Hamilton Financial Index: July 2012

7/31/2019 Hamilton Financial Index: July 2012

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The Hamilton Financial Index: !A semi-annual report on the sta

of our financial services industry

With a review of the upcoming

fiscal cliff !

July 2012!


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About this Report

The Partnership for a Secure Financial Future comprisesthe Consumer Bankers Association, Mortgage BankersAssociation, Financial Services Institute, and The Financial

Services Roundtable, which combined represent morethan 2,700 member companies across all organizations.

Hamilton Place Strategies is a consultancy based in Washington,DC with a focus at the intersection of business andgovernment. HPS Insight conducts in-depth analysis on public

policy issues.

About the Authors

Matt McDonald is a Partner at Hamilton Place Strategies. Heformerly worked on economic issues at the White House and isa former consultant with McKinsey and Company.

Steve McMillin is a Partner at US Policy Metrics, an economic and

public policy research firm serving asset managers, hedge fundsand the investor community. He is a former Deputy Director ofthe Office of Management and Budget and a former partner atHPS.

Patrick Sims directs research for HPS. He is a former leadresearch analyst in the financial institutions' group at SNLFinancial and is a former representative of CFA Institute.

Russ Grote is an Analyst at Hamilton Place Strategies specializing

in economic policy analysis and strategic communication.


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Hamilton Place Strategies | 1!

Executive Summary

The U.S. financial sector continues to make important changes to strengthen

itself against ongoing risks. As we document that improvement in this report,we also explore the tradeoffs inherent in todays higher capital levels, and theirimplications for economic growth.

The key findings of the report are:

The Hamilton Financial Index (HFI) rose seven points since the previousquarter and stands at 1.22 as of the end of the first quarter. Banks increase

in Tier 1 capital is driving the rise in the HFI. For the HFI to dip belowhistorical norms, systemic risk would have to increase five times thesecond quarter high. Conversely, if banks had not increased their Tier 1

Common Capital Ratio from the level of three years ago, the secondquarter high of systemic risk would have pushed the HFI below normallevels.

While the European debt crisis presents risks to the global economy, fromthe end of the first quarter of 2011 through the first quarter of 2012, U.S.

banks reduced exposure to the European periphery by over 16 percentand Europe as a whole by eight percent.

Lastly, our policy spotlight found that the upcoming fiscal cliff could bethe largest fiscal contraction in four decades, potentially causing a

significant drop in consumer demand and business investment. The fiscalcliff is further complicated by elevated U.S. debt and annual deficits, apolitically contentious debt ceiling debate, constraints on the Fed, and theslowing of the global economy.

There remain significant challenges to the U.S. and global economies. Despitethis, the financial sector is positioned to support stronger growth as theeconomy improves.

This report was commissioned by the Partnership for a Secure Financial Futureand the conclusions are that of the authors.

Matt McDonaldSteve McMillinPatrick SimsRuss Grote


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2 | The State of Our Financial Services!

CONTENTS

THE HAMILTON FINANCIAL INDEX3An index to measure both risk within the financial system andhow firms are dealing with that risk.

SAFETY AND SOUNDNESS .11A look at how our financial services sector has rebuilt after thecrisis and how they are meeting current challenges particularlyEuropean risk.

VALUE TO THE ECONOMY 20An examination of the everyday value that financial servicesbring to our lives, as well as an in-depth look at how thesector continues to supports the economy during therecovery.

POLICY SPOTLIGHT THE FISCAL CLIFF...38An explainer of the individual pieces of the fiscal cliff and itseconomic consequences in the context of a slowing globaleconomy, the debt ceiling, rising US deficits and the dispositionof the Federal Reserve.


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Hamilton Financial Index (HFI)In its second release, the HFI focuses on

the continued improvements in the financialservices industry and its ability to strengthenitself in economically challenging times. Italso incorporates the idea that tradeoffsexist and can have significant economicoutcomes.

The notion that decisions come withtradeoffs is nothing new. An economictradeoff can be compared to anopportunity cost, which represents thebenefits you could have received by takingan alternative action. The accumulation ofcapital involves an opportunity cost. Anyincrease in capital may indicate the industryis better able to absorb losses. But it isimportant to understand that capital held as abuffer is capital unused to fund important lending that would aid economic growth.

This tradeoff between economic safety and economic growth is why the aboveFederal Reserve quote is so meaningful capital has two purposes: it is used toabsorb unexpected losses andto lend businesses and consumers. A delicatebalance is needed to promote industry safety while encouraging healthy investmentand lending.

!

!

Key Findings Q112:

At 1.22, the Hamilton

Financial Index was 7

points higher than the

previous quarter and 22

percent above evennormal pre-crisis levels.

At current capital levels,

system level risks would

have to increase 5 times

the 2nd quarter high forthe HFI to dip below

historical norms.

Tier 1 Common Capital

increased to above $1.1

trillion, driving the Tier

1 Common Risk-Based

Ratio to 12.76 percent.

!

Capital is central to a

[banks] ability to absorb

unexpected losses and

continue to lend tocreditworthy businesses

and consumers.

- Federal Reserve CCAR


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

As of the first quarter of 2012, the HFI, a measure of both systemic risk and bankscapital levels, was valued at 1.22, 22 percent above the historical norm. The indexsvalue is up from its original release at 2011 year-end, attributing its rise to increasing

levels of capitalization and a reduction in system-wide volatility over the period(Exhibit 1).1

The HFI combines capital levels and financial stress to provide a snapshot of thefinancial sectors ability to handle risk. It uses two commonly accepted metrics:

1. The St. Louis Federal Reserve Financial Stress Index captures 18 marketindicators and is a well-established indicator of financial stress

2. Tier 1 Common Capital Ratio for commercial banks measures financialinstitutions ability to absorb unexpected losses in an adverse environment

In the first quarter of 2012, the St. Louis Federal Reserve Financial Stress Index fell,while the Tier 1 Common Capital Ratio for U.S. banks rose, causing the index toimprove. During the second quarter of 2012, events in Europe have caused stressin the system to rise. However, because U.S. banks have increased industrycapitalization, systemic stress would have to be significantly higher for the HFI to bein unsafe territory.

Exhibit!1 !

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

2010

All-Time High!1.24!

2011

2009

Crisis Low 0.46!

2008

IndexValue

0.50!

1.50!

1.00!

1.25!

0.75!

0.25!

Current !Release!

1.22!

2007

2006

2005

First Release!1.15!

THE HAMILTON FINANCIAL INDEX ROSE IN THE

FIRST QUARTER OF 2012!

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

Hamilton Financial Index!

2012

The Hamilton Financial Index

rebounded to a level 22% above

normal after a small dip due to a

rise of financial stress in the fall.!


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Effectively, for the index to fall below normal levels, the level of systemic stresswould have to increase by five times the second quarter high. The economy hasnot seen that level of stress in three years. Conversely, if banks had not increased

their Tier 1 Common Capital Ratio from the level of three years ago, the secondquarter high of systemic risk would have pushed the HFI below normal levels. This

dramatic shift by U.S. banks over the past three years has better positioned them towithstand shocks from Europe and elsewhere (Exhibit 2).

Methodology

The index value is the difference between the quarterly averages of the FederalReserve of St. Louis Financial Stress Index and the quarterly Tier 1 Common CapitalRatio for the banking industry. All data points are indexed to 1994 levels and 1.00 is

the historical norm from 1994 to the present.

St. Louis Financial Stress Index

The first variable in the Hamilton Financial Index is the St. Louis Financial StressIndex, which combines 18 market variables segmented into three sections: interestrates, yields spreads and other indicators (Exhibit 3). Interest rates help determine

the markets assessment of risk across a number of different sectors. High interestrates represent an increase in financial stress. Yield spreads help determine relativerisk across time and geography. For example, the Treasury-Eurodollar (TED)spreads capture risk not just in the U.S., but also throughout the globe. Other

Exhibit!2 !THE HFI ROSE DUE TO SIGNIFICANTLY HIGHER CAPITAL

LEVELS AND SUBDUED FINANCIAL STRESS!

Source: FDIC, SNL Financial, St. Louis Federal Reserve, HPSInsight!Note:*Tier 1 Common Ratio is a %, St. Louis Financial Stress unit is an index value !

0

2

4

6

8

10

12

141.22

St. Louis

Financial

Stress Index!Tier 1

Common

Capital Ratio!

0

2

4

6

8

10

12

14

Units*

0.46

St. Louis

Financial

Stress Index!Tier 1

Common

Capital Ratio!

HFI During 2008 Crisis: Less

capital, high risk! Current HFI: More capital,moderated risk! Corresponding !HFI Value!14!12!10!8!6!4!2!0!

14!12!10!8!6!4!2!0!

For the index to dip

below its historical

average of 1, financial

stress would have to

increase five times its

Q212 high.!


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indicators fill in important pieces not captured by interest rates or yields. Forexample, the Chicago Board Options Exchange Market Volatility Index captures themarkets expectation of volatility in the financial system. Each indicator captures anaspect of financial stress within the system with some overlap. Collectively, theyprovide a snapshot of systemic risk in financial markets.

