE deflator is close to the Feds target, leaving little room for action especially since the unemployment rate, while elevated, is trending downward (Exhibit 36). However, if the U.S. enters a recession, the rate of inflation would fall, opening up more room for Fed action to stimulate the economy. In reality, however, the Fed is constrained by more than just inflation. If the Fed feels constrained by the political controversy associated with unconventional policy, this discomfort may impair their ability to mitigate the economic effects of the fiscal cliff. Yet, even without constraints, the Fed will have difficulty of offsetting the sheer magnitude of the entire fiscal cliff.
The Fed has tools to mute the effects of the fiscal cliff, but they are atypical actions that still face one major constraint, inflation.
Exhibit!36 ! UNEMPLOYMENT IS FALLING WHILE THE FEDERAL RESERVES PREFERRED MEASURE OF INFLATION IS CLOSE TO FED TARGET!
Core PCE deator is near Fed target! PCE, Percent Change from Year Ago! Unemployment rate has fallen over the past 2 years! Unemployment Rate! 10! 9!
5!
PCE Deator! Core PCE Deator! Target!
3!
4!
Percent (%)!
Percent (%)! Jul-08! Jul-09! Jul-10! Jul-11! Jul-12!
8! 7! 6! 5!
-1!
0!
1!
2!
-2!
4!
Jul-08!
Jul-09!
Jul-10!
Jul-11!
Jan-08!
Jan-09!
Jan-10!
Jan-11!
Jan-12!
Jan-08!
Jan-09!
Jan-10!
Jan-11!
Source: St. Louis Federal Reserve!
Conclusion
A decade of deferred fiscal decisions by policymakers will come to a head on December 31, 2012. Should Congress and the President be unable to act (or choose not to act), higher taxes and abrupt spending reductions would cause severe disruptions for families and businesses, leading to harmful impacts on the macro economy. Most observers are hopeful that, rather than simply falling off the fiscal cliff, the federal government will enact a rational program of deficit reduction that more than offsets actions taken to mitigate near-term demand shock. With the notable exception of the Budget Control Act, these hopes have proven elusive in earlier showdowns on fiscal policy. Getting agreement on short-term fixes has been far easier to achieve than the painful choices necessary to address the long-term fiscal imbalance. Slow economic growth and persistent unemployment increase the chances that expiring spending and tax relief will simply be extended while deferring necessary actions to reduce long-term deficits. It remains to be seen whether this years showdown over the fiscal cliff will more closely resemble December 2010 or August 2011.
Jan-12!
Jul-12!
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
1 2
Data provided by SNL Financial unless otherwise noted. Quarterly Banking Profile: First Quarter 2012, FDIC Quarterly, 2012, Volume 6, Number 2. 3 Capital: How Much is Enough? Banks are Having to Puff Up their Capital Cushions, The Economist, May 12, 2012. 4 Berrospide and Edge, The Effect of Bank Capital on Lending: What Do We Know, and What Does it Mean? Federal Reserve Board, August 17, 2010. 5 Assessing the Macroeconomic Impact of the Transition to Stronger Capital and Liquidity Requirements, Financial Stability Board and the Basel Committee on Banking Supervision, Bank for International Settlements, December 2010. 6 General Assessment of the Macroeconomic Situation, OECD Economic Outlook, Volume 2, 2010. 7 Suttle, Measuring the Cumulative Economic Impact of Basel III, Institute of International Finance, Sept. 19, 2011. 8 Holtz-Eakin, Douglas. The Costs of Implementing the Dodd-Frank Act: Budgetary and Economic. Testimony at House Financial Services Hearing. March 31, 2011. 9 Hrle, Lders, Pepanides, Pfetsch, Poppensieker and Stegemann, Basel III and European Banking: Its Impact, How Banks Might Respond, and the Challenges of Implemention, McKinsey & Company, November 2010. 10 Buehler, Samandari and Mazingo, Capital Ratios and Financial Distress: Lessons from the Crisis, Risk Practice, McKinsey & Company, December 2009. 11 Comprehensive Capital Analysis and Review for 2012 FAQ. Federal Reserve, November 22, 2011. 12 Daruvala, Malik and Nauck, Why U.S. Banks Need a New Business Model, Investors Want Radical Plans to Boost ROE Above the Cost of Capital, Financial Services Practice, McKinsey & Company, January 2012. 13 Greene, This is Not a Fiscal or Debt Crisis, But a Growth Crisis, Sunday Independent, April 22, 2012. 14 2011 The Economist Intelligence Unit Ltd, a Division of the Economist. 15 Standard & Poors Rating Services 16 Country Exposure Lending Survey and Country Exposure Information Report: First Quarter 2012, Federal Financial Institutions Examination Council, June 29, 2012. 17 Phillips, Matthew. How Europes Contagion May Hit the U.S. Economy, Bloomberg Businessweek, June 7, 2012. 18 Schnurr, Leah. Small business lending cools in April for fourth month.Reuters, June 1, 2012. 19 Dunkelberg, William and Wade, Holly. NFIB Small Business Economic Trends. NFIB, June 2012. 20 Roxburgh, Lund, Daruvala, Manyika, Dobbs, Forn, Croxson, Debt and deleveraging: Uneven progress on the path to growth, McKinsey Global Institute, January 2012. 21 Hilsenrath, Jon. Fed Wrestles With How Best to Bridge U.S. Credit Divide. The Wall Street Journal, June 19, 2012. 22 Wotapka, Dawn. Rents Increase as Vacancies Dry Up. The Wall Street Journal, July 5, 2012. 23 Page, Benjamin. Economic Effects of Reducing The Fiscal Restraint That is Scheduled to Occur in 2013. Congressional Budget Office, May 2012. 24 Greenlaw, David. How Big is the Fiscal Cliff in 2013?. Morgan Stanley, April 13, 2012. 25 Philips, Matthew. The Fiscal Cliff Will Drive the U.S. Into Recession. Bloomberg Businessweek, May 17,2012. 26 Fiscal Cliff. IMG Forum University of Chicago Booth Business School, June 5, 2012. 27 Romer, Christina and Romer, David. The macroeconomic effects of tax changes: Estimates based on a new measure of fiscal shocks. March 2007. 28 Baker, Scott, Bloom, Nicholas, and Davis, Steve. Measuring Economic Policy Uncertainty. 2012. 29 Baker, Scott, Bloom, Nicholas, and Davis, Steve. Measuring Economic Policy Uncertainty. 2012. 30 Stevenson, Betsy and Wolfers, Justin. Debt-Ceiling Deja Vu Could Sink Economy. Bloomberg, May 28, 2012.
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Hamilton Financial Index: July 2012

