How The Next Bust Is Brewing

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by: Douglass Gaking

Summary

Consumer credit scores have reached a record high.

The mistakes that caused the 2008 financial crisis are falling off credit reports.

Credit card debt remains on the rise.

FICO is lowering the standards for achieving a high credit score.

The average American household is a higher credit risk than it appears to be.

The Wall Street Journal reports that the average American consumer's credit rating is at a record high since Fair Isaac, the creator of the FICO score, started tracking it in 2005. The average American now has a very respectable credit score of 700. A sudden improvement in responsible lending does not appear to be the primary cause of Americans' improving FICO scores, and that should make investors very concerned about the direction of the economy in the next few years.

A chart released by Fair Isaac shows that the number of Americans with credit scores below 600 has dropped from 25.5% in 2010 to 20% in 2017.

The percentage of Americans with the riskiest credit scores has dropped from 25.5% in 2010 to 20% in 2017.

That sounds like good news, but further examination of the underlying causes of this improvement shows that it could indicate approaching trouble for the economy.

How Foreclosures and Bankruptcies Affect Credit Scores

The chart below from Black Knight Financial Services shows that American foreclosure starts reached a peak of over 600,000 starts per quarter in 2009. Foreclosure starts were at their highest over a 3-year period from 2008-2010.

Millions of Americans foreclosed on their homes from 2007 to 2012.

The number of foreclosures happening around this period is alarming, with millions of Americans losing their homes between 2007 and 2012.

When a foreclosure happens, it stays on the borrower's credit for up to 7 years. The number of Americans with risky credit dropped rapidly from 2014 to 2016, about 7 years after foreclosures were on the rise.

Chapter 13 bankruptcy filings stay on a consumer's credit for upwards of 7 years. These filings peaked in 2009-2010, about 7 years before credit scores soared to record highs, as shown in this chart from the Federal Reserve Bank of St. Louis.

Bankruptcy filings peaked in 2009-2010.

These correlations seem to indicate that American credit scores are so good right now because the bankruptcies and foreclosures from the housing crisis and Great Recession are falling off borrower's credit scores.

Chapter 7 bankruptcies stay on credit reports for 7-10 years, so the falling off of those bankruptcies from credit histories could be expected to peak around 2017-2020. The improvement of credit scores since the crisis may have more room to go.

The people who made the biggest mistakes leading up to the financial crisis are starting to look like good candidates for credit again. How many of the borrowers and lenders who created the financial crisis learned from their mistakes? How soon will it be before those who didn't learn from them repeat them?

"Credit-card lending, already on the rise, could increase further as a result of fresh starts," reported the Wall Street Journal. "Consumers who have one type of bankruptcy filing removed from their credit report experience a roughly $1,500 increase in spending limits and rack up $800 more in credit-card debt within three years, according to the Federal Reserve Bank of New York."

Most American consumers who file for bankruptcy begin repeating their mistakes as soon as they are able to. We have now reached the point where the credit rating system enables them to overextend themselves again, and history shows that they will do so within 3 years.

How Badly Americans Manage Their Credit

Mortgages were not the only problem affecting Americans' finances during the financial crisis. Credit card debt was also at record highs, contributing to the high number of bankruptcies. As you can see from the chart below, American households are approaching those record highs yet again.

Average credit card debt per household peaked in 2007 and is reaching those heights again.

According to WalletHub, the average credit card debt per household was $8,463 in Q4 of 2007. It dropped during the Great Recession, and has returned to $8,377 in Q4 of 2016.

Interestingly, Lucia Dunn, economics professor at The Ohio State University told Business Insider that "credit card (debt) shrank in some sectors [during the Great Recession] because people had their accounts closed. But for our sample who maintained a credit card, credit card debt actually rose. People substituted credit for income."

The growth of credit card debt could in part be attributed to the power of compounding interest and the ineffectiveness at minimum payments to counter it. However, much has been done to educate the public about the risks of credit card debt and ways to manage it better. The consistent growth of credit card debt since the 1980s, despite increased consumer awareness, shows that Americans are not managing their credit well.

How FICO Scores Are Changing

In 2014, just as the number of risky credit scores began its most rapid decline, Fair Isaac announced that FICO scores would no longer include records of a consumer failing to pay a bill if the consumer paid the bill or settled it with a collection agency.

Fair Isaac announced in March of this year that many tax liens and civil judgments would soon be removed from credit reports as well.

John Ulzheimer, a credit specialist and former manager at Experian told Morningstar that "It's going to make someone who has poor credit look better than they should. Just because the lien or judgment information has been removed and someone's score has improved doesn't mean they'll magically become a better credit risk."

FICO estimated that the judgment and lien adjustment would only improve scores by less than 20 points. However, lenders have to factor that in with the 2014 adjustment as well. Lenders should also consider checking public records for judgments and liens, since they may not be reflected in borrowers' FICO scores.

Investors should consider how well the financial institutions that they invest in are handling these changes. It is not a good time to be invested in banks and lenders that do not have a history of good management, responsibility, and trustworthiness. This consideration should not be limited to banks and direct consumer lenders. Real estate investment trusts, homebuilders, auto manufacturers and dealers, residential mortgage-backed securities, and the CEFs and ETFs that invest in them could all be directly affected by a massive overextension of consumer debt. Other sectors of the economy will certainly be affected as well, but less directly.

Conclusion

The most recent Census ACS data puts the average American household income at $55,775 for 2015. The average household credit card debt around that time was about $7,000-8,000. So the average American household has 1/7th of their income in credit card debt--not to mention student loans, auto loans, mortgage loans, and other personal loans--yet the average American's credit rating is 700. They are considered relatively low risk for opening new lines of credit. This is a recipe for disaster.

One has to wonder if the 700-point FICO score of 2017 is this business cycle's version of the AAA credit rating for residential mortgage-backed securities of 2007. If a significant number of lenders treat a 700-point FICO score in 2017 like they treated the same score 3 years ago, then another financial crisis is inevitable.

Investors should not see it as a good thing that consumer credit ratings are at an all-time high. They should be preparing for what may happen to their securities when the market finally realizes the disastrous state of the American consumer's unhealthy relationship with debt.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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