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

The second variable in the HFI is the Tier 1 Common Risk-Based Ratio, whichcaptures banks ability to absorb unexpected losses. The Tier One Common Risk-Based Ratio has ticked up to 12.76 percent as of the first quarter of 2012, anotherrecord (Exhibit 4).

The ratio is calculated by taking the industrys Tier 1 Common Capital (numerator)as a proportion of its Risk-Weighted Assets (denominator). Tier 1 Common Capitalacts as a cushion in case of unexpected losses. Therefore, any increase in Tier 1

Common Capital (numerator) improves safety and soundness, all else equal. Anydecreases in the holding of risky assets as measured by Risk-Weighted Assets(denominator) will improve a banks capital position.

Exhibit!3 !THE ST. LOUIS FINANCIAL STRESS INDEX

INCORPORATES 18 VARIABLES TO MEASURE STRESS!

Source: St. Louis Federal Reserve!

St. Louis Fed Financial Stress Index!Other Measures!

1. Effective federal funds rate !2. 2-year Treasury rate!3. 10-year Treasury rate!4. 30-year Treasury rate!5. Baa-rated corporate rate!6. Merrill Lynch High-Yield

Corporate Master II Index!7. Merrill Lynch Asset-Backed

Master BBB-rated!

8. 10-year Treasury minus 3-month Treasury!

9. Corporate Baa-rated bondminus 10-year Treasury !

10. Merrill Lynch High-YieldCorporate Master II Index

minus 10-year Treasury!11. 3-month LIBOR-OIS spread!12. 3-month (TED) spread !13. 3-month commercial paper

minus 3-month Treasury bill !!

14. J.P. Morgan Emerging MarketsBond Index Plus!!

15. Chicago Board OptionsExchange Market Volatility Index

(VIX)!!16. Merrill Lynch Bond Market

Volatility Index (1-month)!17. 10-year nominal Treasury yield

minus 10-year Treasury Inflation

Protected Security yield

(breakeven inflation rate)!18. Vanguard Financials Exchange-

Traded Fund (equities)!

Interest Rates! Yield Spreads!


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Capital levels have increased 38 percent since 2007 to more than $1.1 trillion. In

addition to higher capital levels, the first quarter of 2012 also saw a further declinein banks holdings of risky assets as a percentage of total assets. The fall from thepre-crisis highs calculates to a drop of 13 percent (Exhibit 5). The industrys ability

to shed problem assets and retool balance sheets is an important step. With areduction of risky assets, the financial industry can turn its focus to aiding theeconomy.2

Exhibit!4 !REGULATORY CAPITAL LEVELS HIT ANOTHER

ALL-TIME HIGH IN THE FIRST QUARTER OF 2012!

Source: FDIC, SNL Financial!

1.0!0.8!0.6!0.4!2!

14!

12!

10!

Tier1CommonCapital($T)

1.4!

0!Tier

1Common

Risk

-Base

dRa

tio

(%)

8!

6!

1.2!

Q112

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

Tier 1 Common Capital ($T)!Tier 1 Common Risk-Based Ratio (%)!

Tier 1 Common Capital and Tier 1 Common Risk-Based

Ratio for U.S. Banks!Tier 1 Common Capital

Ratio has risen 38%

since 2007 to an all-

time high.!


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A Tradeoff Between Capital and Lending

Crisis-era efforts from both government and the private sector proved successful inrestoring stability to the financial system. Much of this reflected a recapitalizationprocess, whereby capital was provided to individual firms with a promise to repay.

Without question, these injections of capital reduced financial stress, restoredconfidence and set the foundation for recovery.

However, setting the foundation for recovery is not recovery in itself. The U.S.economy depends on a firms ability to use its capital to grow profitability, therebyinvesting in new business and hiringadditional employees. Ultimately, a

tradeoff exists between increasingcapital as a buffer against future lossesand using capital to fund importantlending and aid economic growth.

Having too little capital is dangerous tothe system, leaving it crisis-prone. Toomuch capital and institutions do notfund growth and may becomeunprofitable. A delicate balancebetween stability and growth is needed.

Exhibit!5 !U.S. COMMERCIAL BANKS CONTINUE TO REDUCE

THEIR HOLDINGS OF RISK-WEIGHTED ASSETS!


63!

60!

-13%

Q112

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

Percent(%)

78!75!72!69!66!

Risk-Weighted Assets as a Percent of Total Assets for U.S. Banks!

!

Ultimately, a tradeoffexists between increasing

capital as a buffer againstfuture losses and using

capital to fund importantlending and aid economic

growth.


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The need to increase capital dominates the current political consensus around bankcapital levels with little discussion about the magnitude and impact of reducedlending. When banks convert maturing loan proceeds into capital rather than re-lending them into the economy, they increase the safety and soundness of thesystem at the expense of current economic growth. Over the long run, increased

safety and soundness may prevent crises and improve growth prospects. However,there are diminishing returns to each additional dollar of capital (Exhibit 6). At acertain point, higher capital standards could actually reduce growth. The magnitudeof this effect is uncertain, but the tradeoff is real and unfortunately under-recognized.

Calculating the Effects of Rising Capital Levels

Debate is rife about the impact of rising capital levels on the supply of loans, thecost of borrowing and, on a macro level, GDP growth. Unfortunately, studies thathave attempted to measure its impact have produced a wide-range of estimates.3

According to the Federal Reserve, for each percentage point of extra capital a bankmust hold, growth slows by about 0.09 percent a year, a modest impact onlending.4 On the other hand, the Basel Committee and the Bank for InternationalSettlements calculates that the damage is closer to one-third of the Feds value.5And while the OECD calculates the widest range,6 the Institute of InternationalFinance calculates that the impact could be up to 10 times bigger than all otherestimates.7

Exhibit!6 !

At what point are the gains from

increased safety and soundness

outweighed by less economic

growth? !

WHILE INCREASING SAFETY, INCREASED CAPITAL

REQUIREMENTS ALSO REDUCE LENDING!

Decision:!What to

do with

marginal

dollar?!

Less lending!

Re-loan into

the economy!

Higher!interest rates!

Less growth but!more safety!

Lower interest!rates! More growthbut less safety!

Increase !capital and !safety!

Decision Tree and Effects!

A higher capital ratio increases safety and soundness but may

reduce lending. At a certain point, the marginal increase to safetyand soundness may be outweighed by lower economic growth.!


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A study by American economist and former director of the Congressional BudgetOffice, Douglas Holtz-Eakin, states each dollar of capital supports between $7and $10 dollars of lending activity.8 McKinsey estimates that American banks aloneneed an additional $870 billion in capital to meet future regulatory standards.9These numbers imply that economic growth could take a major hit as a result of

significantly higher capital levels.

A more important aspect of requiring higher capital levels is that a banks ability toraise additional capital in economically challenging times would be more difficult

than doing so in periods of higher economic growth. To save in good times andthen spend in bad is traditional economic thought. Unfortunately, the regulatoryworld never seems to function in this manner. In requiring higher capitals now, thepossibility emerges that it could drive changes in lending activity and reduce

transparency.10

The Hamilton Financial Index Summary

Since the last release of the HFI in February of 2012, the index value has risenseven points. The industry continues to increase capital levels above required ratesmandated by federal regulators. Current levels of safety and soundness far surpass

the levels seen during the crisis and in the periods leading up to it. According to theindustrys Tier 1 Common Capital Ratio (12.76), higher levels of capital ($1.1

trillion) and a reduction in the ratio of risky assets to total assets by 13 percentfrom pre-crisis highs are driving the index higher. Because of the HFIs two-partapproach, a reduction in system-wide volatility additionally contributes to the indexincreased value.

It is important to note that an index value that constantly increases does notnecessarily point to an improving economy. Institutions that hold capital above theregulatory required rate could be less motivated by safety and more by policyuncertainty, expecting a higher required rate in the future and, therefore,dampening growth. Also, an industry that is over-capitalized may indicate aconstrained lending environment, representing high borrowing costs and tight creditconditions. Further, an over-capitalized industry may reflect a lack of demand frombusinesses and consumers. If borrowers are not requesting additional loans to fundgrowth, then capital will be left sitting in banks a scenario that fits the currenteconomic environment.

As the this section discussed, holding capital poses an economic tradeoff, as capital

is used as both a buffer to unexpected loss and to fund future growth. A questionwe posed in the first report can now be altered to include the tradeoff argument What is the appropriate capital level for a financial institution to hold to absorblosses resulting from unexpected shocks to the systemwhile ensuring an organic

and sustainable recovery?11


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Safety and Soundness:Balancing Risks in Uncertain Times

As the HFI shows, the level of safety andsoundness in the financial industry hassignificantly increased since the crisis. Inmany cases, the industry is in a much saferplace today than in periods before thecrisis. Moreover, the findings of the HFI arereinforced by improvements in otheraspects of safety and soundness such asliquidity, insurance companies Capital andSurplus, and performance measures.

