America’s Daunting Debt Picture

There is much to like in the current economic snapshot of the U.S. The overall unemployment rate has slipped below 4 percent — the lowest it’s been in nearly 20 years. After a brief dip in consumer spending early in the year, consumer enthusiasm for shopping seems to have returned as sales numbers in retail have been stronger than expected of late. Even big brick-and-mortar players like Macy’s have shown signs of reversing their recent ill fortune by luring customers back into their stores.

But among all the good news is a bit of a question mark floating around U.S. household indebtedness. As of this year, Moody’s is forecasting U.S. household debt could hit $4 trillion primarily in the form of credit cards and auto loans, which have been steadily climbing. By itself, that’s not terrible news: Debt is a tool — one that many consumers had been locked out of for several years following the recession as banks pulled back their lending to all put the most prime of customers.

But combined with default rates that have also been climbing, experts are starting to get concerned about what comes next.

“Although consumers’ financial health is generally strong, there is a risk that they will take on too much credit in the present accommodative environment,” Moody’s wrote in a recent report on U.S. indebtedness in 2018. “Auto loan underwriting standards remain weak, and we expect credit card underwriting standards to deteriorate because lenders will likely grow complacent and increase the risk in their consumer loan portfolios — believing that they have plenty of time to tighten before the next downturn. Lenders have repeatedly proved unable to tighten in time.”

So, what are the particularly concerning points?

Auto Lending

The bulk of the trouble in the auto underwriting market seems to be located in subprime borrowers who — according to data from Fitch Ratings — are defaulting on auto loans at a higher rate than they did during the financial crisis.

By the numbers, subprime delinquency for loans more than 60 days past due reached its highest since 1996 at 5.8 percent. By comparison, the default rate during the 2008 financial crisis was around 5 percent.

Lenders are reportedly stepping back in an attempt to get the market under control. They’re increasingly less likely to underwrite for deeply subprime customers and are developing more rigorous standards for those loans they package up and sell to investors. According to data from Equifax, subprime borrowing in auto lending fell 10 percent year over year between January 2017 and January 2018. Auto lease origination to subprime customers decreased by 13.5 percent.

The volume of bond sales backed by these loans is not likely change, since banks and credit unions don’t turn most of their loans into securities. According to Wells Fargo, only about 10 percent of $437 billion outstanding subprime auto loans have been securitized into an asset-backed security (ABS).

“ABS is a fraction of the total auto credit market, which is mainly funded on balance sheets,” Wells Fargo analyst John McElravey said in an interview with Bloomberg. “If the pullback from subprime is more from the balance sheet lenders, banks, then maybe securitization keeps moving along.”

Subprime, auto, asset-backed security sales don’t seem to have declined all that much; they stand at about $9.5 billion, on track with the $9.6 billion from a year ago, according to data from Bloomberg.

“Neither banks nor credit unions have done ‘deep subprime’ lending,” Gunnar Blix, deputy chief economist at Equifax, said. “That’s mainly done by smaller dealer-finance and independent finance companies” who rely almost solely on ABS for funding.

While auto lending has pulled back some over the last year, credit card lending has been picking up.

Credit Card Debt

As of Q1 2018, credit card lending growth outstripped auto loan growth for the third consecutive quarter.

The year-over-year loan growth rate for credit cards in Q1 of 2018 reached 6.7 percent, higher than the 5.3 percent for auto loans and 3.6 percent for residential mortgages. The three-year annualized loan growth rate for credit cards stands at 6 percent.

And as access to credit has risen, so too have defaults.

However, data from the Financial Crisis Inquiry Commission indicates that consumers more than three months behind on their bills or otherwise in distress are currently running a $12 billion bill in terms of their late credit card debt, which is an 11.5 percent increase during Q4 alone.

One prominent theory to explain those rapidly mounting potential losses is that middle- and working-class Americans aren’t benefiting enough from improving economic conditions.

Others believe that the big debt increase flows from an issuing boom that saw banks working actively to pursue consumers with rich benefits, which has led to card use, described by David Rosenberg, chief economist and strategist at Gluskin Sheff, as “absolutely epic.”

“Now it’s time to the pay the piper,” he added.

However, the concerns aren’t universal. Bankers say the losses, while growing, are still well within historical norms and are not enough of an issue for concern.

“The absolute level of losses on any basis is still exceptionally strong,” said Gordon Smith, JPMorgan Chase’s retail banking chief in March, noting that he was encouraged by the health of the bank’s customer base.

And though balances were high at the start of the year — a common post-holiday season occurrence — credit card debt has begun to go down again. Revolving credit, primarily credit card spending, fell by $8.1 billion to $976.6 billion in March, representing the second consecutive month of declining balances.

So, is it time to worry?

Probably not, since it seems that although there are rough patches — particularly around subprime lending — there are also emerging signs of strength. Capital One, a credit card issuer that works extensively in the subprime auto and credit card lending market, reported strong Q1 growth driven by renewed strength in both segments.

Moreover, unemployment remains low, and wage growth (albeit sluggish) has been reported.

But given the rising debt numbers — and the reality that economies don’t grow forever — it’s a segment well worth watching.