Hot or Cold?

By Lauri Giesen

Bankers remain optimistic about consumer lending, but warning signs abound. Is it time to cut back on the credit flow?

For consumer lenders, it's a time of mixed signals. Many economic indicators were already flashing red this summer — including bankruptcy trends, credit default statistics and unemployment reports — and this negativity only intensified in the wake of the September 11 terrorist attacks on New York and Washington, D.C. Consumer confidence, heretofore one of the economy's few bright spots, suddenly looks much less assured.

Yet retail bankers are not quite ready to retreat into their bunkers. They still believe consumer and small business lending will provide some growth in 2002 — certainly more than commercial lending, which has been hit much harder by the current economic slowdown. The housing market remains strong in most areas of the country, and home equity loans are still in demand. Credit cards are a question mark, but widening spreads are helping to offset the effects of rising delinquencies.

It boils down to managing risk. "If you focus too much on not making bad loans, you will lose an awful lot of money turning down good ones," says Kelly Matthews, a Wells Fargo & Co. economist based in Salt Lake City. "That means you have to find better ways to manage your risks while staying active in lending."

To improve their risk management, bankers are making greater use of computerized consumer behavior models that allow them to predict early on when consumers are likely to get into trouble. "When the economy goes sour, the antennas go up," says James Accomando, president of Fairfield, Conn.-based Accomando Consulting, which advises banks and other credit card issuers. "Fortunately, bank databases are better than ever, which allows them to make better predictions."

Card issuers, for example, are using these models to take protective measures while remaining active in the market. That means either reducing the credit issued to some customers, or contacting others who are falling in arrears to work out payment plans before problems become too severe. When faced with an application that doesn't meet their criteria, issuers often come back with a counteroffer that features more restrictive terms and a higher interest rate.

Less generous pricing, in fact, will almost certainly become a feature of the consumer lending landscape going into 2002. "There are fewer financial service companies offering discounted rates to attract new business," says David Littman, senior vice president and chief economist for Detroit-based Comerica Inc. On top of that, many banks are requiring that loans be predicated on larger collateral holdings than in the past.

If the economic situation becomes severe enough, however, bankers still could be forced to tighten the credit spigots. The real question is: how bad will it get? Consumer confidence is at its lowest point in nearly eight years, according to the University of Michigan index.

David Wyss, chief economist for Standard & Poor's Corp. in New York, says the events of September 11 pushed the U.S. economy from "a near recession" into "a real recession," although official confirmation was not available as this magazine went to press.

Card Play

Based on the most recent reported numbers, the credit outlook for consumer loans is not yet alarming. The delinquency rate for fixed installment loans — which includes direct and indirect auto, home improvement, recreational vehicle, home equity, mobile home and marine loans — rose just slightly in the second quarter, to 1.94% of the dollar amount of credit outstanding. That compares with 1.78% in the first quarter and 1.73% in the year-ago period, according to the American Bankers Association.

Stronger signs of distress are coming from the credit card sector, however. Standard & Poor's says card chargeoffs reached a new annualized high of 6.9% of credit outstanding in May, compared with a previous record of 6.4% posted in 1997. Those chargeoffs are expected to keep rising through next year as more people lose their jobs in the wake of business disruptions caused by the terrorist attacks. Before September 11, Wyss had been predicting the chargeoff rate would remain close to 6.9% in 2002; now he's revised that forecast to 8.4%.

So far, the mood of card issuers remains upbeat, as reflected in the fact that they sent out 1.2 billion pieces of direct-mail promotions in the second quarter, about 21% more than the 992 million solicitations sent out in the year-ago period. This remains a profitable business for issuers because their credit losses can be covered by the wide spread between their yield rate and cost of funds.

The Federal Reserve lowered interest rates nine times this year, bringing the federal funds rate down to 2.5%, its lowest level since 1962. "While the loss rate on credit cards has been pretty dramatic, there's also been an equally dramatic shift in the cost of funds — a shift for the better," Wyss says.

The results could be seen in the second quarter, when issuer profits grew 21% from the prior period, according to a report by New York-based Keefe Bruyette & Woods Inc., an investment firm that specializes in financial services. "Banks are still doing well with their card programs," says Randi Weinberg, director at Auriemma Consulting, Westbury, N.Y., which advises credit card issuers on strategies.

Armed with better analytical tools to evaluate credit worthiness, Weinberg adds, most banks do not yet feel the need to stop promoting their card products, although some are a little more selective about credit extension. For example, when faced with applications from consumers who don't meet their lending criteria, many issuers will come back with counteroffers — possibly with more restricted terms and a higher rate to reflect the higher risk.

"The technology allows you to keep lending — just lend a little smarter," Weinberg says. "In the past, issuers cut back on lending when times got tight and ended up losing market share to newer, typically nonbank, entrants. They don't want to do that this time."

Bankruptcy Debate

Consumers may draw down less of that credit, however, which could exacerbate any economic slowdown. "Further slowdowns in consumer spending, and in turn borrowing, will compound the effects of a downturn, posing growth and credit quality challenges," says Michael Dean, senior director of Fitch Inc., the New York-based rating agency.