Much like capital levels, the bankingindustrys liquidity levels are at historichighs, meaning that the industry is betterable to meet any potential funding needs

than at any time in the past. Another

important signal of safety, insurercapitalization, is also at all-time highs,indicating that the broader financial servicesindustry is also better capitalized. Asindustry profitability continues to bounceback from crisis lows, it is important thatwe note the current global economy facesmany challenges.

This section will examine these metrics tocomplement the HFI such as liquidity,

insurance capital levels and performancemeasures. The section will also look at theEuropean crisis and its potential impact on theU.S. financial sector as well as the broader economy.

!

Key Findings Q112:

Bank liquidity measures

show that banks aremore liquid than anytime before and thus

better able to meetfunding needs.

Total capital and surplusfor the P&C and Life &

Health industries rose to

$576 billion and $314

billion, respectively.! U.S. financial institutions

exposure to the

European periphery fell16 percent over the past

year.!


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A Highly Liquid Industry

Liquidity, a measure of the ability to fund ongoing operations, is a financialinstitutions lifeblood, especially in times of crisis when funds may not be readilyavailable from outside participants. The same can be said for consumers and non-

bank businesses; their ability to pay expenses, make on-time payments and use cashin other ways is vital for financial success. Banking industry liquidity is high relative to

the levels seen over the past decade, which indicates that the industry is safer,though the economy is growing at a slower pace.

To assess bank liquidity, we examined two ratios: the Loans-to-Deposits (LTD)ratio and the Cash Ratio. The LTD ratio looks at the amount banks are lendingrelative to the amount of deposits that banks hold. While deposits are consideredcore funding for a bank, loans measure risk-taking and potential profitability;

therefore, the ratio captures risk relative to funding. As of the first quarter of 2012,the LTD Ratio was valued at 72 percent an all-time low, meaning that the banking

industry is holding more core-funding for their loans than they have at any time inthe past decade (Exhibit 7).

Exhibit!7 !

Percent(%)

100!90!80!70!60!50!

-21%!

THE U.S. BANKING SYSTEM IS MORE LIQUID NOW

THAN AT AN ANY TIME IN THE PAST!


Total Loans as a Percent of Total Deposits for U.S. Banks!

Cash & Cash Equivalents as a Percent of Liabilities for U.S. Banks !Both ratios show that the

industry is more liquid today

that at any time in the past.!

2010

10!5!0!

Q112

2011

Percent(%)

25!20!15!

2004

2003

2002

2001

2000

2009

2008

2007

2006

2005


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The second ratio, known as theCash Ratio, is Cash and CashEquivalents-to-Liabilities. It alsogauges liquidity; however, itrepresents cash on-hand and other

assets easily converted to cash,which can then be used to pay anyfinancial obligations. As of the firstquarter of 2012, the Cash Ratio wasvalued at 23 percent (Exhibit 7).The Cash Ratio is nearly three-

times the level it was the year before the crisis and is at an all-time high. Both ratiosindicate an extremely liquid banking industry.

While the banking industry has a high level of liquidity, indicating a less risky market,a high level of liquidity also represents less profitable lending opportunities andlower demand for loans in the economy. When the economy returns to higherlevels of growth, the banking industrys liquidity will be reduced as lending increases.Therefore, increased liquidity may be a sign that the economy is still in recovery.

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

The financial services industry is made up of a diverse set of sectors and companies.Each has a role in supporting the U.S. and global economies. As the crisis reflected aloss of confidence in institutions ability to meet their financial obligations, much like

the banking sector, the insurance sector has built a sizeable capital cushion for anyfuture unexpected losses.

Both U.S. Property & Casualty (P&C) andLife & Health insurers have increasedcapitalization by greater than 16 percentsince the crisis low in the first quarter of2009. As of the first quarter of 2012, totalCapital and Surplus for the P&C and Life& Health industries were $576 billion and$314 billion, respectively (Exhibit 8).Similar to banks, insurers use capital to investin new business and customers. While banks base their operations around lending,insurers invest the premiums obtained by policyholders, pay policyholders for any

losses and further reward stakeholders in the form of dividends.

!

Much like the banking

sector, the insurance

sector has built a

sizeable capital cushionfor any future

unexpected losses.


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Performance Metrics Rise to Pre-Crisis Highs

Banking industry profitability stands at its highest level since the second quarter of2007, and according to the FDICs quarterly banking profile, more than two-thirdsof all institutions reported year-over-year improvements in earnings. Few firms,

roughly 10 percent, reported losses, which is also a promising indication theeconomy has stabilized.

Since the crisis, the industry has taken painstaking steps to repair loan portfolios andhelp address borrower-refinancing needs. Like most businesses, a banks ability tomake a profit signals a healthy economy. Increased profitability for the bankingsector indicates businesses and consumers can access credit and keep up withpayments.

As new rules are released for increased capital levels, it is important that thebanking sector remains profitable.12 Profits often heavily correlate with borrowing

costs; greater profits for the industry translate to an increased supply of credit andlower costs to borrowing. Profits also are used for investing in new products andservices that end up benefiting the consumer. Lastly, profits can be used to add toan institutions capital cushion. Profitability is at its highest point since the crisis,

totaling $35.3 billion for U.S. commercial banks, as of the first quarter of 2012(Exhibit 9).

Exhibit!8 !P&C AND LIFE INSURERS CAPITAL AND SURPLUS

CONTINUES TO RISE SINCE THE CRISIS!

Source: NAIC, SNL Financial!

200

300

400

500

600

20

24

28

32

36

40

C&S as a Percent of Assets (%)!Surplus as Regards to Policyholders ($B) !40!36!32!28!24!20!

150

200

250

300

350

8!9!

6!

2008

Q112

2006

2009

7!

2011

10!

2007

2010

5!

2005

2004

2003

2002

2001

CapitalandSurplusasa

PercentofAssets(%) C

apital&

Surplus($B)

Life Insurers!

P&C Insurers!600!500!400!300!200!350!300!250!200!150!


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The U.S P&C insurance industry posted healthy profits in the first quarter of 2012,as net income rose to $12.2 billion, up from $11.2 billion just a quarter prior(Exhibit 10). During the crisis, much of the loss suffered by the P&C industry related

to loss on investment income via the market crash. However, losses also can occurfrom catastrophic events. This was seen in the second quarter of 2011 when

several natural disasters occurred throughout the world. Fortunately, a largenumber of individuals and businesses had insurance plans with many U.S.institutions, triggering massive payouts to plan owners.

Increased profits for the P&C industry are a promising sign, as income now can beused to invest, lower premium costs for buyers and as savings to absorb anyunexpected losses that occur in the future.

While the P&C industry saw healthy profits in the first quarter of 2012, the Lifeinsurance industry witnessed its most profitable quarter since the crisis. Net Incomerose from $4.4 billion in the last quarter of 2011 to $14.9 billion as of March 30,

2012 (Exhibit 10). To put this in perspective, the Life insurance industry sawmassive losses in the last half of 2008 of more than $51 billion. The large gainsassociated with the recent quarterly data strongly indicate that U.S. financialinstitutions are supporting a growing economy. The industry is still in recoverystages, as profitability is volatile from quarter to quarter. Future earnings willdetermine if the recovery is sustainable.

Exhibit!9 !BANK PERFORMANCE MEASURES ARE STILL STRONG

IN Q112!


Net Income and Return on Average Assets and !Equity for U.S. Banks!

-40

-30

-20

-10

0

10

20

30

40

-15

-10

-5

0

5

10

15

Percent(%)

Dollars($B)

Q112

Q411

Q311

Q211

Q111

Q410

Q310

Q210

Q110

Q409

Q309

Q209

Q109

Q408

Q308

Q208

Q108

Net Income ($B)!ROAE (%)!ROAA (%)!

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

-15!

40!30!20!10!0!

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


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Economic Challenges Lie Ahead European Distress

The financial industrys resilience has been on display since the recovery began.Many unknowns existed at the markets lowest point, and many still do, but theindustry has managed to provide the support needed to place the U.S. on a more

sustainable path. The following section will spotlight some of these key problemsfacing Europe, and then provide clarity around the potential impact it could have onU.S. banks and the broader economy.

A Crisis of Growth

It is apparent that what started out as a crisis of debt has morphed into a crisis ofgrowth. The loss of investor confidence is bearing down on governments asinvestors continue to question their ability to pay back debt. Though steps havebeen taken to cut government spending, increasing austerity without morestructural reforms has provided little assurance that future growth will be large

enough to resolve the issue.

Megan Greene of Roubini Global Economics writes that the trade-off betweenausterity and growth was crystal clear in Ireland in late 2010No matter what theIrish government did, it could not regain market confidence, and Ireland was forcedinto an EU/IMF bailout within weeks. She states further that Eurozone leadershave not learnt their lesson.13 To date, governments around Europe havecontinued to replicate what occurred in Ireland, only to see themselves in the same

Exhibit!10 !P&C AND LIFE INSURERS PERFORMANCE SHOWS

STRONG GROWTH IN Q112!

