Consumer Credit
Surveying the landscape
Today’s post was prompted by a recent WSJ article discussing the currently low default rate on consumer loans and the shifting investor demand for various types of consumer credit in anticipation of a possible downturn in the US economy. The article is interesting and a quick read and I encourage you all to open the link above.
But rather than discuss the article in detail, I thought I would take this opportunity to answer a few frequently asked student questions about consumer credit. I don’t think you will find anything particularly profound in what follows, but my hope is that some of you may find this background useful.
What do we mean by “consumer credit”? When we talk about consumer credit, we are talking primarily about loans to individuals and households. When you read “credit”, think “loan” or “debt”, which is an asset to the lender but a liability to the borrower. We distinguish consumer credit from other types of debt, for example business or commercial real estate loans, investment and non-investment grade corporate bonds, and federal, state and local government debt. In the realm of consumer credit, think of all the various purposes for which an individual or head of household might borrow money over their lifetime: to buy a house (mortgage loan), to buy a car (auto loan), to finance a college education (student loan), or to purchase consumer goods (credit card loans). And of course there are other forms of consumer credit with which we should also be familiar, for example home equity lines of credit or reverse mortgages, personal loans from a bank or other lending organization, installment credit provided by merchants, loans against the equity in insurance policies, margin loans collateralized by securities portfolios, intra-family loans, and pay day loans for those who have nowhere else to turn.
What is the current interest rate on consumer loans? The interest rate charged on different forms of consumer loans varies widely and is impacted by the purpose of the loan, the tenor and terms of the loan, the nature of any collateral securing the loan, the credit quality of the borrower, and the laws and regulations governing credit extension, loan foreclosures and bankruptcy. The interest rate on a conventional 30-year fixed rate residential mortgage loan is between 5% and 6% today, compared to 4-5% on an adjustable rate mortgage, but the rates charged to borrowers with poor credit scores and not much in the way of downpayment will be higher. The rate on federal student loans ranges from 5% to 7.5% depending on the program, and rates are higher in the private market. Auto loans range from 4-7% or so depending on the circumstances (new or used car, purchased from dealer or private party, etc). Unsecured personal loans from a bank probably start around 5-6% but can go much higher, although top credit borrowers with strong banking relationships and collateral to post may borrow at much lower rates. The annual interest rate charged on overdue credit card balances starts at 13% or so and runs above 20% on some cards. And the interest rate charged on short-term payday loans is off the charts, with annualized rates of 300-500% or more in states which do not legally cap the rates charged to borrowers.
The reference rate for many consumer (and business) floating rate loans is the so-called “prime rate”, generally the rate published by the WSJ. The WSJ Prime rate is currently 5.5%, up several hundred basis points over the past months. But banks often lend money to their best customers at rates well below prime, which is not to be confused with a “sub-prime” loan (ie a high interest rate loan to a borrower with a below prime credit score).
Contrast these consumer loan rates with the annual interest rates paid on bank deposits of 0-1% (depending on maturity) and to the rates paid on UST notes and bonds of 2-3% (for maturities of 1-month to 30-years). USD corporate credit is priced at a premium credit spread to UST yields, ranging from 50bp or less at the low end (best credits) to 500bp or more at the high end (worst credits).
How big are the various consumer credit markets? The total amount of outstanding consumer debt is currently around $16 trillion, up 7% year on year. Of this amount, over 70% ($11.5 trillion) consists of residential mortgage debt. The remaining 30% (ca $4.5 trillion) consists of student loans ($1.6 trillion), auto loans ($1.5 trillion), credit card loan ($900 billion) and other ($500 billion). (See data here,). These totals include loans held by banks, non-bank lenders and other financial institutions, and capital market investors. As noted below, most of the outstanding US consumer debt is not held on the balance sheets of commercial banks.
The current outstanding balance of US household debt ($16 trillion) represents about 80% of GDP ($20+ trillion), up five percentage points over the past three years (pre-covid), but down from a peak of 100% during the 2008 financial crisis (when household debt was high and GDP fell significantly). (See data here.)
Within the US commercial banking sector, the total amount of consumer debt held on balance sheet is around $4.2 trillion, consisting of $2.4 trillion of residential real estate debt (primary mortgage loans plus a small amount of home equity loans) and another $1.8 trillion of non-real estate consumer debt (including credit card, auto and other forms of consumer loans). (See data here.)
