Rising consumer debt driving the recovery: boon or bane?

Larry Kummer, Editor

10 years ago

Summary: Have we learned much from our 2008 brush with another depression? Look at the growth in subprime education and auto loans, and decide. Will we reforge the fetters on lenders forged in the New Deal to prevent events like 2008? Failure to learn is one sin that Nature always punishes.

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Contents

Borrowing as a driver of growth
Car loans: sub-prime galore
College Loans: the new sub-prime
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(1) Borrowing as a driver of growth

In modern economies borrowing drivers growth. Government borrowing to build infrastructure or even out benefit payments across generations. Business borrowing to fund investments. Households borrowing to buy home or fund consumption.

Such borrowing not only boosts GDP, but creates assets (your debt is the creditor’s asset). Centuries of experience show that this works well when prudently done. Centuries of experience shows the unpleasant results when imprudently done. Loan defaults hurt the debtor, often forcing bankruptcy. Loan defaults convert assets (the loans) into dust — destroying capital of banks and investors (e.g., insurance companies, pension plans).

So the foundation of growth can be sound or fragile. As in 1929, 1999, and 2007. Let’s look at our slow-growth recovery.

Consumer credit growth has accelerated during the past year. Most of this growth is in revolving loans: loans for motor vehicle, mobile homes, education, boats, trailers, and vacations. These loans may be secured or unsecured. Total revolving loans are up 33% from the previous cycle peak in July 2008 (SA), to $2.2 trillion. Most of that growth has been in autos and education loans.

(2) Car loans: subprime galaore

Bloomberg has a disturbing article about auto loans: “Good Job Is Good Enough as Subprime Car Buyers Lift Sales“. Car loans are being made with an average maturity of 62 months and high loan-value levels (80%), so that a high fraction will have no equity if they default. And to make that more likely, lenders are boosting sales by increasing lending to sub-prime buyers.

As the fifth anniversary of the Federal Reserve’s policy of keeping interest rates near zero approaches, the market for subprime borrowing is once again becoming frothy, this time in the car business. As with mortgages in 2006 and 2007, the central bank’s stimulus is making it easier for people with spotty credit to buy cars as yield-starved investors purchase riskier bonds linked to auto loans.

While surging light-vehicle sales have been one of the bright spots in the U.S. economy, it’s increasingly being fueled by borrowers with imperfect credit. Such car buyers account for more than 27% of loans for new vehicles, the highest proportion since Experian Automotive started tracking the data in 2007. That compares with 25% last year and 18% in 2009, as lenders pulled back during the recession.

Issuance of bonds linked to subprime auto loans soared to $17.2 billion this year, more than double the amount sold during the same period in 2010, according to Harris Trifon, a debt analyst at Deutsche Bank AG. The market for such debt, which peaked at about $20 billion in 2005 …

“Perhaps more than any other factor, easing credit has been the key to the U.S. auto recovery,” Adam Jonas, a New York-based analyst with Morgan Stanley, wrote in a note to investors last month.

(3) College Loans: the new subprime

Education loans by the Federal government and Sallie Mae have grown almost 6X since July 2008, to $716 billion. These are, as a group, the new subprime. Default rates are rising. The Department of Education estimates that the default rate over 20 years for loans made in 2009 will be 17%. If economy continues its slow growth since 2008 — plus the falling real median incomes of the past few decades — then those forecasts will prove far too low.

The trends look alarming. The following graphs include both Federal and non-Federal student debt. From “Household Debt and Credit : Student Debt“, Federal Reserve, 28 February 2013 — Part of their quarterly report.