Source: NAIC, SNL Financial!

-15

-10

-5

0

5

10

15

-10

-5

0

5

10

15

Net Income ($B)!ROAA (%)!ROAE (C&S) (%)!

!!!!!!!!!

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

-30

-20

-10

0

10

20

-60

-40

-20

0

20

40

Q112

Q411

Q311

Q211

Q111

Q410

Q310

Q210

Q110

Q409

Q309

Q209

Q109

Q408

Q308

Q208

Q108

Percent(%) D

ollars($B)

P&C Insurers!

Life Insurers!

Net Income and Return on Average Assets and Equity!

20!10!0!

-10!-20!-30!

15!10!5!0!-5!-10!40!20!0!

-20!-40!-60!


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troubling situation. Investors have focused on a select number of countries,particularly Greece, Ireland, Italy, Portugal and Spain. According to the EconomistIntelligence Unit, GDP growth rates for 2012 among the distressed Europeanperiphery members are estimated to be the lowest in all of Europe. 14

U.S. Bank Exposure to Europe

It is no coincidence that low GDPgrowth rates are linked withratings downgrades. Yet, U.S.banks have aligned their portfolioswith countries that are rated safer(Exhibit 11). In fact, more than 72percent of all risk claims areassociated with countries with aAAA rating.15

U.S. banks exposure to the European periphery declined over 16 percent in thepast 12 months. Moreover, exposure to Europe on the whole has declined by eightpercent during that time period. (Exhibit 12). The peripheral countries of Greece,Italy, Ireland, Portugal and Spain represent less than $200 billion in risk claims, andare less than 10 percent of total exposure (Exhibit 13).16

Exhibit!11 !U.S. BANKS EUROPEAN EXPOSURE IS CONCENTRATED IN

COUNTRIES WITH HIGH CREDIT RATINGS!

Source: FFIEC, HPSInsight!

S&PCreditRating

Risk Claims ($B)!

$785.9B!

$53.8B!

U.S. banks total exposure to

Greek risk claims is less than 1%

of UK risk claims. Exposure to

peripheral countries is less than

10% of total European exposure.!

$351.4B!

$5.8B!

Total Risk Claims by Country and National S&P Ratings!

!

!"##$#%! "!"#$!"#$%&'()! "!"#$!"#$%&! ! "!"#$!"#$%&! ! "!"#$!"#$%&'(! "!"##!"#$%&'()*&(+%","-./0(!"#$%%&'$"($)*"

!"#$%&'!

!"#$!%&'()$*+,-+.


20/52


Exhibit!12 !

Percent(%)

50!40!30!20!10!0!

-10!-20!-30!-40!-50!-60!

Total

Europe!Swiss!UK!France!Germany!Italy!Portugal!Ireland!Spain!Greece!

U.S. FINANCIAL INSTITUTIONS HAVE REDUCED EXPOSURE TO

THE PERIPHERY BY OVER 16%!


Percent Change of Country Risk Claims from Q111 to Q112!Over the course of the last 12 months, U.S.banks have reduced exposure to the

periphery from $216 billion to $181 billion

and to Europe as a whole by eight percent.!

Exhibit!13 !U.S. BANKS ARE MOST EXPOSED TO THE U.K.,

GERMANY AND FRANCE!


< 10!10 - 100!

> 500!100 - 500!

Risk Claims ($B)!


21/52


The continued turmoil around Europes debt problems has contributed to marketinstability. However, no U.S. bank has reported significant losses tied to the issue asof the date of this report. While it is worth noting that financial contagion effectsare an unfortunate reality and European countries with investment grade ratings

today could lose them in the future, U.S. banks have reduced exposure to Europe

and total direct exposure to the periphery is modest.

Potential Impacts on the U.S. Economy

The threat of financial contagion is ongoing. Although a major public fear is tied toU.S. banks exposure to Europe, there are other important threats to the U.S.economy that are not linked to the U.S. banking sector. For instance, manyemerging markets obtain funding for imports from European banks. If their sourceof funding is cut off, exports to these countries could dry up. This could have a largeimpact on U.S. GDP, since emerging market economies have represented a largeshare of U.S. export growth over the last several years. In fact, U.S. exports to Brazilalone have increased 70 percent since 2007. Although total exports only accountfor roughly 14 percent of U.S. GDP, the increase in exports represents nearly halfof GDP growth in the U.S., according to RBC Capital Markets chief U.S. economist,Tom Porcelli.17

Further distress in Europe could also lead to other issues for the U.S. economy,including direct exports to Europe, U.S. banking losses tied to European debt, andsupply-chain issues involving U.S. multinational firms. When compiling the potentialimpact of emerging market exports with other factors, a Euro break-up could haveserious consequences for the U.S. economy.

Summary

The financial services industry as whole continues to increase levels of safety andsoundness shown through both capitalization and liquidity measurements, althoughincreased levels of capitalization and liquidity are no free lunch as a tradeoff existsbetween these measurements and economic growth. Higher levels of liquidity arealso being driven by a low demand for loans, rather than a low supply. Thisindicates that while the financial sector has quickly repositioned itself since the crisis,other parts of the U.S. economy are recovering at a slower pace. If the economyreturns to higher levels of growth, then liquidity and capitalization will decrease.Therefore, the balance between safety and growth is a delicate one.

As the industry faces global economic challenges, i.e. crises in Europe, its currentlevels of capitalization and liquidity will contribute to, rather than reduce, systemwide stability. Even though banks are continually adjusting to safeguard themselvesagainst catastrophe, the trouble in Europe could potentially impact the U.S.economy via emerging market exports and other links. To an extent, the negativeeffects on the U.S. economy from a further deepening of the European crisis are inmany ways unavoidable.


22/52


Value to the Economy:Increasing Loans During the Recovery

The diversity of institutions in the U.S.financial sector enables individuals andbusinesses to meet all of their financialneeds efficiently. Insurance companiesinsure individuals and businesses against

catastrophes, accidents and unforeseencrises. Community banks provide loans tolocal restaurants and help set-up a highschool students first bank account, while

the largest U.S. banks supply capital,foreign exchange and trade financing tohelp Americas companies sell productsworldwide.

As the winter HFI detailed, U.S. banksprovided financial shelter during the

recession. As a result, commercial bankdeposits increased 25 percent andconsumer credit card loans rose 70percent. When the recovery began, U.S.banks quickly increased loans tobusinesses, including a six percentincrease in 2011.

In the first half of 2012, U.S. economicgrowth decelerated, householdscontinued to deleverage, and uncertainty

about the fate of the Eurozonepermeated the economic climate. Bankscontinued to play the dual role of financial shelter for investors seeking refuge fromvolatile markets and supporter of the recovery for businesses looking to expand.Meanwhile, insurers whose services are less tied to the state of the economycontinue to aid individuals and businesses.

!

Key Findings Q112:

Total loans and leases

rose to $6.8 trillion.

Domestic business loans

rose above $2 trillion

and small business

owners borrowingsatisfaction continues to

improve.

P&C and Life Insurerspaid out $338 billion and

$493 billion in benefits,

respectively.

The total U.S.retirement market

reached $17.9 trillion,

an all-time high.


23/52


The National Economy and Individuals Balance Sheets

After a strong fourth quarter in which the economy grew at a three percentannualized rate, U.S. economic growth decelerated, only expanding at a modest 1.9percent annual rate in the first quarter of 2012. Similarly, job growth, while strong

throughout the winter, fell below 100,000 in April and May. Spring retail salesflatlined, job openings declined and the unemployment rate ticked up. These pastsix months exhibit the economys continued fragility three years after the recessionofficially came to an end (Exhibit 14).

With slower economic growth, consumers continued to deleverage in 2012(Exhibit 15). According to the New York Federal Reserves Quarterly HouseholdCredit and Debit Report, households have reduced total debt burdens by 10percent since the crisis and total household debt is down to $11.43 trillion, a level

not seen since late 2006. Mortgage and home-equity debt fell one percent and 2.4percent respectively, while auto and student loan debt rose slightly.

Deleveraging places households on sounder financial footing for the future.However, it can also potentially drag economic growth. Typically, deleveraging isdiscussed as a temporary phenomenon with the expectation that householdseventually will gain confidence and increase spending. New evidence, though,suggests that households may have adjusted to a new normal.

Exhibit!14 !

RealGDPGrowthPercentage(Annualized)(%)

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

Q112

Q411

Q311

Q211

Q111

Q410

Q310

Q210

Q110

Q409

Q309

Q209

Q109

Q408

Q308

Q208

Q108

No

nfarm

PayrollMonthlyChange(InThousands)

800!600!400!200!

0!-200!-400!-600!-800!

-1,000!

First and second quarter

GDP and job growth iscontinuing to slow down

through the summer.!

THE ECONOMIC RECOVERY DECELERATED IN THE

FIRST HALF OF 2012!