To put these consumer debt numbers in context, consider the size of other large debt markets. The outstanding amount of all US federal, state and local government debt is around $30 trillion, of which ca 90% is federal debt. The total amount of non-financial corporate debt (bank loans plus investment and non-investment grade bond debt), is around $20 trillion, about equal to the amount of outstanding debt incurred by financial institutions. (The totals for financial and non-financial debt are largely double counted, of course, as financial institutions raise money largely for the purpose of lending it to others.) And the total amount of business credit held on the balance sheets of US commercial banks is around $5.4 trillion, split about equally between commercial and industrial loans and commercial real estate loans. (See data here, here and here.)
Tell us about the default rates on consumer debt. The default rate on consumer loans is currently at or near its all-time low, at around 0.4% of the total principal amount outstanding. This is down over 75% from the level of 2013 (1.7%). Shifting metrics somewhat, the delinquency rate on all consumer loans reported by commercial banks is currently running at 1.6%, down from 2.5% in 2013 and 4.8% in 2009. And for single-family residential mortgage loans, the delinquency rate is currently 2%, down from over 11% during the financial crisis (2010). During covid, many consumer loan default and delinquency metrics actually fell, despite the collapse of the economy, most likely due to widespread government income subsidies and mandated debt moratoriums. (See data here, here, here and here.)
A big driver of consumer delinquency and default rates is the ratio of scheduled debt payments to disposable income. This ratio, also used in determining individual credit scores (see below), rises with increases in the amount of household debt, increases in interest rates, and reductions in the amount of household income (often linked to rising unemployment rates). The latest figures show aggregate US household debt payments at around 9.5% of disposable personal income, up from 8.3% a year ago but down from the pre-covid level of 10% and the financial crisis peak of over 13%. (See data here.)
What is the difference between “default” and “delinquency”? The terminology here is often a bit fuzzy and may vary from source to source (eg bank loan accounting vs federal student loan reporting). But let me try to simplify, perhaps at the risk of over simplifying. A consumer loan is generally said to be “delinquent” when the borrower has missed the deadline for a scheduled debt payment, often a single payment. But a loan will not be regarded as in “default” until after the lapse of any contractual grace period, typically ranging from 30-270 days depending on the type of loan. Lender foreclosure happens only after a loan is declared to be in default, the borrower is notified, efforts to collect outside of foreclosure have been unsuccessful and any required legal processes have been complied with.
Both delinquencies and defaults will adversely impact the borrower’s credit score, with defaults having the more significant impact. During a loan foreclosure, the borrower loses control of the asset securing the loan (eg one’s house or car) and may be legally responsible for any loan balance still owed to the lender after sale of the collateral.
What about loss on default? Delinquent loans often turn into defaulted loans with the passage of time. And when a consumer loan goes into default the lender will likely lose some amount of money, ranging from a little to a lot. A mortgage lender, for example, may recover most or all of what it is owed by a defaulting borrower through the proceeds of the house sale in foreclosure (and the proceeds of any private mortgage insurance), with the borrower often legally on the hook for any unpaid balance (which may or may not be collectible). But on unsecured personal loans, for example credit card debt or student loan debt, the costs of collection and the losses on default can be quite high. I should note here that most forms of personal loans, including credit card debts, are generally dischargeable in bankruptcy, but many student loans are not.
The relationship between delinquency rates, loan defaults and estimated loss on default (or “charge offs” in commercial bank parlance) varies with the type of loan. For all consumer loans held by commercial banks, the current delinquency rate is around 1.6% and the rate of bank charge offs is a tad below 1%. During covid, estimated charge offs were higher, at a bit over 2% (higher than actual realized losses) and during the financial crisis the charge off rates were above 6% in 2010. Bank charge offs are only estimates of expected loss, however, and the actual losses may be higher or lower than the amounts estimated (as was the case during covid) and may or may not be fully covered by initial booked loss reserves, which banks adjust with changes in the state of the economy. (See data here and here.)
