Consumer Credit: Is a Crunch Coming?

Thank Amy Bell for helping keep the U.S. economy afloat. Bell, a 27-year-old benefits manager in Atlanta, bought a studio condominium with no money down, leased a Volkswagen Passat, and spent $2,300 on a set of living room furniture -- all in the past six months. "I have been going a bit crazy with the spending," she says.

That's for sure. Bell and plenty of other people are piling up huge debts. The amount that Americans owe on loans for houses, cars, credit cards, and other purchases adds up to nearly 100% of their annual income after taxes. That's up from 75% in 1992, after the last recession ended.

EASY MONEY. Even if consumers are willing to take on more debt, lenders -- and more important, the investors who buy many of the loans they securitize -- may soon decide that enough is enough. If the credit crunch now squeezing business starts to hit consumers, whose spending accounts for two-thirds of gross domestic product [GDP], the U.S. economy could wind up in a world of trouble.

For now, a consumer credit crunch is hardly inevitable. Unlike businesses, consumers still have an easy time raising money. When they max out one credit card, it's a cinch to sign up for another. Outstanding consumer credit, most of it from credit cards and auto loans, rose 5.7% in the 12 months ended in May. And the amount of home-mortgage and home-equity loan debt outstanding keeps rising, too. It's up 10.5% for the year ended in March.

Banks have been eager to expand consumer lending, because profits from their commercial loan, brokerage, and investment banking departments have tanked. Income at Citigroup's (NYSE:C) consumer businesses, for instance, grew 25%, to $2 billion, in the second quarter.

MORE OVERSIGHT. For now, the combination of rising debt and falling interest rates continues to fuel consumer spending. In the past two months, mortgage refinancing has given consumers a further $40 billion to $50 billion to spend, estimates Bank One economist Diane C. Swonk. In nearly two-thirds of recent refinancings of loans owned by Freddie Mac Corp. (NYSE:FRE - News), people took out bigger loans than the ones they paid off, freeing up cash for more spending. And despite being burned repeatedly, lenders still increase loans to subprime borrowers. Swonk thinks that's a big factor in strong auto sales.

But there are signs a consumer credit crunch could be in the offing. Delinquencies on non-mortgage consumer debt reached 1.86% of debts at the end of 2001, up a third from 1.4% a year earlier and the highest in a decade, according to the Consumer Bankers Assn. In the past year, Providian Financial (NYSE:PVN - News), Metris, and NextCard have been crushed by bad debts. The Federal Deposit Insurance Corp. estimates that the liquidation of NextCard Inc. will cost taxpayers up to $400 million.

As a result, the government is stepping up oversight, which in turn could cut the supply of credit to some consumers. So far, attention is mainly on subprime lenders. "We want to put more focus on the higher risks," says David Gibbons, deputy comptroller at the Office of the Comptroller of the Currency. On July 22, bank regulators announced guidelines to prod credit-card lenders into increasing reserves and disclosing defaults promptly, after discovering that many were pushing the limits in their accounting. Some lenders may drop out of the market, predicts Reilly Tierney of boutique investment bank Fox-Pitt, Kelton in New York.

"HIDDEN CREDIT RISK." But credit concerns could also begin to infect higher-grade credits in coming months. That's the way nearly every crunch unfolds: from the bottom up. And the quantity of debt is so large that bad news could cause lenders to retrench, even without regulators' warnings. Analysts warn that any of a number of factors could spook lenders: a decline in house prices, a rise in interest rates, or a softening of the job market that pushes up unemployment and moderates wage gains.

Mortgage lenders would tighten up in a hurry if housing prices soften. That's a distinct possibility, given what Freddie Mac Corp. estimates is a 37% average increase in prices in the past five years. Many homes today are purchased with downpayments of 5% or less, so even a modest decline would leave people owing more than their house is worth. That would cool cash-out refinancings, which have propped up consumer spending. And it would frighten lenders, who would lose the ability to make themselves whole through a repossession. "It could bring to the fore a great deal of hidden credit risk," says Stuart A. Feldstein, president of SMR Research in Hackettstown, N.J. "In mortgage lending, the [profit] spreads are so thin that there's no room for big losses."

An increase in interest rates by the Federal Reserve could be the trigger for a fall in home prices. Right now, a Fed rate hike remains unlikely. But if the stock market keeps rebounding and the recovery continues, it will strengthen Fed hawks who argue that low rates and excessive money creation are inflating new bubbles in the economy.

RISKY DEPENDENCE. For lenders, the problem is that consumers are dangerously dependent on today's superlow rates. When rates fall, the cost of servicing debt should fall, too. Yet the Federal Reserve says that household debt-service payments were more than 14% of disposable income in the first quarter, near the highest level in 22 years.

If rates go higher, the burden of debt service will increase. Mortgage Bankers Assn. economist Phil Colling says that approximately 30% of outstanding mortgage debt has adjustable rates. And about 40% of non-real-estate consumer debt is revolving credit, much of which has adjustable rates. A credit crunch could set in if a rate rise triggers a wave of defaults by holders of adjustable mortgages and revolving debt.