Source: BEA, BLS!

Nonfarm Payroll Monthly Change and Real GDP Growth! GDP Growth (%)!Payroll Growth!


24/52


Household deleveraging continues despite Federal Reserve data demonstrating thatmonthly financial obligations are at lows not seen sine the early 1990s. On average,households allocate about 16 percent of their income to meet their monthlyfinancial obligations, which include debt service, rent for tenant-occupied

households, automobile leases, homeowners insurance and property taxes. This issignificantly lower than the 19 percent they spent before the recession.

Continued deleveraging despite low monthly financial obligations is consistent withlow growth expectations. In fact, the expected increase in inflation-adjusted familyincome has plummeted since the recession according to data from the ThomsonReuters/University of Michigan Survey of Consumers. After 20 years of reportingexpectations of a two-to-three percent increase in family income over the next 12months, households have foreseen less than a 0.5 percent increase, the lowestmedian level on record. These data points suggest that rather than deleveraging tohelp pay current bills, households may be using their excess income as insurance tohandle future financial shocks.

Moreover, the fall in housing prices erased a significant amount of wealth thatallowed people to borrow and spend more. Therefore, with the baby boomersretiring, it is welcome news to see retirement accounts rebounding strongly from

the crisis. In fact, in the first quarter of 2012, the total value of the U.S. retirementmarket reached a record high of $17.9 trillion (Exhibit 16). According to theInvestment Company Institute (ICI), as of the third quarter of 2011, retirement

Exhibit!15 !

Total Q112 Change: ! - 0.9%! Mortgage debt: ! - 1.0%! HE Revolving:! ! - 2.4%! Auto Loans: ! ! +0.3%! Credit Card: ! ! - 3.6%! Student loan debt: ! +3.4%!

7!

12!

9!10!

8!

6!Mortgage!

HE Revolving*!Auto Loan!Credit Card!Student Loan!Other!

Q111

Q110

Q109

Q108

Q107

Q106

Q112

Dollars($T)

11!

13!

HOUSEHOLDS ARE CONTINUING TO REDUCE

DEBT BURDENS IN 2012!

Source: The Federal Reserve Bank of New York, !*Home Equity!

Total Household Debt by Type!


25/52


savings comprised 36 percent of all household financial assets. Current and soon-to-be retirees lost a significant amount of wealth due to the plunge in home prices, but

the recent gains in the retirement market have helped provide more financialsecurity to individuals.

Financial Shelter

Given the fragility of the recovery in the first half of 2012, the U.S. financial sectorcontinues to serve as a safe haven in times of economic crisis. In the first quarter of2012, the U.S. financial industry continued to play the role of safe keeper asdeposits continued to rise, topping out at $9.46 trillion. Moreover, core deposits,which are comprised of accounts holding $250,000 or less, excluding brokereddeposits, and are considered highly liquid, continued to rise. As a percent of totalliabilities, they now stand at 76.2 percent, the highest level since 1993 (Exhibit 17).This level of core deposits provides a large and stable base to fund loans.

Not only did the level of deposits rise, but also the growth rate was faster than theprevious several periods. From the fourth quarter of 2011 through the first quarterof 2012, the growth rate of deposits increased from 9.2 percent to10.3 percent.

As noted earlier, the LTD ratio for U.S. commercial banks continued to fall andnow sits below 70 percent. While the drop represents a more liquid bankingsystem, it also reflects an increased flight to safety as individuals and companies look

to avoid volatility in the markets.

Exhibit!16 !THE TOTAL RETIREMENT MARKET REACHED AN ALL-

TIME HIGH OF $17.9 TRILLION AT THE END OF 2011!

Source: Investment Company Institute!2001

2000

2002

14!16!

Dolla

rs($T) 12!

10!8!6!4!2!

+13%!

IRAs!

DC Plans!

Private DB Plans!

18!Federal Pension Plans!Annuities!

2011

2010

2009

2008

2007

2006

2005

2004

2003

State and Local !Government Pension Plans!

Total U.S. Retirement Market!


26/52


Providing Credit

Despite the economic slowdown and continued movement toward safety, U.S.commercial banks still increased loans to the economy. Total loans and leases in the

first quarter of 2012 rose to $6.8 trillion, slightly below the all-time high set in 2008(Exhibit 18). The increase in loans was driven by rises in real estate lending.

While still increasing, loan growth has slowedin 2012. In the third and fourth quarter of2011, loans grew at 11.4 and 9.3 percent,respectively. During that time, the loangrowth rate outpaced the deposit growthrate. However, in the first quarter of 2012,

the loan growth rate slowed to 4.55 percent.The underlying dynamics show an economy

in flux where consumers pull back from creditneeds, businesses continue to expand at a moderate pace and the housing marketshows signs of life.

Exhibit!17 !DEPOSITS CONTINUED TO CLIMB THROUGHOUT THE

RECESSION AND RECOVERY!


30

40

50

60

70

80

90

100

TotalDeposits($T)

10!9!8!7!6!5!4!3!2!

CoreDeposits/TotalDeposits(%)

+24%!

Q112

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

Total Deposits and Total Core Deposits!

as a Percent of Total for U.S. Commercial Banks! Total Deposits ($T)!Core Deposits/Total Deposits (%)!100!90!80!70!60!50!

40!

30!

!

Total loans and leases in

the first quarter of 2012

rose to $6.8 trillion,slightly below the all-

time high set in 2008.


27/52


Loans to Businesses

The rise in total loans and leaseswas driven by increasedcommercial and industrial loans.

Commercial and industrial loansincreased to $1.3 trillion in thefirst quarter of 2012. Thisgrowth offset the fall inconsumer loans, which wasdriven by a reduction in creditcard loans (Exhibit 19). U.S.commercial banks alsocontinued to increase loans to

businesses in the first quarter of 2012 by three percent. Total loan volume nowtops $2 trillion, the second-highest level on record. Since the end of 2010, domestic

business loans have risen almost 10 percent (Exhibit 20).

Exhibit!18 !TOTAL LOANS AND LEASES ROSE TO $6.8

TRILLION IN THE FIRST QUARTER OF 2012!


Total Loans from U.S. Commercial Banks!

Dollars($T)

7!

6!

5!

4!

3!Q112

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000


28/52


Exhibit!19 !COMMERCIAL AND INDUSTRIAL LOANS HAVE DRIVEN

INCREASES IN NON-REAL ESTATE LOANS IN 2012!


Dollars($T)

2.8!2.4!2.0!1.6!1.2!0.8!0.4!0.0!

Q112

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

Consumer Loans and Commercial and Industrial Loans !for U.S. Banks! Consumer Loans ($T)!

Commercial & Industrial Loans ($T)!

Exhibit!20 !TOTAL DOMESTIC BUSINESS LOANS HAVE

INCREASED IN Q112 TO $2 TRILLION!


Dollars($T)

2.5!

2.0!

1.5!

1.0!Q112

$2 Trillion!

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

Total Domestic Business Loans ($T)!Total Domestic Business Loans for U.S. Banks!


29/52


While total domestic business loans continued to increase, their rate of growth

decelerated from six percent to three percent. This change more than likely reflectsreduced demand for loans as economic growth decelerated.

Commenting on the drop in small businessloans, Paynet founder Bill Phelan said,"These businesses are cautiousThey'reholding back on new investments andexpansions in their businesses, and that'sreally a result of the view of uncertainty in

the marketplace."18 The Federal ReserveSenior Loan Officer survey found that from

January to April 2012, a majority of banks easedstandards on Commercial and Industrial loans. The NFIB Small Business Optimismsurvey tells a similar story, as small-business owners are not signaling reduced loanavailability or lower levels of borrower satisfaction from the previous year (Exhibit21). Moreover, only three percent of small-business owners cite financing as theirlargest problem.19 Businesses that need funding are becoming more likely to receiveloans from banks than several years ago.

!

!

Spotlight: U.S. Bank Support for Metropolitan Transportation

Tashitaa Tufaas bus company, Metropolitan Transportation Network Inc., is on course tohave its best year yet in the Minneapolis-St. Paul metropolitan area. The company plans to

add between 60-80 new buses to its fleet of 300 for the school year that begins this fall,and it already has added 60 new jobs this year. Its strong growth earned the company aspot on the Minneapolis-St. Paul Business Journals l ist of top 50 fastest-growing companiesin the area.

Tufaas success did not come easy. The company hit a rough patch in the midst of therecession as school districts cut costs wherever possible. Tufaa weathered the storm until2011 by self-financing and continually putting money back into the business. That year, hesought counsel from U.S. Bank.

U.S. Bank examined Metropolitan Transportation and determined how it could help thecompany become more profitable and grow. The bank proposed that the companyconsolidate its multiple sites into one location to save time and travel. The company took

the advice and a year later has added employees and equipment. Tufaa expects revenueto rise to record levels.

Consolidating the worksites allowed the company to purchase larger fuel tanks, which hasprovided major savings in the high fuel-cost environment. The new garage is top of theline and makes others want to learn from us, says Tufaa. U.S. Bank helped us controlunnecessary costs and made the consolidation process easy.

