Debt-Laden Consumers: What Risk to the Economy?

You know who you are: You’ve been living off your credit cards or your home equity credit line, or you borrowed to buy a car and now realize you can’t really afford it, or, tragically, you’ve just lost your job or your spouse and can no longer pay what had been reasonable debts.

It’s a miserable situation, and you know what they say about misery loving company: You’ve apparently got plenty of it, because all sorts of lenders are reporting growing problems with deadbeat consumer borrowers.

So much so, in fact, that some Wall Street pros fear that a huge wave of consumer credit defaults is looming out there, threatening to undermine the economy and the financial system the way the real estate crash of the late 1980s and early ‘90s did.

It’s still a muted concern, and as James Flanigan notes elsewhere on this page, the U.S. banking system today looks for all the world to be in great shape to deal with trouble.

Still, what’s unnerving about the surge in consumer credit problems this year is that it is occurring against the backdrop of a healthy economy, faster job growth and higher wages--as Friday’s robust August employment report confirms. That’s supposed to be a recipe for fewer deadbeats, not more.

But some analysts argue that the rise in credit woes is neither surprising nor all that alarming. It’s not a coincidence, they say, that American corporations are in terrific financial shape even as many families are financially weak. (More on that later.)

Moreover, the argument goes, many lenders that have increasingly been extending credit to marginally credit-worthy consumers know exactly what they’re doing: They’re expecting more defaults, but they’re also charging high enough rates so that the people who pay their bills should more than make up for the non-payers.

As the old retail line goes: “How do we do it? VOLUME!”

Whether that “we’ve-got-this-all-planned-out” argument holds water remains to be seen. The banking industry five years ago was littered with the bodies of smug loan officers who were blindsided by the commercial real estate market’s plunge as banks’ rush to finance new buildings led to a horrendous space glut.

For now, what is clear is that many consumer credit problems that were sparking worry in 1995 have gotten worse in 1996:

* The percentage of credit card accounts 30 days or more late on payments jumped to a near-record 3.53% in the first quarter, the latest data available, the American Bankers Assn. says. That’s up from 2.93% at the end of 1994, and the figure has been rising each quarter since then.

Since 1980, the ABA says, the late-payments percentage has only been higher than the latest figure once: in April 1981, at 3.58%.

* Home equity loan delinquencies also have risen this year, to 1.44% of total loans in the first quarter, up from 1.20% in the second quarter of 1995.

* Chrysler Corp.’s financing unit recently disclosed that its car loan delinquency rate rose to 3.17% of total loans in the first half of this year, up from 2.25% in the first half of 1995.

* Finally, consumers are filing for personal bankruptcy at a record pace this year, and often, say lenders, without warning.

Among the few bits of good news in the consumer credit area is that mortgage delinquencies actually dropped in the second quarter, to 4.35% of loans from 4.46% in the first quarter, according to the Mortgage Bankers Assn. That suggests that troubled borrowers are finding the money to pay their mortgages, although there is some suspicion they could be doing it with credit card loans.

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In fact, the explosion of credit card debt in the 1990s has dramatically altered consumers’ balance sheets. The Federal Reserve Board says card debt accounted for just 14% of total consumer debt in 1977. Now, at $444 billion, it accounts for 40% of the total.

People use cards for all sorts of convenience reasons today, of course, and most cardholders still pay their bills in full every month. What is unknown is how many people have been using cards--at the usual sky-high interest rates--to maintain a lifestyle that their wages alone wouldn’t allow.

One worrisome clue, however, is that the fastest growth in card usage in the 1990s has been by families earning less than $25,000 a year, says economist David Wyss at DRI/McGraw Hill.

That also is the income group that, arguably, has been hurt worst by the stagnant wage growth that has been the story of this decade, at least until recently.

Some economists see a definite connection. Businesses have been able to hold wages down, thereby enhancing profitability and leaving corporate balance sheets in great shape. At the same time, many consumers have burdened their own balance sheets with debt to support their lifestyles.

So far, the payoff from extraordinary corporate profitability has been hefty capital spending by companies on new plants and equipment. That has displaced some jobs, but it also has created many.

More important, says economist James Annable at First Chicago/NBD bank, that growing industrial capacity has helped extend the economic expansion by forestalling the development of product shortages that could fuel inflation.

Heavy corporate investment in the economy, in place of the rip-roaring consumer spending of the 1980s, has generated a “virtuous cycle” of sustainable growth for America, Annable says.

The cost, however, seems to be a rising number of lower-income consumers with debt problems.

Which brings us back to two questions. First, will the consumer credit losses for banks and other lenders become significant enough to slam the financial system?

The Fed says it’s watching, but so far it isn’t worried. Fed Gov. Janet Yellen noted in July that “higher risk and higher return go hand-in-hand. . . . Put another way, lenders active in the credit card business are conscious of higher potential loss rates and expect returns that will fully absorb these losses and still provide an adequate profit margin.”

A hopeful analogy, perhaps, is the high-yield corporate junk bond market. It has demonstrated that despite high risk and high defaults, those securities overall are a viable investment class.

Even so, Yellen also noted that many lenders have begun to tighten consumer lending rules in response to rising delinquencies.

That raises the second question: Is the economy finally set to slow down again, if only because mortgage lenders, auto companies, retailers and others with stuff to sell have already funded the proverbial last marginal buyer, and thus satisfied pent-up demand for a while?

“What would the auto industry do without 2% auto loans?” asks economist Susan Sterne at Economic Analysis Associates. “There’s been a tremendous amount of effort expended to keep this going,” she said, referring specifically to sales of big-ticket items this year.

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Yet forecasts of slower growth because of high consumer debt levels also were prevalent at the start of this year. The consumer was said to be “tapped out” then, but so far has proved otherwise.

Richard Rippe, economist at Prudential Securities, argues that “high debt is not usually a trigger for but rather an augmenter of an economic downturn.” In other words, once a downturn begins--for whatever reason--debt magnifies the problems inherent in it.

For now, barring a sudden shock to the economy, job growth, rising wages and surging confidence on the part of the majority of consumers look like enough to offset the credit problems of the minority, albeit a growing minority, many economists say.

Annable notes that it’s “easy to stop consumer spending in a computer model of the economy” by arguing that consumers should react a certain way to certain variables, including higher debt. “But in reality, it’s very hard to stop people from spending” on what they think they need, he says.

Or as Wyss puts it, “Yes, people are living beyond their means, but that’s the good old American way.”