Personal Debt ...
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Precarious Balances: Spending Tempers
Downturn, but Debts May Slow Recovery
By JATHON SAPSFORD and PATRICK BARTA
Staff Reporters of THE WALL STREET JOURNAL
Steven Yamamoto has lots of debt. The 24-year-old apartment-rental agent, whose annual income is roughly $35,000, owes a total of $28,000 on six credit cards. He owes another $6,000 on a debt-consolidation loan he took out years ago. And he continues to rack up more debt by using credit cards to pay for gas, entertainment and vacations.
To ease his financial burden, Mr. Yamamoto, who lives in Los Angeles, recently moved back in with his parents, and he has sought the help of a credit counselor. But none of his money worries have kept him from getting new solicitations in the mail each week from banks and other financial institutions eager to give him yet another credit card.
Ten months into the current recession, consumer-credit defaults and payment delinquencies are as high as they have been since the last recession, a decade ago. This time around, however, lenders, who were quick to reduce the flow of credit during past recessions, have left the tap wide open. That's allowed Americans to continue borrowing to pay for homes, cars and other big-ticket items, bolstering the weakened economy. But the resulting growth in consumer credit -- to a record $7.5 trillion at the end of the third quarter of 2001 -- also has exposed a potential new economic fault line.
Fed's Rationale
Rising consumer debt is typically a sign of robust spending. In the short term, consumer spending stimulates the economy. That's clearly what the Federal Reserve had in mind over the past year as it repeatedly lowered U.S. interest rates. But the unusual growth in consumer borrowing during the current recession also poses a danger: that at some point, consumers will have to divert more and more of their income away from spending on goods and services and toward repaying their debts.
Such a shift would slow the economy, reducing the chances of a speedy recovery. That is, of course, unless consumers defaulted under the weight of all that debt, packing the bankruptcy courts and spreading financial distress among their creditors. Either way, many economists argue, the current mountain of consumer debt is likely to mean trouble.
So far, easy credit has helped soften the downturn, and despite months of dire predictions, there has been little sign of a reckoning. Lenders' charge-off rates for bad credit-card debt, for example, were at 5.35% at the end of the third quarter, up from 4.22% at the end of the last recession. But even if that number abruptly shoots higher, most lenders today are far better capitalized than ever before, and thus better positioned to weather their losses.
Much of the growth in consumer debt, particularly in the mortgage market, reflects consumers' desire to take advantage of the historically low interest rates engineered by the Fed. But many economists worry that by buying now what they would otherwise be buying tomorrow, consumers are dulling one of the few major benefits of a recession. Though painful, recessions usually purge the economy, as lenders reduce the availability of credit to compensate for the higher risk that their loans will go bad.
Piling It On
During the first two quarters of the early 1990s recession, the average American household reacted to those tighter credit conditions by paring its debt by an inflation-adjusted $410, says Mark Zandi, chief economist at Economy.com, a consulting firm based in West Chester, Pa. That helped leave consumers in shape to borrow anew when the economy ultimately turned the corner. By contrast, Mr. Zandi says that during the first two quarters of the current recession, which began in March, the average U.S. household took on $1,420 of new debt.
Thus far, low interest rates have helped keep consumers' debt payments relatively manageable. But when rates rise, as they inevitably will, lots of debt pegged to fluctuating rates -- including many credit cards and mortgages -- will require higher payments, further stretching household budgets.
And if the economy takes a turn for the worse, outsized debt levels and rising layoffs could cause far more personal bankruptcies, adding a new layer to the debt debacle already affecting corporations in sectors from telecommunications to energy. About 350,000 American consumers filed for bankruptcy in the third quarter, and the total number of personal bankruptcies for 2001 appears likely to top the record of 1.4 million set in 1998.
"Consumer balance sheets are coming out of this recession significantly more tattered than in the wake of any other recession we've ever experienced," says Economy.com's Mr. Zandi.
Companies of all stripes are feeding the current debt frenzy. Auto makers such as General Motors Corp. and Ford Motor Co. have bolstered their sales amid the recession by offering zero-interest-rate financing. Retailers such as Sears, Roebuck & Co., Home Depot Inc. and Dell Computer Corp. are offering similarly attractive financing deals.
Despite the surge in layoffs accompanying the current downturn, credit-card companies, led by Capital One Financial Corp. and MBNA Corp., are likely to have mailed out a record five billion new credit-card solicitations in the year just ended, up from 3.5 billion in 2000.