Aside from rising rates, the other nightmare for lenders would be a lull in the job market. Thanks in part to tax cuts, disposable income after inflation rose 5% in the year ended in the second quarter. That helped hold down the debt-to-income ratio. But lenders would be more reluctant to extend credit if the unemployment rate spikes or real incomes slow their rise, because they would be worried about getting paid back. And rates are already so low that the Federal Reserve couldn't easily use further rate cuts to lure consumer lenders back into extending credit.

GOING FOR BROKE? A final wild card is the new bankruptcy bill, which will take effect six months after President Bush signs it into law. Feldstein of SMR Research says some shaky credit-card issuers could be driven under if many of their cardholders file at once to obtain protection from creditors under the old, more lenient law. That, in turn, could disrupt the flow of fresh credit.

The credit crunch on business has been painful. But for Amy Bell and the home buyers, car shoppers and mall walkers like her across the country, a credit crunch would be a real killer.

with credit card interest rates typically between 10 and 22%, and with people maxing their cards, banks will have a hard time clamping down on credit. it's just too profitable to lend, lend, lend.

while consumer debt is a problem, only if it implies that so many people do not understand discipline and how to manage a household, this is not the barometer to watch, or the item to directly go after to 'fix' the economy. if you want to 'fix' the economy, do something about fiscal policy.

"The credit crunch on business has been painful. But for Amy Bell and the home buyers, car shoppers and mall walkers like her across the country, a credit crunch would be a real killer. "

This bubble hasn't bursted but beware of humongous inflation to bail out debt. If we pay attention to the Wizards behind the curtain, don't forget in the last election the leaders of both parties saw a huge surplus, tax cuts and all sorts of spending as far as the eye could see.

'There's too much consumin going on out there.' Time to focus on job-creating production.

The talk seems to be of the Fed lowering rates again, sounds like credit is the only thing running this economy. I'm mostly in paper now and my CD's don't keep up with inflation, but I'll be damned if I'll let these crooked b@st@rds force me into this market.

Much lower bank rates and I'll cash in and put it in a safe deposit box, let em try to make money off me then

The best advice is to get out of debt and stay out of debt.

That is good advice on a person to person scale. But; Have you ever considered what it would be like if everyone actually took that advice and paid off all of their debt? For instance, would you be working? What would you use for money to pay your day to day bills? Add to the mix: What if the government also paid off all of its debts? The more one thinks about it, the more insane our fnancial system seems.

I'm a pay cash guy myself.

You are the enemy of the state.

Well, so am I then. I learned my lesson in the '70's, and to this day I flinch when I go to the mailbox sometimes.

These maxed-out people simply MUST be betting their lives on bankruptcy. If credit is all that is propelling the economy, then it is just perpetrating a bubble as bad as the recent Stock Market/Dot.Bomb one.

The bills wil come due., and banks could fold from all this easy credit provided to people who cannot add and subtract! Look at all the TV Ads and spams for "Pay off all your bills by refinancing".

That is not PAYING OFF anything!

This is a good article. There is just one piece of the puzzle they neglected to note--and that piece may be what ultimately collapses the house of cards.

Here it is, folks:

Demographics, demographics, demographics.

If we had a young population just getting started with new households significant debt would be both expected and reasonable. However, we have an aging population. The fifty something baby boomers should not be taking on more debt, just as they should not have most of their retirement funds invested in the stock market. They are incurring this debt to buy bigger houses, fancier cars, fancier furnishings. These are things they don't need and should not be puchased with debt that they may not have time to repay. Since these fifty somethings will have a hard time finding a new job if they get laid off this is a group that can tank the economy all by itself.

This is why I am a gloom and doomer on the economy.

Demographics is history--and don't forget it!

Reading this made me realize that I haven't thrown out any credit card offers in a few weeks, used to get one a day. The one card I have, that I did use for internet purchase (my credit union finally got debit card service) has quit pleading with me to up the credit line.

On the new BK law, my thoughts are it is aim at letting the credit card companies force people that just ingore them into BK, becoming a indentured servant for seven years.

You are the enemy of the state.

I am an enemy too. I have been saving money to buy a house, and just keep my money in the bank. I am not looking to buy one now, even with the interest rates so low, because if this really is a real estate bubble, I would be buying at the top.

I was taught to NEVER borrow money for personal consumption except for a home mortgage and that advice has been followed for my 65 years and has served me well. I have had no debt of any kind since I paid off my home mortgage 12 years ago and have never borrowed to buy a car or any other consumer item in my life and the condo that I live in most of the time I bought for cash. Credit cards are nothing more than a convienence. If I don't have the money in my checking account to pay for it I would never use a credit card.

By the numbers it is the people who hold mortgages that seem to be getting the short end of it, as last year your typical mortgage was about 7.5% and the typical money market was paying about 4%.
Today mortgages have dropped to 6.5% and money markets pay a paltry 1.75%. The current 0% credit frenzy seems to be funded by these higher than normal mortgage rates. The best strategy here might be to have no mortgage and take full advantage of all the 0% financing your budget can handle.

Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.