Will Consumer Credit Feel the Crunch?

Rising delinquencies on credit cards suggest that problems in the U.S. mortgage market may be spreading to consumer lenders

While the housing market has been behind much of the current turmoil in the U.S. banking system, there are some signs that the stress caused by the downturn in housing is slowly seeping into the consumer finance business, including credit cards and auto loans.

As a result, Standard & Poor's equity research analyst Frank Braden lowered his fundamental outlook on the consumer finance subindustry to negative on Dec. 4.

While the delinquencies and charge-offs (amounts written off as bad debt expense) for consumer credit outside of home loans remain relatively low, they have begun to pick up. According to data from the Federal Reserve and the FDIC, charge-offs on both credit card loans and other consumer loans were relatively stable during the first half of 2007. However, in the third quarter, charge-offs began to increase. According to the FDIC net credit card charge-off rates (as a percentage of the total credit-card loan portfolio) were 4.29% in the third quarter compared with 4.03% in the second quarter. Despite the increase, charge-offs remain well below the 7.69% rate seen in the first quarter of 2002 during the last period of economic weakness.

Growth in consumer finance is also beginning to slow. In the third quarter consumer credit rose at a 5.25% annual rate, according to data from the Federal Reserve. This was slightly slower than the 5.4% annual rate posted in the third quarter of 2006. Although credit growth held up reasonably well, in September growth was only a preliminary 1.75%, down from a 7.5% rate in August and a 6.4% rate in July. Discover Financial Services (DFS; S&P investment rank, 3 STARS, hold) also reported that its consumer spending confidence index, which surveyed 14,000 adults about their spending habits, showed a sequential decline in November. Forty-six percent of respondents also said they felt their finances were worsening.

Billions for Bad Debts

These issues are beginning to have an impact on banks and consumer finance companies. HSBC Holdings (HBC; 3 STARS), which was one of the first banks to call attention to the problems in the U.S. subprime mortgage market, reported in mid-November that it was setting aside $3.4 billion for bad debts in its consumer lending business. The size of the charge suggests that the problems in the U.S. mortgage market may be spreading.

Despite the higher charges related to its consumer finance operations, HSBC reiterated that delinquency rates on credit cards and auto loans remained lower than levels seen in other downturns. The aggregate data from the Federal Reserve also indicate that charge-offs and delinquencies still remain below previous downturns.

So far, these businesses have held up reasonably well for most other banks and consumer finance companies. American Express (AXP; 4 STARS, buy) saw a modest pick-up in delinquencies in its credit card lending business in the third quarter, but that rise was largely a result of conditions returning to their long-term historical average from extremely low levels. The company's provisions for loan losses did rise 44% in the third quarter, due both to a substantial increase in loans outstanding and delinquencies returning to their historical average. Amex has benefited from its exposure to higher-income clients than some other credit card lenders, according to Braden.

Capital One Financial (COF; 3 STARS), which is more exposed to lower quality consumers, took higher provisions in the third quarter in anticipation of a rise in charge-offs in both its U.S. credit card and auto finance businesses. Charge-offs and delinquencies were both up in the quarter as well. For its credit card business, charge-offs rose to 4.13% from 3.39% a year earlier, while delinquencies climbed to 4.46% from 3.53%.

The large banks with credit card operations, including Bank of America (BAC; 5 STARS, strong buy), Citigroup (C; 3 STARS), and JPMorgan Chase (JPM; 4 STARS) have, as of yet, not reported a major increase in delinquencies or charge-offs related to their consumer finance businesses.

Relative Economic Health

Despite some signs of strain, the relative health of the U.S. economy has been the main mitigating factor for these businesses. While housing remains a drag on overall growth, S&P is forecasting U.S. gross domestic product (GDP) growth of 2.1% in 2007 after growth of 2.9% in 2006. Housing is subtracting about one percentage point from headline GDP.

Additionally, employment remains robust, with an unemployment rate at only 4.7% as of October, 2007. S&P forecasts that the unemployment rate is likely to increase to about 5% over the next few months, while average payroll growth comes in at about 100,000 per month, slightly slower than in the previous 12 months.

Without a significant slowdown in the U.S. economy and accompanying layoffs, most consumers should be able to continue to meet their credit card and consumer loan obligations. Still, S&P is more concerned about the economy falling into a recession. The odds of that happening are now at about 40% compared with prior expectations of 33%. Any more significant slowdown in U.S. GDP could extend the current credit crisis to the lower quality players in the consumer finance market. Additionally, U.S. personal bankruptcies have been trending higher. Personal bankruptcy filings reached 212,000 in the third quarter, up from 166,000 in the third quarter of 2006, according to the FDIC.

Despite the current health of the U.S. economy, with the housing crisis likely to remain prolonged, gas prices continuing to rise, and consumers facing high debt burdens, Braden believes the consumer finance industry could suffer an adverse impact.

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