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A Tipping Point in the Rapid Growth of Unsecured Revolving Credit?
(Month Posted: 09/2009)
The latest Federal Reserve release reports that revolving credit (98% credit card) fell by 8% in July ’09, declining for the sixth straight month - the longest series of declines since 1991.
Are we are witnessing a tipping point in the rapid growth of unsecured revolving credit over the last few decades?
The sharp increase in credit card debt can be traced to the advent of credit card related Asset Backed Securities (ABS) in 1987, that freed-up the balance sheet of Banks to dramatically increase their pace of lending.
Before securitization the total outstanding unsecured revolving debt in the US was at about $200 billion.
Since 1987, the total outstanding has grown exponentially (see chart) by an additional $750 billion with over half of this amount funded by ABS.
However, with a proposed accounting rule (FAS 140) change, issuers may be forced to bring all the securitized debt back on their books in 2010.
This is only going to add to the woes of the industry that is already bracing up for new trade practice regulations that also kick-in in 2010.
After an incredible run for nearly 50 years and now with changing consumer behavior, is unsecured revolving credit gradually becoming an out-dated lending instrument?
The 'credit-card' was invented in the late 1940's as a 'charge-card' to pay for expenses that were settled in full on the due date.
Cardholders who continue to do so ('transactors') are not necessarily the most profitable customers for issuing Banks.
The practice of taking credit on ‘charge-cards’, where customers ('revolvers') carry a revolving balance on their account and incur a monthly interest charge did not start in a big way until 1966.
Over the years, revolvers have been the 'creme de la creme' for most issuers and have accounted for 60-70% of their profits.
Today, increasing unemployment and lower income levels across the country is only swelling the ranks of such 'revolvers' who are using credit cards as a lifeline to survive the downturn.
What this means from an accounting perspective, is that more customers are postponing repayment of 'principal' and are happy to pay just the 'interest' in the interim.
It’s like an 'interest-only' mortgage payment for credit cards, with dire consequences for issuers if employment/ income levels (equivalent to home prices for mortgages) do not significantly improve in the near future.
Reacting to this surge in ‘dangerous’ revolver activity, leading credit card companies including Citigroup, JP Morgan Chase, American Express and most recently Bank of America have announced
that they are increasingly wary of customers 'carrying a balance' and have significantly hiked interest rates on cardholders who do so.
This is clearly not a sustainable business model when the ongoing economic meltdown is expected to drag on.
How different is card usage and unsecured consumer lending in other developed countries?
Let us consider the other G7 nations. While the UK and Canada have to a certain extent been influenced by US card practices, Germany, Italy and France all have a much wider usage of debit than credit -
a trend that is emerging in the US too. In Japan the average size of transaction per credit card is much higher than the US -
but the amounts are typically settled in one installment on the due date. In the less populated, higher income, higher taxation regions like Scandinavia, small ticket purchases are done via 'electronic funds transfer' or
debit cards and big-ticket items are more often funded by point of sale installment loans, which may be secured or unsecured.
Such loans typically carry lower interest charges, are for fixed terms with fixed monthly payments and have simpler fee structures.
How are consumer credit attitudes changing and is there a ‘silver lining’ for retail lenders?
As per a continuing monthly trend, in the July ’09 Gallup poll, nearly half of all Americans intended to decrease their debt levels over the next six months.
How can banks meet this need? One possible win-win solution is offering lower interest, unsecured installment loans to not only re-finance existing credit card debt but also
'consolidate' debt on multiple cards into one loan with the objective of making customers 'debt free' over the next 3 to 5 years.
The benefits for banks include shoring-up falling receivables numbers, accelerating repayment of the principal, sustaining relationships with ‘good customers’ and attracting ‘positive selection’.
While installment loans tend to be less profitable than credit cards, they can easily generate pre-tax ROA's upward of 3%.
From the perspective of consumer borrowers, with the prime rate at a historic low of 3.25%,
it is a perfect time and a great opportunity to swap high interest bearing revolving debt with lower cost, fixed term unsecured installment loans.
What are some challenges that credit card issuers face in this changing credit environment?
As credit cards gradually fall into the original slot for which they were designed, the clean-cut, definite, accountable and ‘no frills’ nature of the installment loan
could just be the new face of unsecured consumer lending in the years to come.
For long standing credit card businesses, unsecured installment loans may appear to be a simple, boring and easy product to manage.
However, there is strong evidence to indicate that the product can be quite a nightmare if managed through the hard-trained lens of ‘revolving credit’.
Unlike credit cards, installment loans need to be managed for a fixed term. They require significantly greater risk management and underwriting at the time of acquisition.
Above prime loans are typically for much higher amounts. There is very little fee income and profitability is better measured using ROA than NPV.
Among other differences, installment loans also carry risk that is very weakly correlated to FICO scores – and this is even more so in the current economic environment.