Businesses that need

funding are becomingmore likely to receive

loans from banks thanseveral years ago.


30/52


Loans to IndividualsBeyond loans to businesses, banks lend to consumers to help finance consumerspending. Overall, consumer loans have fallen since last quarter, led by a slight dropin credit-card loans. However, as we saw in the winter HFI, credit-card loans

increased 70 percent during the crisis as consumers looked to finance purchases intough times. Therefore, a gradual reduction of these loans is unsurprising in theshort-term. Consumers have continued to increase their holdings of automobiledebt to finance car purchases for the fifth consecutive quarter. May auto sales wereup 17.4 percent from 12 months earlier. The largest type of loan to individuals, real-estate loans, has started to tick up for the first time since the crisis. Total real-estateloans rose to $3.6 trillion in the first quarter of 2012 (Exhibit 22).

Exhibit!21 !SMALL-BUSINESSES LOAN AVAILABILITY AND BORROWER

SATISFACTION REMAINED UP SINCE THE END OF 2011!

Source: NFIB Small Business Optimism Survey!

3-Month Rolling Average of Net Small-Business Owners Responding Loan

Availability is Increasing vs. Decreasing and That Borrowing Needs AreSatisfied!

BorrowingNeedsSatisfied(%)

45!40!35!30!25!20!15!10!5!0!

LoanAvailability(%)

0!

-10!

2012

2011

2010

2009

2008

2007

2006

-5!

-15!

Borrowing Needs Satisfied!Availability of Loans!


31/52


!

Spotlight: Fifth Third Bank Support for Square 1 Art

In 1999, Andrew Reid, a former businessman, and his wife Martha, a former elementaryschool art teacher, received a small loan from Ballston Spa National Bank to combine

their passions and start their own business, Square 1 Art. The company reproduceschildrens art onto shirts, mugs and other products and shares the profits of their saleswith schools. The product affirms students artistic achievements, gives parentskeepsakes of their childrens art and provides schools a fundraising option in difficultbudget times.

After several years of impressive 20 percent annual growth, Square 1 Art had theopportunity to expand. Andrew and Martha moved the operation from Upstate NewYork to Atlanta. They recently acquired 84,000 square feet of warehouse space toincrease production, employment and opportunities for schools throughout the country.Tired of expensive leases, they found a partner in Fifth Third bank. It representedSquare 1 Art to the Small Business Administration for a loan guarantee. The couplereceived a larger line of credit that allowed them to make critical purchases and meet

the up-and-down cost requirements of a highly seasonal business.

Fifth Third is known as a bank with a hands-on approach. Andrew, for one, needed toknow what will a bank do for you todayandwhat will they do for you tomorrow. Hefound a bank ready to tackle his financing needs while giving his wife and him the

confidence to take advantage of growth opportunities down the road. Not only isSquare 1 Art the realization of the American Dream for them, it has also become thatfor their adult children, Travis and Jane, who are now members of the leadership team.Square 1 Arts continued growth will mean the passing down of the family business

thanks to two caring banks.!


32/52


Throughout the recovery, many analysts predicted a housing bottom and, according

to CoreLogic data, housing prices increased month-over-month in both March andApril, thus showing signs of stabilization. Housing starts also increased significantlyfrom last year according to data from theDepartment of Commerce. In May, year-over-

year total privately owned housing unit startswere up 28 percent at a 708,000 seasonallyadjusted annual rate. With inventories

tightening in many markets, especially in themultifamily sector, Americas housing sectorshowed promise of making a comeback andpropelling the recovery. In fact, residentialinvestment increased 19.3 percent in the first quarter of 2012. Despite recent gains,

the housing market remains in recovery given the low levels of starts. Thefundamentals of the market still point to slow but improving growth in the near-

term.

Every year from 1992 to 2006, more than 1 million single-family homes werestarted, more than double the current rate of 492,000. The annual pace ofmultifamily home construction, which is up over 100 percent from 2009 lows, is still17 percent below the average from 1990 to 2008 (Exhibit 23).

Exhibit!22 !REAL-ESTATE LOANS HAVE INCREASED IN THE

FIRST QUARTER OF 2012!

Source: SNL Financial, FDIC!2001

2005

2011

2010

2009

2006

2007

2008

Q112

2000

2002

2003

2004

Dollars($T)

1!

4!

2!

3!

U.S. Commercial Bank Real Estate Loans!

!

In May, year-over-year privately ownedhousing unit starts

were up 28 percent.!


33/52


While overbuilding occurred prior to the recession, low levels of construction in thelate 2000s brought household construction more in line with household formationin the 2000s (Exhibit 24). Demand for housing has slowed for two reasons:household formation has declined significantly since the crisis; and consumers

tenuous credit situations make mortgage lending more risky.

Household formation since the crisis is 57 percent below trend growth, equating tothree million missing households (Exhibit 25). More specifically, the high rate ofyouth unemployment combined with rising student debt levels may have led tosignificantly less household formation among recent college graduates. According to

the Census CPS/HVS survey, more men and women aged 24 to 30 years old areliving with their parents now than in the past 20 years. Nineteen percent of menand 10 percent of women in this age group currently live with their parents,compared to 14 and nine percent pre-recession. Moreover, the entire dropoffcomes from family household formation as opposed to groups.

Exhibit!23 !WHILE INCREASING THIS YEAR, NEW HOUSING

STARTS ARE WELL BELOW NORMAL LEVELS !

Source: Census CPS/HVS!

0.2!

0.8!

1.8!1.6!

1.0!

0.6!

1.2!

2.2!

0.4!

1.4!

0.0!2012

2011

2010

2009

2008

2007

2006

2.0!

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

Multifamily! Single Unit!Single Unit and Multifamily Starts!

Millions

Multifamily starts have

increased while single

unit starts continue to

lag!


34/52


Exhibit!24 !RELATIVE TO HOUSEHOLD FORMATION, THE 2000S DID

NOT SEE SIGNIFICANT OVERBUILDING IN HOUSING!

Source: Census Decennial, CPS/HVS, HPS Insight!

Starts(Thousands)

18!17!16!15!14!13!12!11!10!9!8!7!

HouseholdsAdded(InMillions)

17!16!15!14!13!12!11!10!9!8!7!

2000s!1990s!1980s!1970s!1960s!

New Households!Starts!Pace of 2000-2007!Housing Starts and Household Formation!

There was a boom in the

early 2000s. We were on

pace to build more houses

in that decade than any

since the 1950s while

having a very low level of

household formation. !!However, the bust over the

past four years brings the

total to normal levels.

Moreover, low levels of

construction in 2011

continues to reduce supply

issues.!!

Exhibit!25 !SINCE 2007, HOUSEHOLD FORMATION IS ROUGHLY 3

MILLION HOUSEHOLDS BELOW TREND!

Source: Census CPS/HVS, HPS Insight!

Households(InMillions)

125!

120!

115!

110!

105!2012

2010

2008

2006

2004

2002

2000

3 million

households!

Household Formation!Household formation

is 53% below trend

since 2007.!The reduction in

household formation puts

downward pressure on

prices and reduces the

incentive to build new

single and multifamily

units.!!However, if household

formation snaps back to

trend, inventories will

tighten, putting upward

pressure on prices. Higher

prices will incentivize

more housing starts. !


35/52


This data suggests that new families are putting off moving into their own home. Inaddition to young people moving in with parents, a decline in immigration hasreduced household formation during the crisis.

Beyond slower household formation, high debt levels and poor credit further

constrain growth in the housing market. The main method for deleveraging hasbeen foreclosing on houses. According to The McKinsey Institute, two-thirds ofhousehold deleveraging has been through foreclosures and defaults on consumercredit.20 While this reduces debt burdens, the negative effect on credit scoresmakes mortgage lending less attractive. Real-estate assets, while improving forbanks, still have high non-performing rates (Exhibit 26).

Banks have responded to these dynamics by tightening lending standards for lesscreditworthy borrowers - 90 percent of all new mortgages last year went toborrowers with high credit scores compared to 50 percent several years ago.21 Thishas helped banks improve their balance sheets, but it also results in less lending and

lower growth in the sector.

Despite headwinds, the fundamentals show signs of improvement. Home prices arebeginning to stabilize, inventories are shrinking, debt burdens are falling and real-estate loan performance is improving. With the improved bank balance sheets asdetailed in Section 2 of the report, banks should be in a prime position to support asustained housing recovery. In the near-term, the fundamentals point to an increasein multifamily housing, as the vacancy rate is historically low and rental prices have

Exhibit!26 !

Source: SNL Financial, FDIC!

NONCURRENT REAL-ESTATE LOANS ARE IMPROVING,

BUT ARE STILL ABOVE HISTORICAL NORMS!

20!10!0!

2012

!2011

!2010

!2009

!2008

!2007

!2006

!2005

!2004

!2003

!

15!

10!5!0!

