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Borrowing to Just Get By: The Worrisome Growth of Non-Discretionary Consumer Debt


Before you get excited that consumers are borrowing again, you need to understand why.

Nowhere has the unequal nature of the post-banking-crisis recovery raised more significant concerns for the long-term sustainability of the US economy than in the clear rise of non-discretionary consumer credit.

While the "haves" have fully returned to their pre-crisis behavior of paying for everything from higher education, cars, and luxury homes with cash, and fully leveraging their investment portfolios, the rest of the consumer sector has changed dramatically over the past six years.

Upper middle class "aspirational wealthy" families who were overexposed to the housing bubble continue to see debt of all kinds as a negative.  Rather than using lower interest rates to purchase larger homes, if not vacation homes, they have instead opted to convert their 30-year mortgages to 10- and 15-year loans with essentially equal monthly payments terms.  Lower interest rates have translated into faster loan amortization rather than economic growth. Well into the recovery, the focus of the upper middle class remains on less rather than more credit, and -- thanks to demographics -- less rather than more home, too.

Further down the credit spectrum, the world of consumer debt has changed even more profoundly.  For the "have nots," the continued absence of wage growth has resulted in an unprecedented boom of non-discretionary credit.  Ordinary life in America now simply requires more debt rather than less to live.  It is needs, not wants that are behind the post-banking-crisis growth in consumer credit.

The clearest example of non-discretionary credit growth today is in higher education.  With tuition costs rising far above wage inflation, and families no longer willing to take out home equity loans to fill the gap, lower and middle class students have no choice today but to borrow for college.  A completed FAFSA (Free Application for Federal Student Aid) form is as much a prerequisite to college entry as four years of high school English and math.  For those entering college, it is not a question of whether they will borrow, but rather how much.

But higher education is not the only place in our economy where non-discretionary credit is now the norm.  The same condition today exists with auto sales, too. With the average car on the road more than 11 years old, it's no longer if Americans will replace their cars, but how.

Here again non-discretionary credit fills the void.  With savings low, few Americans can afford much more than the down payment on a new car.  Financing, whether in the form of a loan or a lease, is the only way low and middle class Americans can afford a new or used car.

But please appreciate how stretched non-discretionary car financing has now become. The following is per the Wall Street Journal:

[The] average automotive loan term [reached] 66 months for the first time. According to Experian Automotive's latest State of the Automotive Finance Market report, loan terms in the first quarter of 2014 reached the highest level since the company began publicly reporting the data in 2006. The analysis also shows that loans with terms extending out 73--84 months made up 24.9 percent of all new vehicle loans originated during the quarter, growing 27.6 percent since Q1 2013.

The average amount financed for a new vehicle loan also reached an all-time high of $27,612 in Q1 2014, up $964 from the previous year. In addition, the average monthly payment for a new vehicle loan reached its highest point on record at $474 in Q1 2014, up from $459 in Q1 2013.

"As the cost of purchasing a new vehicle continues to rise, consumers clearly are stretching the loan term to help lower monthly payments, keeping them at a manageable level," said Melinda Zabritski, Experian Automotive's senior director of automotive credit. "The benefit of a longer-term loan is the lower monthly payment; however, the flip side of that is consumers can find themselves paying more in interest or being upside-down on their loan if they seek to trade their vehicle in early. It is definitely a choice that consumers will want to weigh carefully before making a final purchasing decision."

Consumers also continued to lease new vehicles at record levels. Of all new vehicles financed, 30.2 percent were leased in Q1 2014, compared to 27.5 percent in Q1 2013. Interestingly, of all new vehicles sold (whether financed or purchased in cash), a staggering one in four, or 25.6 percent, were leased in Q1 2014, compared to 22.9 percent in Q1 2013.

Overall, loans and leases for new vehicles were easier to obtain in Q1 2014. For new vehicle loans, the average credit score was 714, down from 722 in Q1 2013. For leases, the average credit score was 721 in Q1 2014, compared to 731 in Q1 2013.

"Over the last several quarters, leasing has come back as a very desirable option for consumers," Zabritski continued. "Whether they are interested in getting the latest and greatest models or simply do not want to commit to a long-term purchase, consumers are leasing new vehicles in greater numbers than ever before. However, what they need to remember is that without good credit, it may be more difficult to get a lease, and that leases have mileage caps so they need to make sure their lifestyle fits the leasing requirements."

With maturities of seven years or more, car loans might better be called car mortgages.  But as the Wall Street Journal report makes clear, it isn't just lengthened terms that have been required. Lenders have lowered credit scores while lessors have introduced lower and lower mileage caps.  Just as we saw in housing at the top, lenders are doing whatever they can to lower the monthly payments to consumers.

Two weeks ago I read a quote from the CFO of America's Car-Mart in which he offered, "Our customers have never been more stressed, yet they have never had more aggressive financing options."

Those aggressive finance options are sustaining auto sales just like federally supported student loans are keeping higher education afloat.  Outside of the very wealthy, the borrowing is required. The only way the sale happens at the car dealer is with a lender's support.