The Home Price Domino Effect
(Month Posted: 10/2008)
The continued correction in US home prices has triggered a trend reversal in:
A. Personal Consumption Expenditure
B. Capital Markets
C. Unemployment Rate and
D. Consumer Lending
An overview of the change in market conditions in each of these areas is as below:
Home Price Decline
As per the S&P Case-Shiller Index (Composite for 20 cities in the US) home prices peaked in July 2006.
Using US Census Bureau data, national median home prices touched a high of $262,600 in March 2007.
Between 2000-2006 based on the Case-Shiller index, home prices increased by over 100% at its peak. In retrospect, this was primarily driven by:
- Government policy initiative (White House 'social activism')
- Post 9/11 expansive monetary policy measures to overcome recessionary trends
- Demand for Fannie/Freddie issued MBS as a supplement to low yield US treasury's
- Change in leverage rules for Wall Street Banks in 2004
- Clever use of conduits (CDO's,CMO's and CDS) for selling MBS
- Demand for new homes in the US from increased employment and income levels
Now that a 'top' in home prices is in place, demand for new homes weakened and supply of funding under pressure, the consequence has been a sharp reversal in macro economic conditions in the US that is also taking its toll globally.
A. Decline in Consumption
One factor that has been cited as fueling increased consumption levels in the US has been the sharp increase in home values of homeowners.
Rising home prices have created 'housing wealth' effect to the extent that people have taken on second mortgages (home equity loans nearly trebled to over $1 trillion from 2000 to 2006) against incremental existing home values.
Over the last decade nearly 30% of these home equity loans have been used for PCE.
Contributing about 70% to GDP, increase in PCE has largely driven the last economic boom in the US.
The current decline in consumption seems to follow the drop in home prices more closely than previously.
Moreover, there has also been a sharp uptick in savings rates.
This is bad news for retailers, whose performance in the upcoming holiday season is going to be closely watched to gauge the extent of damage to consumption and corporate earnings forecasts.
B. Volatile Capital Markets
Declining home prices have exposed the weakness in regulatory oversight of lenders and related agencies.
While sub-prime lending has been a high-risk business proposition, the implied increase in Loan To Value (LTV) ratios from falling home prices on even good mortgage loans has raised requirements for additional capital to comply to regulatory capital-adequacy norms.
Banks have been skittish in declaring their own exposure to mortgages fearing a loss of confidence of depositors and investors and doubting the financial soundness of their counterparts on the same grounds.
The result has been a flight to cash and break-down in the inter-bank lending market widening credit risk spreads as measured by USD LIBOR.
Market guesstimates on the exposure of Bear Stearns, Lehman and Merrill Lynch to mortgages made them early victims of this crisis of confidence.
While Financials have acted as a catalyst in driving down equity capital markets, now with a sharp fall in PCE imminent and increasingly evident, valuations of a broader set of US corporations is being revised downwards and reflected in the current bearish trend in US Equities.
Debt markets on the other hand are staging a revival with help from government intervention, although a lot more needs to be done to address the root cause of the current credit crisis - declining home prices.
C. Increase in Unemployment
With rising home prices, it seems that the pace of increase in home ownership and 'housing wealth' since the start of the century has surpassed the growth witnessed in employment and income levels.
Employment rates in the US peaked in 2007 as measured by Non-Farm Payrolls (touched 138m in 2007) - which can also be used as a good proxy for gauging strength of the active US taxpayer population.
With falling consumption, a hiring freeze and sharp cut-backs by major US Corporations, the unemployment rate is currently at a five year high of 6.1% and expected to deteriorate even further.
For home prices to find a bottom and 'bounce back' - demand for new homes driven by employment activity has to dramatically increase to maybe even higher levels as compared to the last peak.
D. Consumer Lending
Consumers are increasingly feeling impoverished not only from declining home equities, but also from depreciating investments in the Stock Markets and their 401K's vested in the latter.
Personal consumption expenditure is down and the new buzzword is 'de-leveraging' with personal savings rates expected to rise sharply.
On the other hand, with unemployment on the rise, lenders are bracing up for an increase in delinquencies and charge-offs (visit links to charts in left panel).
Retail lenders are additionally faced with new challenges such us:
- Increased government oversight
- A shrinking market for good customers and
- Increased volatility in loss rate and funding costs
Our markets view is that for US macro-economic conditions to improve, employment rates have to stabilize and reverse the current trend. This will stabilize home prices, bolster consumer confidence and improve consumption and credit.
A useful indicator to watch out for is the stance of the Fed on monetary policy, which is currently dovish. A definitive change in stance to a hawkish monetary policy - will clearly signal that a bottom is in place in the current economic downturn.
With inflation pressures now evaporating, it may be a while before we see such a shift.
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