Card issuers will definitely be forced to cut back if the consumer credit picture continues to worsen. One troubling trend is bankruptcy filings, which reached an annualized rate of 1.35% in the second quarter, down from 1.38% in the first quarter but higher than the year-ago period's 1.19%, according to Standard & Poor's.

In fairness, some of this increase can be traced to legislation now pending in Congress that will make it more difficult for bankrupts to shield their assets from creditors. In response, bankruptcy attorneys have aired television and radio advertisements encouraging consumers to file bankruptcies now to get ahead of tightened regulations. "Some of the increase is the result of consumers anticipating new laws and wanting to file ahead of any changes," says Wells Fargo's Matthews.

But that's not the full explanation. "If this was just a bubble related only to legislation, we would not see the sustained growth in filings we've seen over the past year or so," says analyst Sean Ryan, with Fulcrum Global Partners in New York.

U.S. consumers are certainly stretched thin right now, by historical indices. Standard & Poor's estimates the average U.S. household owes 107% of its annual after-tax income, although this includes mortgage debt. "With unemployment rising, there's a concern as to whether consumers can pay their bills," Wyss says.

Fortunately, a surge in credit card delinquencies would not be catastrophic for U.S. banks. While the top issuers today include Citigroup Inc., Bank One Corp., J.P. Morgan Chase & Co. and Bank of America Corp., many regional banks have sold off their portfolios in recent years. "Any negative impact on the credit card market will be concentrated within a small group of big banks," says Richard X. Bove, securities analyst for Raymond James & Associates, St. Petersburg, Fla. "If there is a downturn in that market, it won't even affect 99% of the banks in this country."

Equity Appeal

Other consumer lending markets appeared relatively healthy as of last summer, although much has transpired since then.

Consumer credit outstanding did fall by $1.5 billion in June, or at a 1.2% annual rate, the first such decline since November 1997, according to the Federal Reserve. Most of that decrease came in the so-called "non-revolving debt" category, of which slightly more than half comprised auto loans. But since revolving debt, which includes credit card activity, actually rose by $2.3 billion, economists initially viewed the decline as temporary.

That view is changing in the wake of the September 11 attacks and subsequent stock market turmoil. Wells Fargo's Matthews now worries that rising layoffs will keep consumers at home. Indeed, sales of cars and light trucks fell 8.7% in September. Analysts said the decline would have been worse had the Big Three automakers not offered aggressive zero-interest rate financing incentives. "The economic ramifications following the terrorist attack amounted to a substantial shock on top of what had already been a weak economic environment," Matthews says.

Increasing job loss is the key factor in that economic environment, at least for retail bankers. The unemployment rate reached 4.9% in August, up from 4.5% the month before, and held steady at that rate in September. Experts say the widespread layoffs in the airlines and travel industries announced after September 11 will show up in the October report. Many expect the unemployment rate to reach 6% or 7% next year, which will surely dampen consumer spending.

Mortgage products remain one bright spot, even after September 11, since housing markets in most areas of the U.S. have continued strong and refinance activity is robust. Credit quality is also less of an issue when it comes to first mortgages or home equity loans. Delinquency rates for home equity loans have been flat this year, even into September.

"Most people are pretty rational in their use of home equity loans," says economist Wyss. "Studies have shown that the biggest use of these loans is still home-related improvements and the next biggest use is to pay college tuition. People aren't taking out these loans frivolously."

And the outlook for 2002 still remains good. While the double-digit appreciation of home values seen in the late '90s may be a thing of the past, growth is expected to stay in the mid- to high-single digits. Although mortgage delinquincies showed a worrisome uptick in the third quarter, default rates are expected to stay within reasonable bounds. "Consumers have not shown a desire to lose their homes, even in the worst of times," says analyst Bove.

Small business could provide another growth area in 2002. A recent study by the Federal Deposit Insurance Corp. showed that loans to commercial borrowers of less than $1 million rose about 5% in the year ending June 30, even as loans to larger borrowers fell 3% during the period. Small business loans are often treated as an extension of the consumer market since many business owners use personal credit cards or home equity loans to finance their businesses.

So far, then, bankers still are inclined to lend to consumers. They point out that growth in this sector, even if increasingly pinched, is still healthier than with commercial credits. "The growth in commercial lending was only one-fifth this year of what it was a year earlier, whereas consumer credit lending growth was about half of that a year earlier," says Comerica's Littman.

Littman expects 2002 to be a better year for retail bankers than 2001, but doesn't think the improvement will take hold until the second or third quarter. "We have to have about a half year of recovery behind us before we see a pickup in the consumer lending business," he says.

Others say the outlook is just too murky right now to be sure of anything. "The recent developments were a shock to our system," Matthews says, "and until we know how any future security directives and military responses will affect our country, it's hard to make any predictions about consumer confidence." So while bankers may not shut off the credit spigot, they certainly will be keeping their hands on it.

Ms. Giesen is a freelance writer based in Libertyville, Ill.

Copyright © 2003 by Banking Strategies, published by BAI.

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