While the extreme reliance of both higher education and the automotive industry on the widespread availability of credit is worrisome to me, something even more troubling looks to now be afoot.

Over the past two weeks I have seen many different versions of the chart below from economists, all of whom are salivating over what 12% revolving credit growth will mean for second half of 2014 growth.

To them, higher borrowing, particularly credit card debt, suggests a rebound in consumer confidence is finally here.  Before you break out the champagne over a whopping 12% annual increase in credit card balances, let me offer a few words of caution.

First, while the seasonally adjusted figures are spectacular, the unadjusted (i.e. real) figures aren't particularly noteworthy.

As the chart of real weekly balances from the Federal Reserve shows, 2014 balance growth looks alarmingly like what we saw during early 2012.  Furthermore, I would note that even with the supposedly strong growth, overall balances are still below 2012 levels.

Many economists are linking the growth in credit card balances to growth in consumer purchases, citing charts like the one from Gallup, as a reason for their enthusiasm.  Daily spending has risen 10% this year, to $98, and is closing in on the pre-banking crisis peak of $114.

The economist community believes that consumers are spending more, and are more willing to charge larger credit card balances because they are feeling better about the economy.  Unfortunately, Gallup's own economic confidence figures do not support the linkage. 

As the Gallup chart above shows, weekly economic confidence has been flat-lined between -13 and -15 since the beginning of the year.  The growth in credit card balances and purchases has not being driven by higher levels of consumer confidence.

So what is driving the figures?

I believe there are two factors.  First, I would not be at all surprised to see that credit card underwriting standards have been lowered in order to accelerate balance growth.  With literally free deposits, credit card losses at record lows, and double-digit yields, credit card loans represent an attractive relative risk for the banking industry today.  With every credit segment outside of home mortgages experiencing a complete abdication of risk management today, it seems only likely that some of this has rubbed off on banks' credit card businesses, too.

Besides, if I learned anything from my tenure in the card business it's that the worst customers always take the offer.  If you want to build card balances in a hurry, there is no better way than dropping credit standards. 

I believe that less stringent credit terms are a large part of the volume growth that we have been seeing this year.

Second, I would not underestimate the impact of rising food and energy prices on consumers' daily purchases on this year's credit card balance growth.  As the chart below shows, gasoline prices have risen more than 10% since the beginning of the year, while natural gas and heating oil prices have spiked as well.  Overall, the CRB Index is up 8.3% year-to-date.

With wage inflation still meager, particularly at the bottom of the economy, and access to 0% purchase teaser rates on new credit cards now in large supply, I would not be at all surprised if a significant part of the increase in consumer purchases being financed on credit cards are a function of higher food and energy costs, which skews to lower income Americans.

While in the very short run this will look good for the banks and ease the financial stress of lower and middle income Americans, it is worrisome longer term, especially now with oil prices spiking even further due to developments in Iraq.

Despite five years of economic recovery, lower and middle class Americans' financial staying power is still very weak. Few have the resources to cover rapidly rising food and energy costs.

My concern is that as we've seen in higher education and car sales, Americans are now turning to credit card debt to stay afloat. 

Revolving credit has now become non-discretionary, the only way to close the gap between stagnant incomes and rising food and gas prices.

If we see further increases in consumer spending accompanied by falling economic confidence, it will confirm the truly non-discretionary nature of the purchases as well as the credit card charges.  In addition to higher rent, lower and middle class Americans will now be spending 15% or more in annual interest payments just to stay afloat.

Admittedly, with card lenders lowering credit requirements, some of the card lenders' balance growth may represent a migration of lending away from payday lenders and other even more egregious creditors to the banks.  At best, though, I think that is a small percentage of the whole.  Again, from industry data, it appears that the vast majority of growth is coming from 0% purchase teaser rates, not balance transfers.

In the very short run, the credit card lenders' balance growth will likely be eyed by the markets as it has been by the economists -- a green shoot ready to bloom during the second half of 2014. 

My concern is that without wage growth, higher food and energy prices, coupled with free deposits at banks charging low-income consumers 15% or more in interest, will be yet another source of contention between the establishment and the voiceless.

Non-discretionary credit for cars and higher education was bad enough.  If a growing number of Americans are now borrowing just to put food on the table and gas in the car, the potential for broad scale social unrest is high.
Peter Atwater's groundbreaking book "Moods and Markets" is now available on Amazon and Barnes & Noble.
"Peter Atwater brilliantly provides a framework for understanding both the socioeconomic hubris that led to the great credit bubble of the past decade and the dark social-psychological hangover that has resulted from its collapse. In so doing, he offers an invaluable guide to what promises to be a very difficult and turbulent period ahead as we experience what he calls the 'me, here, and now' behavioral tendencies of the post-crash world."  -Sherle R. Schwenninger, Director, Economic Growth Program, New America Foundation

Twitter: @Peter_Atwater
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Arthur holds positions in SH, JPM and SLV.
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