Story:
FOOL ON THE HILL
The Threat of Bad Consumer Debt
As the stock markets spiraled, individuals as well as corporations took on large amounts of debt, sure that
the good times would continue. Well, the bon temps did not continue to roulez, and now the bill is due.
Whether you are drowning in debt or pay your cards in full, the high level of consumer debt can affect you. It
was, for example, one of the major reasons that the Fed kept raising interest rates in 2000.
By Bill Mann (TMF Otter)
January 19, 2001
According to the Nilson Report, the amount of credit and debit purchases made in the
U.S. from January to June 2000 increased 20.5% over the same period the previous year.
The total amount charged was $1.054 trillion, $600 billion of which was charged on Visa
alone.
Credit Card Purchase Volume Jan.-June 2000
($ in billions) Amount Change from 1999
Visa $601.9 +22.4%
MasterCard $273.5 +16.7%
American Express $141.5 +19.8%
Diners Club $20.8 +7.0%
JCB $16.7 +5.9%
Total $1,054.5 +20.5%
(Source: Nilson Report)
This is just for general purpose cards, and does not include those branded Sears (NYSE: S), Gap (NYSE: GPS), or
Exxon (NYSE: XOM) cards. To compare, the gross national product in 2000 was a shade over $11 trillion, so upward
of 20% of that, at some point, was paid for by credit or debit card.
There is an enormous number of corporate cards out there, to be sure. The above figures should not be attributed
solely to consumers, so let's not make too much of an issue of them. Rather, we should look at the growth rates,
because we can use them as a proxy for consumer debt. And that amount rose in excess of 20%. Even if we make a
giant mockery of statistics and back out the growth rate of the U.S. economy, you still have an increase of 15%
ABOVE the rate of economic expansion. That, my friends, is exactly why the Federal Reserve was raising rates at the
beginning of this year. The availability of and cost of debt was low enough that consumers spent, spent, spent.
Another factor was the "wealth effect," the euphoria that came along with a skyrocketing stock market, job security,
and wage increases, allowed people to feel as if the debt they were assuming was manageable. Ah, the bloom is off
that rose now: We as a country feel much less wealthy than we did even six months ago. Unfortunately the wealth
effect is a trailing indicator; it is reactive to economic realities, not predictive. And the debt that we gladly racked up
when we were feeling great is yet another brick on our shoulders now.
You'd think that rising debt levels would be excellent for banks and financial service companies. American Express
(NYSE: AXP), for example, had revenue growth of 13% in 2000, and even higher net income growth. Loosening credit
is great when the economy is robust. But when times get tougher, lenders become nervous about their debtors' ability
to service the money owed. It's akin to a big hangover: The firms and their customers just partied the night away,
oblivious to the fact that at some point in the future, the credit environment would change.
Where the credit problems of companies are well documented, the rising credit issues of individuals have been largely
untouched by the press. But banks are now increasing their reserves for bad debt. Bank One (NYSE: ONE), for
example, is increasing its bad debt provisions by more than 200%, from $416 million to more than $1.51 billion. This
does not mean that the company is writing off these debts, but banks and lending organizations are required by law to
hold a reasonable amount of cash aside in the event that their debtors begin to default. If the environment improves,
Bank One could remove some of the unused provisioned funds, but for the time being they are treated as expenses,
depressing the reported earnings of the company.
By moving so much over, Bank One is essentially hedging against a rising level of defaults on credit card, mortgage,
car loan, and other obligations of its customers. Bank One's bad consumer loans were 61% higher last quarter than
they were the previous year. Additionally, Bank One took a pre-tax write-down of $575 million for currently impaired
assets, including vacant real estate and abandoned car leases. Bank of America (NYSE: BAC) has also recently
increased its loan loss provision, adding nearly $500 million.
All of this points to a worsening picture for consumers who have taken on a large amount of debt. And that is a lot of
us. According to the Federal Reserve, there is $4000 of consumer debt for each man, woman, and child in the United
States, or about $9000 per household. There are both personal and societal costs for this much debt, as our individual
propensity to take on additional obligations add up to a society that is drowning under the weight of things that we
get today but pay for in the future.
If at all. As I reported in Wednesday's Fool on the Hill, in 1999 more people declared bankruptcy than graduated from
college. 1999, if you recall, was the year that the Nasdaq rose more than 80%. And yet record numbers of people had
spent so much money that they were unable to pay! Of course, behind every number there is a human face, so
certainly there are some legitimate cases -- medical problems, divorces, sudden unemployment, and the like that
would cause normally responsible people to default. But there are plenty among that number who simply lacked the
self-control to stop spending.
All of this credit, if it deteriorates, actually hurts banks. Though they make a mint on credit card interest, the large
reserves come directly from cash flow. The only ways they can improve their cash flow in the short term are to a)
improve the quality of their credit portfolios -- tough to do in a declining market -- or b) increase the amount of credit
they have outstanding -- also tough, because the problem is that there is too much credit exposure out there in the
first place. So in a declining market, banks with credit exposure actually have to tighten their standards and wait for
the bad loans to flush through the system. Those of you who have credit card balances have probably noticed a
dramatic increase in solicitations for cards, especially if you've got high credit scores. You, as you may have guessed,
are the banks' contingency plan.
Don't bail them out for their poor lending habits by taking on more debt.
Finally, the editorial and community content at the Fool by necessity dwells on investing and stock picking a great
deal. But if you have consumer debt, some words of wisdom: DO NOT INVEST. There is no investment program in
existence that will guarantee you returns of 13% each year. But holding credit balances will certainly COST you that
much, on average. You can worry about building up a nest egg later. If you rush to invest before you have taken care
of your debts, you will essentially be bailing out a boat with a leak. It's a futile undertaking. It is not Foolish.
Have a great Inaugural weekend, everyone.
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