Editor's note: This story was originally featured in the March issue of DSNews, out now.
In February 2017, the financial media sounded the alarm that total U.S. consumer debt was at $12.6 trillion, just a hair short of the $12.7 trillion peak observed on the way into the Great Recession. Clearly, posited the media, approaching debt levels previously achieved only through capricious underwriting of Alt-A Option-ARMs was a sign that our industry had not learned its lesson from the last economic cycle.
Over the following year, consumer debt continued its march forward, posting three consecutive all-time highs, and ending the fourth quarter over $13 trillion, for the first time. Each time the New York Fed updated the “Household Debt and Credit Report,” it triggered a flurry of headlines containing apocalyptic warnings and judgments on the irresponsibleness of the financial industry.
As we digest the data from the fourth quarter of 2017, it is worth considering one of the main reasons these numbers keep growing: in a country with a growing economy and a growing population, nominal financial and economic indicators tend to increase over time. To account for that, we need to consider two factors between the prior peak in the third quarter of 2008 and the fourth quarter of 2017:
Although inflation has been low for the last decade, the value of a dollar (and thus of consumer debt) has decreased by about 11 percent since the most-recent peak in consumer debt levels.
Over the last decade, the population of the United States has increased about seven percent, which means an additional 22 million people hold this debt.
Accounting for these factors, per-capita, inflation-adjusted debt levels have decreased by 14 percent during the last decade. At the individual asset class level, two separate stories emerge, with mortgage and card appearing relatively healthy by historical standards, and some warning signs appearing in auto and student lending.
RELATIVELY HEALTHY SEGMENTS
Real per-capita mortgage debt has decreased 21 percent over the last decade. Over the same period, home equity revolving debt decreased 47 percent. Average mortgage rates decreased over 200 basis points during this period, which, combined with lower overall real per-capita debt levels, has lowered mortgage payments as a percentage of per-capita income by 36 percent, a substantial change in monthly debt burden in the asset class that represents two-thirds of total outstanding consumer debt. Combined with historically low-interest rates, low delinquency rates, and a relatively stable housing market, there is little immediate cause for concern regarding these numbers.
However, as interest rates begin their long-anticipated return to historically normal levels, and, given the effective reduction in the tax deductibility of mortgage interest beginning in 2018, the cost to the consumer of mortgage payments will begin to increase, driving up the cost of new and non-fixed-rate mortgages. Whether some of this increase in debt burden is absorbed through moderation in home price appreciation remains to be seen.
Combined, real per-capita credit card and “other” consumer debt, which includes retail and installment loans, decreased 20 percent over the past decade. Credit cards experienced a significant amount of deleveraging from their peak in late 2008 through their trough in early 2014. Much of that deleveraging occurred via charge-offs, which peaked in late 2009, and the decrease further accelerated through underwriting tightening, ultimately resulting in a one-third reduction in real, per-capita balances. Competition has now heated up again, and issuers are beginning to market more aggressive offers, particularly at the top end of the credit spectrum where substantial points and miles bonuses have become common. As a result, real per-capita credit card balances have increased about 18 percent since their dip in 2014. With that expansion has come moderate increases in credit risk, although levels remain healthy by historical standards. For the near term, this sector appears relatively healthy.
Although peer-to-peer lending has generated more than its fair share of headlines, the sector does not appear to be on track to reach a size at which it poses a meaningful risk to the consumer debt landscape. Lending Club, for example, originated about $8.5 billion of volume in the four quarters ending the third quarter 2017, with an annualized growth rate of 24 percent in the third quarter. In total, the size of the alternative consumer lending market is estimated at well under $100 billion. Given the difficulty developing experienced by major players, this segment is unlikely to have a near-term, structural impact on the consumer lending landscape.