What are credit scores? A credit score is a numeric score calculated by a consumer credit rating agency (eg Equifax, Experian and TransUnion) which is meant to indicate how likely a borrower is to miss payments or default on their loans. Credit scores reflect a number of borrower metrics, including employment status and history, outstanding debt and personal income, debt service to income ratios, and bill payment history. Credit scores generally range from 300-850, with higher scores awarded to more credit-worthy (less risky) borrowers. The cut off between “prime” and “sub-prime” credit scores is generally considered to be between 620 and 650. (To learn more about credit scores, read here and here.)
What role does collateral play in consumer credit? Collateral plays a big role in some forms of consumer credit, particularly with respect to home mortgages and auto loans. Borrowers who default on their residential mortgage loans may find their homes foreclosed upon and resold by the lender. And the same thing happens with auto loans and other forms of secured consumer credit (eg margin loans). In the mortgage market, lenders typically require the borrower to put up cash equity of 10-20% of the purchase price, or procure private mortgage insurance, and this is on top of giving the lender a first lien on the home purchased with the loan. Home equity lines of credit generally have second priority liens (subordinate to the lien of the primary mortgage lender) and generally require combined loan to value (CLTV) ratios of less than 85%. Margin loans typically require 50% or so margin (ie the difference between the loan balance and the market value of the collateral).
But of course many types of consumer credit do not have any form of collateral securing the loan, most notably student loans and credit card loans. The borrowers on these loans also tend to have low credit scores and high delinquency and default rates and the lenders tend to incur large collection costs and large losses on default, which explains why these loans are so expensive.
Who are the primary originators (initial lenders) in the US consumer finance market? For some time now, the largest lenders in the US have not been commercial banks but rather various other categories of non-bank financial institutions (NBFIs), which do not take customer deposits and are not regulated in the same way as commercial banks. (This is quite different in other parts of the world, eg in Europe, where bank loans represent a much larger share of total private credit.) Non-bank financial institutions include investment banks, insurance companies, money market funds, investment funds and various types of consumer finance companies (eg auto finance companies, non-bank mortgage lenders and peer-to-peer lenders). Not all of these categories of NBFIs are active in the consumer finance market, but many are and collectively they now dominate some categories of consumer lending.
In the biggest segment of the US consumer loan market—residential mortgages—over two-thirds of new loans are now originated by non-bank lenders such as Rocket Mortgage. In fact, seven of the ten largest residential mortgage lenders in 2020 were non-banks, quite a change from a decade earlier when 56% of all residential mortgage loans made in 2010 were originated by just three financial institutions, all banks: Wells Fargo, Bank of America and Chase. (See data here.)
What role does securitization play in the consumer finance market? Securitization plays a significant role in many segments of the US consumer finance market, most notably in the residential mortgage market, where 80% or so of home mortgages are securitized and sold to investors in the form of Mortgage Backed Securities (MBS), generally with credit guarantees from Fannie Mae or Freddie Mac. (See data here, Table 2.) Non-mortgage consumer loans are also securitized and sold into the capital markets, in the form of Asset Backed Securities (ABS). Excluding mortgages, however, the total size of the consumer ABS market is not large (under $1 trillion), consisting mostly of auto and student loans. (See data here.)
How is consumer credit regulated? I wish I could give you a clear and concise answer to this question, but I cannot. Some of this is due to ignorance on my part, but much of it is due to the fragmented and mind-numbingly convoluted nature of financial regulation in this country. At the federal level, national banks and bank holding companies are regulated by some or all of the Federal Reserve, the Comptroller of the Currency and the FDIC, agencies which historically have had only minimal focus on consumer protection (as became evident in the sub-prime mortgage crisis). The SEC regulates investment banks and certain types of investment funds, with a big focus on the protection of investors (including individual investors), but primarily with a disclosure-based regulatory framework. Fannie Mae and Freddie Mac effectively establish underwriting standards for most residential mortgage loans—more so today than in the years leading up to the 2008 financial crisis—but they are not regulators per se. (They also do not lend money or originate mortgages.) The FTC plays a big role in many areas of consumer financial protection, but primarily as an educator not a regulator. The Consumer Financial Protection Bureau (CFPB) was established in 2010 as part of the Dodd-Frank legislation (the Wall Street Reform and Consumer Protection Act) to consolidate much of the responsibility for consumer financial protection, but the level of regulatory and enforcement activity at the CFPB has varied widely across various presidential administrations. And then of course there are the many financial regulatory departments and agencies at the state and local level. And of course we should not forget insurance, which is regulated primarily at the state not federal level, with some degree of inter-state coordination via the the National Association of Insurance Commissioners (NAIC).
