Consumer Credit: A Crunch May Be Coming

Thank Amy Bell for helping keep the U.S. economy afloat. Bell, a 27-year-old benefits manager in Atlanta, bought a studio condominium with no money down, leased a Volkswagen Passat, and spent $2,300 on a set of living room furniture--all in the past six months. "I have been going a bit crazy with the spending," she says.

That's for sure. Bell and plenty of other people are piling up huge debts. The amount that Americans owe on loans for houses, cars, credit cards, and other purchases adds up to nearly 100% of their annual income after taxes. That's up from 75% in 1992, after the last recession ended.

Even if consumers are willing to take on more debt, lenders--and more important, the investors who buy many of the loans they securitize--may soon decide that enough is enough. If the credit crunch now squeezing business starts to hit consumers, whose spending accounts for two-thirds of gross domestic product, the U.S. economy could wind up in a world of trouble.

For now, a consumer credit crunch is hardly inevitable. Unlike businesses, consumers still have an easy time raising money. When they max out one credit card, it's a cinch to sign up for another. Outstanding consumer credit, most of it from credit cards and auto loans, rose 5.7% in the 12 months ended in May. And the amount of home-mortgage and home-equity loan debt outstanding keeps rising, too. It's up 10.5% for the year ended in March.

Banks have been eager to expand consumer lending, because profits from their commercial loan, brokerage, and investment banking departments have tanked. Income at Citigroup's (C ) consumer businesses, for instance, grew 25%, to $2 billion, in the second quarter.

For now, the combination of rising debt and falling interest rates continues to fuel consumer spending. In the past two months, mortgage refinancing has given consumers a further $40 billion to $50 billion to spend, estimates Bank One economist Diane C. Swonk. In nearly two-thirds of recent refinancings of loans owned by Freddie Mac Corp. (FRE ), people took out bigger loans than the ones they paid off, freeing up cash for more spending. And despite being burned repeatedly, lenders still increase loans to subprime borrowers. Swonk thinks that's a big factor in strong auto sales.

But there are signs a consumer credit crunch could be in the offing. Delinquencies on non-mortgage consumer debt reached 1.86% of debts at the end of 2001, up a third from 1.4% a year earlier and the highest in a decade, according to the Consumer Bankers Assn. In the past year, Providian Financial (PVN ), Metris, and NextCard have been crushed by bad debts. The Federal Deposit Insurance Corp. estimates that the liquidation of NextCard Inc. will cost taxpayers up to $400 million.

As a result, the government is stepping up oversight, which in turn could cut the supply of credit to some consumers. So far, attention is mainly on subprime lenders. "We want to put more focus on the higher risks," says David Gibbons, deputy comptroller at the Office of the Comptroller of the Currency. On July 22, bank regulators announced guidelines to prod credit-card lenders into increasing reserves and disclosing defaults promptly, after discovering that many were pushing the limits in their accounting. Some lenders may drop out of the market, predicts Reilly Tierney of boutique investment bank Fox-Pitt, Kelton Inc. in New York.

But credit concerns could also begin to infect higher-grade credits in coming months. That's the way nearly every crunch unfolds: from the bottom up. And the quantity of debt is so large that bad news could cause lenders to retrench, even without regulators' warnings. Analysts warn that any of a number of factors could spook lenders: a decline in house prices, a rise in interest rates, or a softening of the job market that pushes up unemployment and moderates wage gains.

Mortgage lenders would tighten up in a hurry if housing prices soften. That's a distinct possibility, given what Freddie Mac Corp. estimates is a 37% average increase in prices in the past five years. Many homes today are purchased with downpayments of 5% or less, so even a modest decline would leave people owing more than their house is worth. That would cool cash-out refinancings, which have propped up consumer spending. And it would frighten lenders, who would lose the ability to make themselves whole through a repossession. "It could bring to the fore a great deal of hidden credit risk," says Stuart A. Feldstein, president of SMR Research Corp. in Hackettstown, N.J. "In mortgage lending, the [profit] spreads are so thin that there's no room for big losses."

An increase in interest rates by the Federal Reserve could be the trigger for a fall in home prices. Right now, a Fed rate hike remains unlikely. But if the stock market keeps rebounding and the recovery continues, it will strengthen Fed hawks who argue that low rates and excessive money creation are inflating new bubbles in the economy.

For lenders, the problem is that consumers are dangerously dependent on today's superlow rates. When rates fall, the cost of servicing debt should fall, too. Yet the Federal Reserve says that household debt-service payments were more than 14% of disposable income in the first quarter, near the highest level in 22 years. If rates go higher, the burden of debt service will increase. Mortgage Bankers Assn. economist Phil Colling says that approximately 30% of outstanding mortgage debt has adjustable rates. And about 40% of non-real-estate consumer debt is revolving credit, much of which has adjustable rates. A credit crunch could set in if a rate rise triggers a wave of defaults by holders of adjustable mortgages and revolving debt.

Aside from rising rates, the other nightmare for lenders would be a lull in the job market. Thanks in part to tax cuts, disposable income after inflation rose 5% in the year ended in the second quarter. That helped hold down the debt-to-income ratio. But lenders would be more reluctant to extend credit if the unemployment rate spikes or real incomes slow their rise, because they would be worried about getting paid back. And rates are already so low that the Federal Reserve couldn't easily use further rate cuts to lure consumer lenders back into extending credit.

A final wild card is the new bankruptcy bill, which will take effect six months after President Bush signs it into law. Feldstein of SMR Research says some shaky credit-card issuers could be driven under if many of their cardholders file at once to obtain protection from creditors under the old, more lenient law. That, in turn, could disrupt the flow of fresh credit.

The credit crunch on business has been painful. But for Amy Bell and the home buyers, car shoppers and mall walkers like her across the country, a credit crunch would be a real killer.

By Peter Coy and Heather Timmons in New York, with Brian Grow in Atlanta, David Welch in Detroit, and Mike McNamee in Washington

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