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Hamilton Financial Index: July 2012

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July 2012!

Hamilton Place Strategies | 1

2 | The State of Our Financial Services

Hamilton Financial Index (HFI)

The Hamilton Financial Index: A Snapshot of Firm and Systemic Risk

THE HAMILTON FINANCIAL INDEX ROSE IN THE FIRST QUARTER OF 2012!

All-Time High! 1.24!

Current ! Release! 1.22!

First Release! 1.15!

Crisis Low 0.46!

Source: HPS Insight, St. Louis Federal Reserve, SNL Financial!

4 | The State of Our Financial Services

Current HFI: More capital, moderated risk!

Corresponding ! HFI Value!

10! 10 8!8 6!6 4!4 2!2 0!0

Tier 1 St. Louis Common Financial Capital Ratio! Stress Index!

St. Louis Financial Stress Index

Source: St. Louis Federal Reserve!

Tier 1 Common Capital, Risk-Weighted Assets and Tier 1 Common Ratio

6 | The State of Our Financial Services

Tier 1 Common Risk-Based Ratio (%)!

Tier 1 Common Capital ($T)!

1.0! 10! 0.8! 0.6! 8! 0.4! 2! 0!

Source: FDIC, SNL Financial!

Hamilton Place Strategies | 7

U.S. COMMERCIAL BANKS CONTINUE TO REDUCE THEIR HOLDINGS OF RISK-WEIGHTED ASSETS!

69! 66! 63! 60!

Source: FDIC, SNL Financial!

A Tradeoff Between Capital and Lending

8 | The State of Our Financial Services

WHILE INCREASING SAFETY, INCREASED CAPITAL REQUIREMENTS ALSO REDUCE LENDING!

Calculating the Effects of Rising Capital Levels

Hamilton Place Strategies | 9

The Hamilton Financial Index Summary

10 | The State of Our Financial Services

Safety and Soundness:

Balancing Risks in Uncertain Times

Hamilton Place Strategies | 11

A Highly Liquid Industry

20! 15! 10! 5! 0!

Source: FDIC, SNL Financial!

12 | The State of Our Financial Services

Insurers Capital & Surplus (C&S) Continues to Climb

Much like the banking

Hamilton Place Strategies | 13

40 40! 36 36! 32 32!

Capital & Surplus ($B)!

300! 300 200! 200

350 350! 300 300!

Source: NAIC, SNL Financial!

Performance Metrics Rise to Pre-Crisis Highs

14 | The State of Our Financial Services

BANK PERFORMANCE MEASURES ARE STILL STRONG IN Q112!

10! 10 0! 0 -10! -10 -20! -20 -30! -30 -40! -40

Source: FDIC, SNL Financial!

Hamilton Place Strategies | 15

P&C AND LIFE INSURERS PERFORMANCE SHOWS STRONG GROWTH IN Q112!

15! 12! 9! 6! 3! 0! -3! -6! -9! -12!

-5 -5! -10 -10!

0 0! -5 -5! -10 -10! -15 -15!

Source: NAIC, SNL Financial!

Economic Challenges Lie Ahead European Distress

S&P Credit Rating!