That's equivalent to about 20 solicitations for every man, woman and child in the U.S. No wonder, then, that Capital One, based in Falls Church, Va., is the nation's largest single generator of mail.
From his vantage point, Peter Stouder can see the current economic storm clouds as well as anybody. The 31-year-old salesman for a Denver pipe-fitting distributor says his commissions are down, cutting his 2001 income by about $5,000 to $60,000. Mr. Stouder is the breadwinner for his family of three, which includes his pregnant wife. A few months back, the company he works for made a small round of layoffs.
Yet like many Americans, Mr. Stouder doesn't have any qualms about going deeper into debt, and his lenders are encouraging him to borrow. Mr. Stouder says his mortgage lender, E-Loan Inc., recently gave him a $176,000 mortgage to buy a larger house. His new mortgage payments are nearly three times as high as those on his old house, and he says that, with that heavier mortgage burden, he will have to apply about 56% of his annual income to paying debt. Mr. Stouder also bought a $27,000 "thunder-gray" four-wheel-drive Toyota Tundra last year, again relying mostly on credit.
"I want to enjoy everything and not worry about cutting back," says Mr. Stouder, who regularly gets solicitations for new credit cards.
Irrational Exuberance?
Credit counselors say they are busier than ever, in large part because many people don't fully realize the dangers of the credit that's available to them. They say many consumers know that they are acting irrationally but are convinced that the rules of the game have somehow changed to keep them out of trouble.
"People are under the impression that something is wrong with them if they aren't getting preapproved credit-card applications," says Tara McCarthy, a credit counselor at Auriton Solutions Inc., a nonprofit credit-counseling company based in St. Paul, Minn.
But, "just because somebody will give you credit doesn't mean you can afford it," says Steve Rhode, president of MyVesta.org, a Rockville, Md.-based credit-counseling service.
In the short run, the continued availability of credit -- and consumers' willingness to use it -- is one reason the current recession seems less painful than past downturns. Although retail sales dropped 3.7% in November, consumer spending overall continues to hold up surprisingly well. Many store chains are beginning to report that their Christmas-season sales fell by only 1% to 2% from a year earlier. Auto sales surged to an all-time high in October, thanks to those aggressive financing deals, and 2001 is expected to be the second-best year ever for U.S. home sales.
But those purchases take a heavy toll on the family budget. American households spend nearly 14% of their disposable income servicing debt. Though that proportion fell somewhat in the third quarter, in part because of an influx of cash linked to tax rebates, economists still consider it unhealthily high. "Everyone's telling [people] to spend, spend, spend, but it's going to be difficult for them if they're being hounded by collection agencies," says Economy.com's Mr. Zandi.
Some corporations have already been burned by the recent growth of consumer debt, largely in the riskier, or "subprime," corner of the market, which focuses on consumers with marginal credit histories. In August, Bank of America Corp. said it was taking a $1.25 billion charge to shut down its subprime lending operations, conceding that the risks outweighed the benefits. In October, shares of Providian Financial Corp., the fastest-growing company in the consumer-finance industry, sank 58% in a single day after the company announced losses in its subprime loan portfolio.
Then, in December, Ford announced it would report a large fourth-quarter loss, in part because of a sudden rise in soured auto loans. Such missteps have come despite the Fed's 11 interest-rate cuts last year, which have drastically reduced lenders' costs of raising the money they lend.
Those casualties aside, "the numbers don't show any slowdown in the availability of credit," says Mike Heller, president of Veribank Inc., a bank-rating and research company based in Wakefield, Mass. In fact, many lenders seem to be more openhanded than ever.
Pushing the Limit
Consider the size of the average credit limit on a credit card, which has been growing at a rate of 15% to 19% a year in recent years. Despite the current downturn, the average credit limit during the third quarter of 2001 was up 16% from a year earlier.
That's partly because the Fed's low-interest-rate policy has helped reduce, at least for now, the risks lenders face from deteriorating credit quality, says Christophe Germain, an analyst at Moody's Investors Service. But new technology and other factors have also played a role, transforming the way lenders design, market and manage their credit products.
Over the past decade, lenders have been boosting their capital reserves, and they have learned to manage their risks more effectively by selling some of the loans in their portfolios, in the form of tradable securities. Those sales shift the lenders' risks to pools of outside investors.
