When borrowers miss a payment or two, it’s their problem. If they start missing lots of them, it becomes investors’ problem too. The big question is which investors might be left holding the bag.
Over the course of the pandemic, something remarkable happened in consumer credit: It got way less risky to lend. At the outset of the crisis, U.S. lenders started setting aside huge reserves anticipating that a surge in unemployment and economic stress could lead many debts to go unpaid. But after stimulus payments and tax credits from the government, private forbearance and restructuring programs, and a drop in nonessential spending, the wave of defaults didn’t come.
By the end of last year, U.S. banks’ charge-offs of credit card loans had dropped to the lowest rate since at least the mid-1980s—an annualized rate of 1.57% of balances, according to Federal Reserve data.
But that was then. The average percentage of credit-card loans with payments at least 30 days past due—or delinquent, in credit parlance—rose sequentially in each of December, January and February, according to data on big U.S. issuers’ credit-card loans tracked by Autonomous Research analyst Brian Foran. Typically delinquencies only jump in January after people have stretched their budgets over the holidays.
This delinquency rate is still historically quite low at roughly 2.2%, or about a third below the level it was at going into the pandemic, according to Autonomous. That presents little immediate threat to lenders’ earnings, especially as many are still carrying relatively large set-asides for loan losses on their books. But indicators like these have been enough to mark a turning point in some investors’ minds, since they have been accompanied by a rapid rebound of borrowing and spending.
Shares of big consumer lenders and card issuers including Ally Financial, Capital One Financial, Discover Financial Services and Synchrony Financial well underperformed the KBW Nasdaq Bank index in March. KBW analyst Sanjay Sakhrani estimates that card-issuer stocks were on average pricing in charge-off rates that are about 25% above 2019 levels as of Wednesday’s close. Those would be levels generally not seen since the aftermath of the 2008 financial crisis.
There are definitely some reasons to think this might be an overreaction to a long-anticipated normalization from extraordinarily good credit performance. Many economic inputs that usually are correlated with credit risk still look good, such as the strong labor market. People created a significant amount of wealth over the course of the pandemic in the form of cash savings, investments and the rising value of their homes and vehicles. They also lowered their bills by refinancing mortgages at superlow rates.
But investors are also right to wonder if normal is just a stop on the way to abnormal. For one, the Federal Reserve might raise rates aggressively, which will raise the cost of borrowing for new loans and for floating-rate debts like credit cards. And U.S. inflation running at the highest level in decades was already potentially adding hundreds of dollars to the average household’s monthly expenses as of February, according to Moody’s Analytics. That is of particular concern at the lower end of the credit spectrum—especially if wages can’t keep up. Though only a small percentage of borrowers at big lenders might be considered “subprime” credits, they can drive a significant portion of losses, notes Mr. Foran.
There are other unusual factors to consider, too. The JPMorgan Chase Institute recently noted that with many consumers having put their elevated savings into the stock market, they could have to cut their spending if rising rates lead to tighter financial conditions.
Consumers also have new ways of tapping debt now, such as a wider array of “buy now, pay later” loans and installment plans. Small, short-term payments for purchases already made might be among the first to be skipped, though more regular reporting of those payments to credit bureaus could alter consumers’ behavior. Credit cards can be prioritized by borrowers in trouble because they are needed for daily life, especially as payments are increasingly digital. But installment payments can often also be used for everyday purchases, and a review by researchers at the Federal Reserve Bank of Kansas City last year found that BNPL can be a less expensive form of credit. So losing access by missing payments might be painful to some.
According to a study of the hierarchy of payments by
consumers in late 2020 showed higher delinquency rates on their cards over the course of a year than their personal loans—except when they had just one credit card. The subset of people who had just one card, a mortgage and an auto loan sometimes prioritized their card ahead of auto payments, but not their mortgage, the study found. Mortgages overtook auto loans as the least-likely to be past due starting in 2018, according to TransUnion’s study.
Rising home prices make it rare to be deep underwater on mortgages, which often happened around the 2008 financial crisis. Today a home or vehicle that has dramatically risen in value may be fairly easily sold if a borrower runs into trouble. How long vehicle owners and lenders can count on a surge in used-car prices, though, is another point of debate. But as much as life has changed over the past couple of years, people still likely view their cars as necessities.
The bottom line is that coming out of the pandemic, with inflation running at levels not seen in years, “normal” may be anything but.
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