A Closer Look At Consumer Debt

by: Kristina Hooper

Last week was chock full of economic events. The release of the Federal Open Market Committee meeting minutes garnered significant attention particularly after Janet Yellen's surprisingly dovish speech the week before. Her remarks were later vindicated by the Atlanta Fed GDP Now Indicator with 2016 first quarter growth being downwardly revised to just 0.1%.

Also sharing in the limelight was the ISM non-manufacturing index, which positively surprised. And with last week's events as a backdrop, now the focus turns to earnings season, which unofficially begins tomorrow and promises to be far less than stellar.

Credit where credit is due

Amid all the excitement, investors may have overlooked the release last Thursday afternoon of consumer credit for the month of February, but it is most certainly worth noting. It was reported that consumer credit rose $17.2 billion for the month, while the results for January were revised higher. Drilling down, non-revolving credit, which is made up mainly of student and auto loans, rose $14.2 billion and greatly outpaced revolving credit, which is largely comprised of credit card debt and rose just $2.9 billion. This is a trend we've seen for several years - according to the St. Louis Fed in its Quarterly Consumer Debt report, student and auto loans have accounted for approximately 90% of debt growth in the US since the fourth quarter of 2012.

Debt, of course, is best acquired when interest rates are low, as now, or when consumers wish to sustain their current level of lifestyle, which can lead to more distressed borrowing. Debt enables consumption, and therefore consumption can be "brought forward" by lowering interest rates, which has been a key intention of the Fed's monetary policy in the aftermath of the financial crisis

Changing composition of consumer debt

The current trends in consumption and consumer debt, however, have been a double-edged sword. On the one hand, low growth in credit card debt suggests limited consumer spending, which is what we've seen. While on the other hand, it also means that because a larger percentage of American consumers' debt has become non-revolving, a larger percentage of American consumers' debt has become fixed rate rather than floating rate - and it typically carries a far lower interest rate. In other words, the changing composition of consumer debt could be considered somewhat negative for the shorter term but arguably healthier for the longer term.

Additionally, it also means that the US Government has become a large lender to its own citizens via student loans, to the tune of over $1 trillion. And auto manufacturers have become aggressive lenders to their own customers as they can finance loans at better rates than banks and thereby continue to support impressive sales levels.

But is a larger composition of auto loan debt and student loan debt really healthier for the longer term? While auto and student loans typically carry a far lower interest rate than credit card debt and are predictable because they're typically a fixed rate for the life of the loan, there are some significant drawbacks. Notably, student loans are one of only a few types of debt that cannot be discharged in bankruptcy.

Student loan debt is causing a slowdown in household formation because servicing that debt has become a sizable burden, thereby affecting home buying and population growth. Also, auto loan debt secures a depreciating asset - unlike student loan debt and mortgage debt, which typically secure appreciating assets - and that carries with it risks.

Sub-prime less than sublime

There has been some attention recently focused on the potential risks in the sub-prime auto loan market - and with good reason. Last month Reuters reported that auto loan payment terms are increasing, with the average length of a loan on new vehicles extending to 67 months for new cars and 63 months for used cars. There has been a significant increase in the length of car loans in the past year, with 29% of new vehicle financing now longer than 73 months.

What this means is that in many cases a car's value will depreciate well below the value of the loan before the loan is paid off - creating a negative equity scenario. This situation provides a real incentive to default on that debt when times get more difficult - especially if the consumer already has a poor credit score; they arguably have nothing to lose. Keep in mind that there is no immediate risk-auto loan delinquency rates have improved since the recession, remaining fairly steady at slightly over 3% for the past two years, but this remains elevated compared to levels seen before the recession and bears close monitoring.

Student loan delinquencies

However, what's more concerning is the growth in delinquency rates for student loan debt. Delinquencies spiked in 2012-2013 but have since stabilized at about 11%, but that again is far higher than levels seen before the recession. While student loan borrowers can't dispense with such debt in bankruptcy, it doesn't mean they can't stop paying off that debt-and some clearly are doing just that. Those who are servicing that debt are foregoing other spending as a result.

Some economists worry that sub-prime auto loans will be the epicenter of the next great economic crisis in the US, while others worry that the burdens of student loan debt will prevent a generation from spending as past generations have done. While we do not believe either form of debt poses immediate risks to the US economy, particularly in an environment of financial repression, we recognize the downside risk potential over the longer term and will continue to follow it closely.