At the same time, powerful computers have enabled banks and other financial institutions to automate the process of assessing their credit risks and approving borrowers. In some cases, automation has shortened the waiting period to a matter of minutes for everything from credit cards to car loans to mortgages.
Credit-card issuer Capital One has based its entire business plan on the use of computer models that test how recessions affect consumers' ability to manage credit, pay it back and spend more. The company has the equivalent of 20 pages of printed material for every American, with details about what individual consumers buy and -- most important -- how they pay their bills.
So far, Capital One has managed to sidestep many of the problems that have haunted rivals such as Providian. Its third-quarter charge-off rates, a measure of credit-card loans that go bad, are 3.92%, well below Providian's 10.3% and the current industry average of 5.35%, which compares with a peak of 6.3% during the previous recession. "We have specifically designed this business to prosper in a recession," says Richard Fairbank, Capital One's co-founder and chief executive.
When their clients do get in credit trouble, lenders tend to deal with the problem -- and sometimes prolong it -- by easing their terms. Until he was laid off about two months ago, Joe Bloch, 35, of Byram, N.J., was making $57,000 a year as a computer network administrator. Now, he and his wife, Karen, are falling behind on their $190,000 mortgage and other debts. Their mortgage lender, Wells Fargo & Co., has told Mr. Bloch that he can pay just $308 a month -- less than his usual $1,800 payment -- until February. After that, however, he will have to make a lump-sum payment of $8,460 to catch up. Wells Fargo says Mr. Bloch may qualify for other breaks on his repayment terms but said it couldn't give any guarantees.
Change of Heart
"We're just completely wrecked," says Mr. Bloch, who has filed for unemployment benefits while looking for a new job. "I used to look down on people" that used federal assistance, he adds. "Now I've had a complete change of heart."
1See the Federal Reserve's historical data on consumer credit
* * *
2Wal-Mart, Target Thrive as Season Ends, While Others Are Hurt by Markdowns (Dec. 27, 2001)
3Older Americans' Debt Burden Grows as Memories of the Depression Fade (Dec. 26, 2001)
4Prepayment Clauses Come With Some Nasty Surprises (Dec. 12, 2001)
5At a Price, Low-Income Borrowers Forfeit Cheaper Mortgages to Pay Off Their Debt (Dec. 7, 2001)
6Consumers Have Extra Pocket Change but Are Hard-Pressed to Part With It (Dec. 7, 2001)
7Loan Modification Programs Are Helping Homeowners Soften Blow of a Slowdown (Oct. 30, 2001)
Of course, not all financial institutions have been expanding their credit lines, and not all Americans are mired in debt. Some mortgage lenders have begun requiring riskier home buyers to make bigger down payments. And many people in upper-income brackets have accumulated considerable wealth through investments in stocks or homes and other assets that are still gaining value.
But for most of the rest of the economy, the debt buildup continues. The government is pushing consumers to keep spending -- and thus borrowing -- in the wake of the Sept. 11 terrorist attacks. Officials from the Bush administration visited Detroit immediately after the attacks and pushed car makers to come up with ways to keep consumers spending. GM officials say that visit was one reason behind the auto industry's much-publicized zero-percentage-financing offers.
Nor have housing values fallen as in earlier recessions. During the third quarter of 2001, home prices rose 6.1% from a year earlier, after adjusting for inflation, according to the Office of Federal Housing Enterprise Oversight, leaving many consumers with a ready asset to borrow against. By contrast, home prices fell in real terms during each of the past three recessions.
According to the Consumer Federation of America, a Washington-based advocacy group, the percentage of Americans who said they are "concerned" about their nonmortgage debt payments is just 39%, down from 48% from a year ago. The percentage of Americans worried about holiday credit-card payments is only 27%, down from 35%.
Meanwhile, consumers such as Mr. Yamamoto, the Los Angeles rental agent, continue to spend. Mr. Yamamoto says he has cut back somewhat, but a recent holiday in New Orleans added another $400 to his credit-card debt. He also continues to draw a monthly total of between $40 and $100 in cash advances from credit cards and still has enough credit remaining to make him feel flush.
At 24, Mr. Yamamoto says he hopes to pay all his debts off by the time he turns 30, but he concedes that he's vulnerable to temptation. "The more money you have, the more you want to spend," he says.
Write to Jathon Sapsford at jathon.sapsford@wsj.com8 and Patrick Barta at patrick.barta@wsj.com9
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