10!5!0!6!4!2!0!

Noncurrent Total

Real Estate vs Non

Real Estate (%)!

Noncurrent 1-4Unit Family Loans

(%)!

NoncurrentMultifamily Unit

Loans (%)!

Noncurrent Land

Dev/ Construction

Loans (%)!

Noncurrent Non-Real Estate Loans (%)!Noncurrent Real Estate Loans (%)!!

Noncurrent Non-Real Estate loans

have fallen unlike

Real Estate Loans! Noncurrent 1-4

Unit Family Loans

remain very high!! Noncurrent

Multifamily and

Land Dev/

Construction

Loans have fallen

but remain high!


36/52


skyrocketed (Exhibit 27). Most recently, Reis data shows the rental vacancy ratedropping to 4.7 percent, the lowest point in a decade.22 It is not surprising to see

that U.S. banks have increased multifamily loans by six percent as of the first quarterof 2012.

Insurance: P&C and Life

While the volume of bank deposits and loans are affected by the state of themacroeconomy, individuals and businesses rely on insurers for support regardless of

the state of the economy. The main categories of insurance are personal auto,which accounted for 39 percent of total premiums, and home and farm ownership,which comprised 15 percent of all premiums. The broad categories listed aboveobscure the actual scope of insurance in the United States. State fairs, food trucks,even hot air balloons, require insurance for business owners to provide their serviceat a reasonable price for consumers. By pooling risks, insurance companies offerindividuals and businesses a low cost way to hedge against catastrophes.

In the first quarter of 2012, P&C insurance premiums, the dollar value paid to theinsurance company in exchange for coverage, continued to rise from 2009 lows,reaching $449 billion. Meanwhile, payouts, which set an all-time record in 2011,dipped slightly in the first quarter of 2012 to $338 billion (Exhibit 28).

Exhibit!27 !THE FUNDAMENTALS POINT TO EXPANSION IN

MULTIFAMILY MARKET!

Source: Census CPS/HVS, St. Louis Federal Reserve !

100

150

200

250

300

350

400

450

V

acancyRate(%)

12!11!10!9!8!7!6!

RentPriceInd

ex

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

V

acancyRate(%)

3!

2!

1!

0!Case-S

hillerPriceIndex

220!200!180!160!140!120!100!80!60!

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

Rental Vacancy Rate !and Price Index!Home Vacancy Rate and !Case-Shiller Price Index! Vacancy Rate (%)!

Rent Price Index!Vacancy Rate!Case-Shiller Index!

Homeowning market vacancy rates remain elevated

and prices continue to fall!Rental vacancy rates are falling and prices are risingrapidly!

450!400!350!300!250!200!150!100!


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Exhibit!28 !P&C PREMIUMS AND PAYOUTS REMAINED

STEADY THROUGHOUT THE RECESSION!

Source: FDIC, SNL Financial !*Premiums are annualized and Loan & Loss Adjusted Expenses are calculated on a Last-Twelve Months basis!

100

200

300

400

500P&C Insurers Net Premiums Written!500!

400!300!200!100!

100

200

300

400

2008

2011

Q112*

2009

2010

2007

2006

2005

2004

2003

2002

2001

2000

Dollars($B)

P&C Insurers Loan & Loss Adjusted Expense (Payouts)!400!

300!

200!

100!

!

Spotlight: Allstate Support for the Gasmans

Dustin and Jill Gasman were driving to the airport to start a relaxing summer vacation inMexico when they noticed their car was having issues. Dustin discovered the catalyticconverter, a device designed to reduce harmful emissions released from a vehiclesexhaust, was sawed off. With no choice but to leave them unresolved before takeoff,Dustin quickly filed a claim and notified their Allstate agent Scott Burlet. Understandinghis clients situation, Scott notified Allstate claims adjuster Mike Nelson and, together,

they worked diligently to ensure the Gasmans had a vacation free of worries about theircar.

Nelson traveled to the Gasmans car, crawled under it to take pictures and arranged fora nearby mechanic to make the necessary repairs. He also arranged a rental car for theGasmans when he realized the repairs wouldnt be finished in time.

The Gasmans were very appreciative. All the parts had been ordered, so all I needed todo was pick our car up from the hotel and drop it off [at the dealership, said Dustin.

Burlet credits mechanic Nelson for his service. He did the extra footwork and arrangedeverything, said Burlet. For Nelson, though, helping the Gasmans wasnt a big deal. Itwent without saying that we needed to do what we could to get the problem resolved,he explains.!


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The Life industry had Premiums, Consideration and Deposits (a comparable metricto Net Premiums for the P&C industry) of $627 billion in the first quarter of 2012,a record high. In the first quarter of 2012, payouts for the industry amounted to$493 billion (Exhibit 29). Life insurance payouts are measured in the form ofBenefits and Surrenders. Benefits include death benefits, matured endowments,

annuity benefits, accident & health benefits, guarantees, group conversions, and lifecontingent contract pay. Surrender benefits and withdrawals for life contractsinclude all surrender or other withdrawal benefit amounts incurred in connectionwith contract provisions for surrender or withdrawal.

As stated above, insurance companies main role is to pool risk to help individualsand companies hedge against unexpected losses. To ensure they can cover lossesadequately, P&C and Life insurers charge premiums. However, one method tolower premiums or provide better benefits to customers is to invest premiums instock markets, bonds and other asset classes. These investments not only helpinsurers better service their customers, but also contribute to economic growth by

turning idle savings into capital for growing companies. As a whole, the insuranceindustry held cash and investments of $4.74 trillion in the first quarter of 2012, ofwhich Life insurers have $3.38 trillion in investments and P&C insurers have $1.36

trillion.

Exhibit!29 !LIFE INSURERS PREMIUMS AND PAYOUTS REMAIN

AT ELEVATED LEVELS!

Source: FDIC, SNL Financial!*Premiums are annualized and Payouts, Surrenders and Benefits are calculated on Last-Twelve Month basis!!

700!600!500!400!300!200!100!

Net Premiums, Considerations and Deposits for Life Insurance!

0

100

200

300

400

500

600

Benefits ($B)!

Surrenders ($B)!

Q112*

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

Dollars($B)

Life Insurance Payouts, Surrenders and Benefits!600!500!400!300!200!100!

0!


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Summary

Despite the deceleration of economic growth, financial services still played a vital role as afinancial shelter, supporter of the recovery and insurer against risk. As detailed in the firstsection, the financial sectors efforts to increase the level of safety and soundness may lead

to reduced lending in the short run. Meanwhile, economic uncertainty has reduced theamount of leverage that households and businesses are willing to undertake. However, byraising capital levels now, banks will be in a better position to contribute sustainably toeconomic growth as the economy continues to improve.

!

Spotlight: Wells Fargo Support for Green Technology and Enfinity

Wells Fargo views solar energy as a viable source of power for the future. Recently, itaffirmed its commitment to environmentally friendly business opportunities by pledgingan additional $30 billion of support by 2020. In the past seven years alone, Wells Fargohas provided more than $11.7 billion in capital across their environmental portfolio,

which includes investments in green buildings, green businesses, and renewable energyprojects. As Jason Kaminsky, vice president of its Environmental Finance group, explains,Wells Fargo is committed to meeting the financial needs of both small and largecompanies integral to the growth of the solar industry."

One Wells Fargo relationship is with Enfinity, among the worlds largest solar developerswith over 390 megawatts of worldwide installed solar capacity. Enfinity provides solarenergy directly to commercial and government customers to provide electricity savings.!David Shipley, Chief Financial Officer for Enfinity in the Americas, says that Enfinityis extremely bullish about the opportunities for growth in distributed solar generation,but we need partners like Wells Fargo to make it happen. Initially, Enfinity relied on

Wells Fargo to provide foreign-exchange services to manage its international operation.More recently, it has invested directly into Enfinity projects.

Describing the relationship between the two companies, David says, Enfinity works withinvestment partners like Wells Fargo that have the appetite and mission to invest in solarassets. Their relationship illustrates how banks and businesses can work together tobring innovative new services to the market.


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Policy Spotlight:The Economic Impact of the Fiscal Cliff

Without legislative action, on January1, 2013, federal tax and spendingpolicy will change so drastically that

the U.S. economy will undergo thelargest year-over-year fiscalcontraction in the past 40 years(Exhibit 30). While partially unwinding

the effects of the fiscal expansion in

2009, the staggering magnitude of thisfiscal adjustment and the severity of itsconsequences have earned thisphenomenon the nickname the fiscalcliff. Without action to avoid thefiscal cliff, the U.S. could be at risk offalling into a recession in 2013.

Moreover, the fiscal cliff only adds toexisting economic concerns such as

the Chinese economy showing signs

of a slowdown and the fate of theEurozone remaining in doubt.Meanwhile, the U.S. is also expected

to hit the debt ceiling in early 2013,meaning Congress will have tostruggle with both the fiscal cliff and

the debt ceiling debate potentiallyamidst a global slowdown.

