While not the theme of 2020 to date, some much needed positive and upbeat news has recently been reported. The US Bureau of Labor Statistics released October 2020 employment data showing a reduction in the National Unemployment Rate to 6.9% beating consensus estimates of 7.7%. This was coupled with a slight increase shown in labor participation rates. Improving labor data comes on the heels of record levels of COVID-19 cases in the US thus blurring the lines on what future improvement may be in the economic environment. However, more encouraging news struck on November 9th when Pfizer announced their COVID-19 Vaccine had shown over 90% efficacy in Stage 3 trials. Markets rallied significantly with the Financial Sector outperforming the broader markets by a wide margin. What does all of this mean for provision levels moving into Q4?
The chart below details loan loss reserve to total loans as compared to the National Unemployment rate (data since 2000).
Overall, a clear correlation can be seen throughout recent history. However, this began to break down starting in the second quarter of 2020 and has held true during Q3 reporting as most institutions have continued to hold reserve levels equal to or slightly above those shown during Q2. Given the adoption of CECL, this is somewhat expected as losses are to be provisioned for prior to their actual occurrence. Well documented and unprecedented levels of government stimulus were prevalent in the reserve levels that have been reported in 2020.
The chart below maps Federal government transfer payments to the National Unemployment Rate and clearly demonstrates how the current environment is difficult to compare to prior recessions.
Most filers have been clear that they feel adequately reserved at current levels and do not expect meaningful reserve builds going forward. Also, they do not expect losses to materialize in 2020 but should see these beginning in Q1 and Q2 of 2021. Given this backdrop as well as the significant improvement in both labor markets and COVID-19 vaccine availability, we should expect provision levels to trend down significantly in the 4th quarter. In their most recent filings, many institutions have reported expected National Unemployment rates at levels between 8.5% to 9% for the remainder of 2020 and into 2021. With this data guiding model results, the question arises as to what level of reserves are needed as we move forward with actual reported data being well below these numbers. Could we potentially see reserve releases?
The graph below showing net losses compared to loan loss reserves demonstrates the historical relationship that these values have shared.
While this is well known and served as the main catalyst for CECL, we can see the divergence of the historical relationship beginning in 2020. As the charge offs mentioned above begin to materialize, will we continue to see CECL perform as intended? While perhaps much easier to adopt the paradigm shift of reserving “earlier”, the idea of lowering reserve levels while charge offs are peaking is one that has many in the industry concerned.