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Consumer Credit and Loans: A Chilly Forecast

With the economy sluggish, unemployment high, and regulatory changes likely, consumers may find it difficult to access credit and loans may cost more

From Standard & Poor's RatingsDirect

During the past two years, as the economy has deteriorated, U.S. consumers have been spending less and less—in our view, partly because their access to credit has dried up. In the wake of rising unemployment, collapsing housing prices, and the foreclosure crisis, many banks and other lenders appear to have tightened standards for granting credit-card, home equity, auto, and other consumer loans. Consumer debt has declined markedly from its peak two years ago as the nation's economic woes have generally caused the consumer to save more and borrow less. We believe that the slow economic recovery, along with consumers' and lenders' possible reactions to new and proposed changes in financial regulation, could form a new, more complex landscape that we are just beginning to understand. It might well mean that consumers, especially subprime borrowers, will find it noticeably tougher to get certain loans. Moreover, borrowing costs could increase even for customers with strong credit histories, as banks seek somehow to make up the loss of fee income some anticipate because of changes in credit-card laws or proposed changes restricting overdraft fees. While the government aims to broaden consumer protection, we believe that lenders could see a drop in this fee income, which has little cost attached to it. If interest rates rise with an economic recovery, it is our view that some consumers could also simply be priced out of the market for certain loans. Yet the environment among many lenders will likely stay competitive as they seek out consumer business. With both lenders and borrowers at a crossroads, we don't believe that the future of the consumer lending business will become clearer until we see how these factors play out. The Economy: A Crucial Role The pace and strength of the economic recovery is expected to have a large influence on both borrowers and lenders. People without jobs have traditionally been viewed as credit risks. But while the unemployment rate continues to rise steadily, we also believe that it's helpful to look at initial unemployment claims, which are an indicator of how many more people will likely be out of work in the near term. These claims have been falling steadily since the second quarter of this year, which could reflect an improving economy, as well as ebbing consumer reluctance to spend. Because so many consumers spend using credit, another major concern is interest rates, which by historical standards are still relatively low for some types of purchases, such as cars. Traditionally, when economies rev up, so does the cost of borrowing. It's difficult to assess how much any upward move in rates would affect spending. We believe that it's too early to see precisely how lenders would respond, in part because they must consider so many other factors, including regulatory changes in the credit-card business, the health of the housing market, possible required increases in bank capital positions, and the employment rate. We suspect that as the economy improves, lenders' appetites for risk in the consumer sphere will grow, but they'll have the benefit of hindsight. Where We Stand Now: The Great Deleveraging What we are observing now, however, is that lenders are looking for borrowers with strong credit and stable employment. This may continue even after the economy recovers. In the near term, this may well limit the amount of credit they grant. Given the choice between more borrowers with shakier credit and fewer borrowers with sound credit histories, they will, in our view, gravitate toward the latter. Many banks' balance sheets have shrunk recently as they've pulled back on lending. In rare instances, we understand that big lenders have even begun to run off their consumer business. But despite the weak economy, we believe that most of the largest consumer lenders and credit-card issuers appear to want to continue lending activity despite the uncertain environment. In our view, the deleveraging of the American consumer has proceeded for roughly two years. Consumer credit-card debt in September 2009 was roughly equal to that in April 2007, having peaked in September 2008. The same pattern applies to nonrevolving consumer credit, much of which is for car loans. We've also seen a radical drop in the home equity consumers have cashed out, which in 2008 was less than half the amount consumers took out in 2006, at the height of the housing boom. Finally, we believe that credit-card delinquencies may be at or near peak levels, indicating in our view that fewer consumers are getting into debt over their heads.

Credit Cards: It Might Become Harder To "Just Charge It" The Credit Card Act of 2009 is expected to take effect in February 2010. It is expected to change the terms of credit-card use in many ways, such as by limiting when lenders can increase interest rates, placing restrictions on fees for purchases that exceed the cardholder's limit, and limiting the conditions under which lenders can issue cards to college-age students. The law also mandates more extensive disclosure of balances and other information to cardholders. The law is widely seen as consumer-friendly. Whether that will prove to be the case remains to be determined. There could be, in our view, opportunities for credit-card issuers to minimize revenue losses that the new law could generate. They could, for instance, simply issue cards at higher initial rates and skip low introductory rates. They might institute annual fees or raise existing ones. And they might simply decline to extend credit to certain prospective borrowers, potentially putting a dent in any upswing in consumer spending. Right now, however, we believe that it's just too early to know how lenders will proceed. Nevertheless, some lenders are expecting a loss of revenue in their retail banking operations because of potential laws that would place limitations on overdraft fees—including those generated by debit cards. (The Federal Reserve recently posted its rules on this matter.) Management at JPMorgan Chase (JPM), which has already altered its overdraft policies, has estimated that as a result of these changes it will see reduced retail banking revenues in 2010, with an annualized reduction in net income of approximately $500 million. Similarly, Wells Fargo (WFC) has estimated that its after-tax fee revenue in 2010 will fall by about $300 million. How accurate those forecasts prove to be will, in our view, depend in part on how consumers react to the new policies. The Home: Tighter Standards For Loans May Lower Consumer Spending The collapse in home prices generally kicked off this recession and values in some markets have fallen 30% or more from their recent peaks, with communities in the overbuilt Sunbelt and economically depressed areas of the upper Midwest especially hard-hit. Before the housing bubble burst, it was for the most part much easier to get home equity loans or lines of credit; lenders often believed that even in default, they could recoup their money by selling homes in a constantly rising market. Home equity cash was a major contributor to consumer spending, especially for big-ticket items such as college tuition. But lenders have pulled back on these loans as home prices have fallen, and we suspect that homeowners could have more difficulty getting them. Just as lenders have raised their standards for home equity products, they've also done so with first mortgages. Underwriting standards, in our view, are significantly tighter, and far fewer lenders appear to be underwriting mortgages for consumers that are unable to put down at least 20% of the purchase price. Not only does this make mortgages harder to come by, but because consumers will need to save more for a home purchase, we could see some decrease in other forms of consumer spending—whether cash or credit purchases. Home prices will probably recover only slowly. We still see many areas of the country as overbuilt, thereby depressing housing prices. Foreclosure activity in economically hard-hit areas of the nation could also continue to rise, although various programs to prevent foreclosure or restructure homeowners' mortgages might begin to help distressed owners more in 2010 than they have so far. A home is one measure of a consumer's wealth. When its value is impaired and wealth declines, borrowing and spending can fall, too. The Consumer Loan: Who Owns It? In our view, one of the most difficult things for lenders to foresee is the state of the securitization market. Banks commonly offload assets by securitizing them and selling the securities to investors. Mortgages, car loans, and credit cards are the heart of that business. Some of these asset-backed securities (ABS) haven't performed well in recent years, however, calling into question the extent to which banks will hold on to loans rather than sell them. Although securitization has gotten a bad name for some assets, we believe that it will continue to play a part in the consumer lending business. Consumer spending has long been a linchpin of the U.S. economy, and much of that spending has depended on access to credit. How much credit remains available as the economy recovers—and under what terms—are the questions that we believe will help determine the degree to which consumers will contribute in the future.

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