Consumers still adding leverage to income; when will this stop?

Friday, November 28, 2008

The NY Times published an interesting article written by an anonymous banker in the credit card industry. It highlights the pitfalls in the credit industry, where lax lending standards are partially to blame for the massive delevering that is likely on the horizon. I simply wonder when consumers will be forced to reduce debt? The massive Fed and Treasury measures designed to shore up real estate and consumer credit markets are clouding the data. It is not clear if/when consumers will stop drawing on existing lines of credit.

According to the NY Times, what goes up must come down:

”He/she said this about the shady business of offering up credit to households: As a banker, let me describe what we do wrong when we accept and review an application for a credit card. First, we don’t verify income. The first ‘C’ of credit: Capacity to repay, is completely ignored by the banks, just as it was in when they approved subprime mortgages. Then we ask for “household income” — as if other parties in the household could be held responsible for that debt. They cannot. And since we don’t ask for any proof of income, the customer can throw out any number they think will work for them. Then we ask if they rent or own and how much they pay. If their name is not on the mortgage, they can state zero. If they pay $1,000 in rent, they can say $500. (Years ago we asked for a copy of the lease to verify this number.) And finally, we don’t ask how much of a credit line the consumer is looking for. The banker can’t even put that amount into the system. There isn’t any place on the application for that information. We simply put unverified information into a mindless computer and the computer gets the person’s credit score and grants them the biggest line that score and income (ha!) qualifies for.

I recently had a client apply for a credit card. She is a homemaker, with no personal income. The house she lives in is in her husband’s name. She would have asked for a $3,000 credit line, just to pay miscellaneous expenses and to establish some credit on her own. So the computer is told that her household income is $150,000; her mortgage/rent payment is zero. The fact is that her husband’s mortgage payment is $7,000 a month (which he got with a no income verification loan). She had a good credit score, but limited credit since she has only lived in this country for the last three years. The system gave her an approval for a $26,000 line of credit!

This has got to stop. People are going to be learning hard lessons over the next years. It would help, though, if the banks could change their behavior now, before things get any worse. Tomorrow is already too late.”
This certainly paints a scary picture of the credit card industry, and I do believe that eventually revolving consumer credit will decline sharply. However, that is not yet evident in the data...still!

The chart illustrates the share of consumer revolving (credit cards) and consumer other (new loan origination not including home equity) credit as a share of total consumer credit. Two things are notable here. First, revolving credit rose relative to other credit during the 2001 recession (the data only goes back to 2000), and reverted back at the conclusion of the recession. It is common for credit growth to decelerate (decline) during a recession.

Second (chart 1), revolving credit took a discrete jump upward in 2004 (upward arrow). Consumer revolving credit accounted for an average of 39% of total credit spanning the years 2000 to mid-2004 and 43% spanning the years 2004-2008.

This surge in the revolving credit share is what the anonymous banker is worried about: lax lending standards on credit cards allowed consumers to become overly indebted to credit card creditors. Interestingly enough, revolving consumer credit was still 43% of overall credit on November 12, 2008. When will it fall?

I suppose that it will fall when consumers are forced to pay down debt (or default). But I don’t see that happening if government intervention prevents consumers from doing so. The Fed is offering $200 billion to shore up consumer lending, including credit card facilities under the new Term Asset-Backed Securities Loan Facility (TALF).

With the Fed’s massive liquidity injections, lending is still very positive, and aggregate revolving credit is not declining. Into 2009, the Fed's balance sheet will rise another $1.2 trillion, where $750 billion of that will go on balance by year’s end. Here is what we know:
  • $450 billion in Term Auction Facility (TAF) lending scheduled through the end of 2009.
  • $200 billion for the new Term Asset-Backed Securities Loan Facility (TALF) to shore up the asset market that backs loans to consumers (student, auto, credit).
  • $100 billion to buy GSE debt this week.
  • $500 billion to buy mortgage backed securities by over the next several quarters.

With the liquidity facilities to come and a $600 stimulus package on the horizon, when will consumers be forced to delever? For now, I will wait to see evidence in the data that consumers are borrowing less. Normally, credit falls during a recession, so I will be looking for a sharp decline in revolving credit.

Rebecca Wilder


Janie November 28, 2008 at 9:58 AM  

Do you remember all the credit card offers you had as a brand new student in college? That is also still going on and the credit card companies KNOW students don't have much, if any, income. This is throughout the population not just adults. How many dogs have credit?

David Pearson November 28, 2008 at 12:06 PM  


Thanks for an excellent blog!

I recommend reading some of Michael Pettis's work on U.S./China imbalances and the Great Depression. Michael is a China expert. The second post linked below is one of the best I've read on the subject of the Great Depression analogy.

Michael recently writes that the PBOC is trying to encourage businesses to produce, much like you say the Fed is encouraging consumers to spend. Both, he would point out, run in opposite directions to the necessary adjustment.

Kirk Petersen November 28, 2008 at 6:27 PM  

You point out that revolving credit soared in 2004, and the chart shows that other consumer loans simultaneously plummeted. What cause the abrupt change in behavior?

ongkaili November 30, 2008 at 8:11 AM  

Another piece of madness to add in the hat... backing up student loans to safeguard their future is somewhat, and only somewhat acceptable, but backing up auto loans and credit card debt is just insanity (einstein's definition).

i'm no expert on economics or finance, but i know what i'm seeing.... all i'm seeing is just 'keeping the booze flowing to keep the party going'.

i agree to a certain extent that morals/ethics should be bent, but only according to sound financial principles- however, this is seriously getting way out of hand.

taxes are for building public infrastructures and for paying civil servants... not these bailouts.

Josh December 1, 2008 at 9:52 AM  

Just a random thought . . . given that over reliance on debt by banks, businesses, and consumers is at the heart of this problem, how is it that government debt is the solution?

Rebecca Wilder December 2, 2008 at 11:07 AM  

Hi Kirk,

The Fed announced a benchmark change for the estimates, which could cause a discrete jump in the series. However, the trend is still the same in 2008: falling share of other loans and rising share of credit debt.


Hi Josh,

You said, how is it that government debt is the solution?

It’s a good point. However, in order to smooth out the aggregate impacts of consumer and firm delivering (if that is ever going to happen), the Treasury is going to run up some debt – the fiscal stimulus. But it is an entirely fair question to ask how much is too much, because eventually this will all have to be paid back. I like this post:


Oh, David - thanks for the links!

Aaron Weber December 5, 2008 at 9:42 AM  

For the ignorant among us, can you clarify the definition of "revolving credit?" How does that figure separate out people who run up large balances each month but pay them off?

I know plenty of people who carry no balance month to month on credit cards, but still run all their purchases through them -- both for convenience and to collect reward points.

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