How might a changing US economy impact consumer credit? Suffice it to say that a changing US economy might impact consumer credit in many ways. Inflation and rising interest rates put pressure on household finances, making debt service more difficult and potentially increasing delinquency and default rates. But the big hit to consumer credit would likely come from a large increase in unemployment, and a corresponding drop in personal income. This does not seem like a major imminent threat to the US economy, but of course this could change quickly as the Fed continues to ramp up interest rates in an effort to cool off the US economy and reduce the current inflation rate.
Remind me, what happened to consumer credit during the 2008 financial crisis and during Covid? During the financial crisis of 2008, borrower delinquency and default rates increased substantially, pretty much across the board. Investor losses in the mortgage market, however, were concentrated in CDOs, consisting of the most junior tranches of unsold private label sub-prime MBS. In contrast, during Covid delinquency and default rates actually fell in some consumer credit markets (eg mortgages and auto loans), despite a big jump in unemployment, due to massive fiscal transfer payments and a variety of loan forbearance programs as well as surprisingly strong secondary markets in housing and autos. (Read here and here.). As noted above, commercial bank charge off rates on consumer loans are currently running around 1%, but were at 2+% during covid and at 6+% during the financial crisis. (See links in previous sections.)
What are the Fintechs up to in consumer finance? Fintech companies are quite active in the consumer finance space, although the jury is still out on how disruptive they will ultimately be to the incumbents. Some of these new companies actually lend money, but many do not, including those who connect lenders and borrowers (eg peer-to-peer lending platforms). Some offer new tools for making more informed credit or lending decisions, while others facilitate various aspects of loan processing, purporting to offer better customer experiences and/or lower costs than the big banks. Some target allegedly profitable but underserved segments of the consumer market, although to date mostly with very high priced offerings. And while a select few payment platforms have really taken off, they have been built largely on the back of (or over the top of) the incumbents’ own payment platforms (eg credit cards).
Not all of this activity is driven by disruptive new technology, however. Some of it seems to be little more than a form of regulatory arbitrage by non-bank intermediaries operating outside or in the shadow of the many governmental regulations governing banks and other large financial institutions, not dissimilar to what was happening in the residential mortgage market in the run up to the 2008 financial crisis.
Before you go load up on the stocks of fintech consumer finance companies, however, keep in mind that the big incumbent operators are also investing heavily in financial technology and they may prove hard to dislodge in their core business lines. No doubt some of the challengers will win, and win big. But who, how big and for how long? I have no idea, but this is an exciting space worth knowing more about. For more on Consumer Finance Fintechs, read here and here.
How can I prepare for a career in consumer finance? I have never worked in consumer finance and in any event have been retired for over a decade, during which time much has changed in this sector. And so I will refer W&M students (present and past) to the Boehly Center, which knows a lot more about this subject than I do and which can connect you with our W&M network of experts in the field for advice, networking and job placement. But my impression is that many of the key skills needed in the fast-changing consumer finance industry relate more to data analytics and marketing than to finance per se. Of course the same thing is true in other segments of the financial services industry, most notably insurance. Yes, you still have to learn the basics of finance, accounting and probability/statistics, but the critical skill sets in consumer finance now seem to be more in the areas of IT, data analytics and marketing marketing than in pure finance per se. So bone up on your skills in those areas if you want to work in this field.
And more importantly talk to others currently working in the field, who can give you better advice than I can. Good luck!
Links
Wall Street Shuffles Bets on Consumer Loans as Economy Slows, WSJ, August 8, 2022
Nonbank Lenders Now Dominate the Mortgage Market, WSJ, June 2021
US Mortgage Lending Statistics 2020, Lending Tree
The Financial Crisis at the Kitchen Table: Trends in Household Debt and Credit, NY Fed 2013
Why is the Default Rate So Low (During Covid)?, Fed Board of Governors, March 2021
Fintech Firms Tap AI to Reach More Borrowers, WSJ, May 2, 2022
Top Fintech Lending Firms, BuiltIn, March 2022