EMERGING SIGNS OF RISK
Auto lending has heated up a bit more. On a real per-capita basis, auto loans outstanding have increased 26 percent over this period, although that 26 percent is comprised of 16 percent deleveraging through the middle of 2011, followed by a 50 percent increase between 2011 and today. The period during which the 50 percent increase occurred included increases in risk on several dimensions, larger loan amounts, longer loan terms (which may partially reflect the longer expected useful life of more reliable new vehicles), lending deeper in the credit spectrum, and new entrants hoping to capitalize on the higher yield available in subprime lending. Not surprisingly, auto loan delinquencies now reflect the market’s frothiness; while the performance of bank-originated auto loans is relatively stable, delinquency rates of auto loans originated by non-bank finance companies are approaching the peak levels of the Great Recession. Although lenders and market watchers have been discussing the exuberance in the auto lending space for some time, the metrics have yet to show any signs of temperance. In fact, the third quarter of 2017 represented the second highest auto origination volume on record. Given the otherwise healthy state of the American consumer, these trends are worrisome and portend a bumpy ride for auto lenders.
Led by rapidly increasing education costs, student lending exhibits the most troubling metrics. Not only have real per-capita balances increased 88 percent over the past decade, but, instead of exhibiting a cyclical trend in response to the Great Recession as other asset classes have, real per-capita student loan balances have increased on a relatively consistent trend since well before the Great Recession, growing by 271 percent since early 2004. At $1.4 trillion, the total balance of student loan debt is second only to mortgage debt. At over 10 percent, 90-day student loan delinquencies are more than double auto loan delinquencies, and eight times higher than mortgage delinquencies. And according to the Federal Reserve Bank of New York, after accounting for student loans that are in deferments, grace periods, and forbearance, the delinquency rate may be understated by 50 percent. These balances are concentrated, with about one-quarter of student debt holders owing at least $43,000, according to a recent report by Pew Research titled “5 Facts About Student Loans.” Further, Pew finds that 37 percent of adults younger than 30 carry student debt. Those with advanced degrees carry on average over four times the student loan debt of a student loan borrower who did not complete his or her bachelor’s degree. Because of this, underwriting caps on student loan debt may eliminate applicants with the greatest earnings potential and the greatest ability to growth their debt capacity over time. It is perhaps the applicant with a small student debt balance that is most worrying over the longer-term.
WHAT LENDERS NEED TO CONSIDER
Despite the pockets of concern, with mortgage accounting for two-thirds of U.S. debt burdens, the total debt picture for U.S. consumers remains quite healthy. After a round of consumer deleveraging through 2013, total real per-capita debt loads have increased by a total of about eight percent over the past four years, during a period of strong home price gains and relatively consistent GDP growth. While the pace of growth is worth watching, there is nothing in recent trends that suggests that a system-wide credit event is currently on the horizon.
Over the near term, the most likely debt-driven risks to mortgage lenders are:
For the last several years, the housing and mortgage markets have benefited from historically low credit costs. Further, although the 2018 tax code did not eliminate the mortgage interest deduction, the higher standard deduction, combined with caps on state and local tax deductions, will reduce the number of people who take the mortgage interest deduction. As rates begin to normalize, the cost of owning a home will increase, which may moderate home price appreciation and slow the speed at which household formation translates into home ownership. Although these affordability effects should be considered in the context of the favorable starting point, the psychological impact may be just as large as the real impact, and the consumer may take time to adjust to the new normal.
Auto lending is already experiencing significant stress, and mortgage underwriters should already be observing the elevated risk in less-qualified applicants. Although more performance degradation may occur, it is now clear that the weakest performing loans will be those with longer-terms, lower credit scores, and newer, nonbank entrants.
The student loan space remains deceptively silent, as the embedded risks have yet to manifest in the credit risk indicators. The public/ private structure of this market complicates this unraveling. However, the tipping point does not appear to be imminent, and a relatively small group of borrowers with the highest balances and the greatest earnings potential, as well as the borrowers who took on smaller debt burdens but did not complete or were unable to monetize their degrees, comprise the greatest risk.
While pockets of risk exist within the consumer debt market, they remain idiosyncratic to a handful of unique segments, and there is little evidence that any individual risk is about to spill over into structural or cyclical issues that will affect the overall health of the consumer in the near term. So stay vigilant, particularly in an environment consisting of rising rates, credit normalization, and increasing volatility, but as the articles about “all-time high” consumer debt burdens begin to arrive, consume them in the right context.
Richard Franks is the Chief Credit Officer of FS Card. He previously led credit card risk for the Commonwealth Bank of Australia, after a decade at Capital One in modeling and risk. Franks holds a BS in Engineering from Georgia Tech and an MBA from the University of Pennsylvania.