However, despite the hyperbole of itsnickname, the fiscal cliff represents aset of choices with tradeoffs in theshort and long run. This section of thereport seeks to explain the manyaspects of the fiscal cliff while properlycontextualizing the issue within thedebt ceiling debate, the U.S.precarious fiscal position and thedisposition of the Federal Reserve.

!

Key Findings:

The fiscal cliff

represents the potential

for the largest year-

over-year fiscalcontraction in fourdecades.

66% of the fiscal cliff is

revenue increases.

The debt ceiling willneed to be raised early

in 2013. Last yearsdebate caused

significant turmoil in the

markets.

Monetary policy canoffset some of the fiscal

cliff, but new Fed action

would yield diminishing

returns and is

constrained by inflationconcerns.

!


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One expiring tax that has received too little attention is the 2007 MortgageForgiveness Debt Relief Act and Debt Cancellation. Normally, if a person owes$100,000 and the lender forgives 20 percent, the borrower must report $20,000 as

taxable income. This provision excludes mortgage debt forgiveness from taxation.Without action, this provision will expire, reducing the effectiveness of foreclosure

prevention efforts for struggling homeowners.

On the spending side, automatic spending cuts or sequestration under the BudgetControl Act (BCA) accounts for $65 billion, or 64 percent of total spending cuts.Also, the expiration of extended unemployment insurance benefits will reduce totalpayments by $26 billion in 2013.

The BCA was passed in the summer of 2011 as a part of bipartisan compromise toraise the debt ceiling. Sequestration was imposed as a backstop to ensure thatdeficit reduction promised by the law would be achieved. These spending cutsprimarily affect defense and nondefense discretionary spending, which together

make up roughly one-third of the budget. The remainder of federal spending islargely made up of entitlements, which are barely affected by the BCA. Forexample, the maximum cut to Medicare is only 2 percent. Meanwhile, Medicaid, S-Chip and SNAP (food stamps) are exempt.

Most analysis of the impending fiscal cliff focuses on the collective impact of allthese decisions on aggregate demand in the national economy. However, eachaspect of the fiscal cliff impacts a specific part of the U.S. economy.

Exhibit!31 !

BillionsofDollars($B)

700!600!500!400!300!200!100!

0!Fiscal Cliff!

$607 B!

Continuation

of other

existing

policies!

Cut in

Medicares

payment!Unemploy-!

ment

Benefits!Budget

Control Act!AffordableCare Act!Other*!Payroll!Income andEstate!Source: Congressional Budget Office !*The main provision expiring is the partial expensing of investment properties, !

66% OF THE $607 BILLION FISCAL CLIFF IS REVENUE

INCREASES!

$399 B in Tax Hikes!$105 B in Spending Cuts!

Fiscal Cliff Breakdown!Total fiscal adjustment is about5% of GDP in CY 2013 and the

U.S. would fall into a recession.!


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What Are The Near-Term Economic Consequences?

The Congressional Budget Office (CBO) estimatesthat if the fiscal cliff is not avoided, the shock to the

economy will likely cause the U.S. economy tocontract deep enough to be judged a recession.They project the economy will contract in the firsthalf of 2013 by 1.3 percent and, compared to aneconomy where all provisions were extended, near

term GDP growth would be reduced by fourpercentage points in 2013 (Exhibit 32).

The CBOs findings are echoed by analysts for Goldman Sachs, who estimates afour percent reduction in growth25, and David Greenlaw of Morgan Stanley, whoargues that even with ultraconservative multipliers, it seems almost certain the U.S.

would enter into a recession next year if the fiscal cliff is not avoided. Moreover,38 of 39 top economists surveyed by the University of Chicago Booth BusinessSchool agreed that output would be lower than the alternate fiscal scenario (whichavoids most of the fiscal cliff) if no action were taken.26

The economic analyses cited above are concerned that the fiscal cliff willsignificantly reduce aggregate demand in the economy. If the fiscal cliff is notavoided, all households would see an immediate reduction in cash as payroll taxes

Exhibit!32 !THE FISCAL CLIFF MAY REDUCE GDP GROWTH BY 4% IN

2013 AND CAUSE A RECESSION IN THE FIRST HALF OFTHE YEAR!

Source: Congressional Budget Office!

Percent(%)

4.5!4.0!3.5!3.0!2.5!2.0!1.5!1.0!0.5!0.0!

2013!

-4%!

2012!2011!2010!

2.5!2.0!1.5!1.0!0.5!0.0!

-0.5!

-1.0!-1.5!

Second half!2013!First half!2013!

With Cliff!Without Cliff!Real GDP Growth! Without avoiding the fiscalcliff, the U.S. would fall into

a recession in the first half

of 2013 !

!

!If the fiscal cliff isnot avoided, the

shock to the

economy increases

the risk of a U.S.

recession.!


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rise. And while income tax hikes willnot be paid until 2014, people will cutspending immediately to save for theirfuture tax bills. Spending program cutswould directly impact government-

dependent jobs, while reducingunemployment assistance will impactconsumer spending. With less after-taxincome, spending will decline.

Moreover, according to research byChristina and David Romer of theUniversity of California at Berkeley, the effectof tax hikes on demand for goods and services is magnified as businesses reducedgrowth expectations translate into lower investment. In total, they find a taxincrease of one percent of GDP reduces inflation-adjusted GDP by roughly threepercent.27 In the intervening time period, uncertainty around policy could putbusiness investment on hold, further stifling growth.

Is The Fiscal Cliff All Bad?

While falling off the fiscal cliff could cause a recession in 2013, it would alsodrastically reduce the federal governments debt concerns in the medium term andwould actually increase output in the long-term. Focusing on the magnitude of theyear-over-year fiscal contraction conceals the fact that last year we spent 24.1percent of GDP while only collecting 15.4 percent of GDP in revenues. According

to Office of Management and Budget data, historically, those averages are 19.7percent and 17.7 percent, respectively. This current imbalance is simplyunsustainable and fiscal contraction is both necessary and inevitable. The question iswhether the contraction is achieved rationally over a period of years or abruptly via

the fiscal cliff.

If there is no action taken to avoid the fiscal cliff, the tax hikes and spending cutswould push federal debt as a percentage of GDP down from 73 percent to 61percent by 2022. Meanwhile, the CBOs alternative fiscal scenario, which avoidsmost of the fiscal cliff without addressing lingering deficits, would increase this ratiofrom 73 percent to 93 percent by 2022 (Exhibit 33).

Reducing government debt, while most likely very painful in the short-run, will

actually raise economic growth over the next decade. As the economy fullyrecovers, higher deficits will crowd out private investment; therefore, by reducingour debt now, higher levels of investment will finance faster growth over the courseof the decade. While a trade-off exists between short-run deficit-financed tax cutsand spending and long-run growth, they are not mutually exclusive if legislation tomitigate the fiscal cliff includes provisions to reduce deficits in future years.

!

Moreover, 38 of 39 top

economists surveyed by the

University of Chicago

Booth Business Schoolagreed that output would

be lower than the alternate

fiscal scenario if no action

were taken.!


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Complications: The Debt Ceiling

The fiscal cliff is not the only political stand-off over Americas fiscal position. Thedebt ceiling, which represents the legal borrowing limit of the U.S. Treasury, willneed to be raised in early in 2013 to avoid

defaulting on payments (Exhibit 34). WhileSecretary Tim Geithner possesses the tools

to defer some borrowing from internalgovernment funds in order to continuespending, his efforts merely delay the crisis.Only Congress can raise the debt ceiling toenable the Treasury to continue to fund allauthorized government obligations, includingservicing existing debt. Without discussing thespecifics behind the politics of the debt ceiling, experience from last summersuggests there is very little reason to be optimistic that a lasting and timely

agreement will be reached. And more importantly, the experience last summersuggests that uncertainty surrounding the debt ceiling can produce harmfuleconomic effects.

Exhibit!33 !THE FISCAL CLIFF WOULD SIGNIFICANTLY LOWER THE

DEFICIT IN THE MEDIUM-RUN!

Source: Congressional Budget Office!

Percent(%)

100!

90!

80!

70!

60!

50!2022

2021

2020

2019

2018

2017

2016

2015

2014

2013

2012

Alternative Fiscal Scenario!Current Law!Debt Held by the Public as a Percent of GDP!

31.9%

of GDP !

According to CBO

analysis, increasing debt

levels will raise interest

rates, reducing growth

over the decade.!!While cuts will hurt in the

short-run, over the next

decade they can be

positive for economic

growth.!!Through this lens, the

fiscal cliff represents a

trade-off between the

short-run and long-run. !

!

Currently, the U.S. is

on pace to exhaust

its borrowingauthority in early

2013.


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While the effect of uncertainty around economic policy has been a polarizing topicin the political debate, research attempting to quantify the effects of uncertaintysuggests it may be highly detrimental to the economy. One attempt to quantify theeffect was the development of The Economic Policy Uncertainty Index byeconomists Scott R. Baker, Nicholas Bloom and Steve Davis, which showed its

larg

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