I am pleased to appear before this Committee today to discuss trends in consumerlending, the Federal Reserve Board's view of the likely causes of these developments, andtheir likely effect on the U.S. economy, banks, and consumers. As Chairman Leach noted in his letter of invitation, consumer delinquencies onnonmortgage debt have increased in recent periods and bankruptcy filings could well exceedone million in 1996. These developments have begun to affect profit margins at somefinancial institutions and the Federal Reserve has been closely monitoring these conditions anddiscussing their implications with individual banking organizations and industry groups. Inour view, given the generally strong financial condition of the institutions most affected bythese developments and that of the U.S. banking system, these adverse trends do not currentlypresent a material threat either to individual banking organizations or to the overall bankingsystem. We have also been carefully monitoring the effect of higher debt levels on thepotential for sustained noninflationary growth in the U.S. economy. While household debtlevels are at or near record levels, we believe that the balance sheet of the household sectorviewed in the aggregate is sound. Barring unexpected developments in either consumer creditpolicies or the wealth or income position of households, we do not believe that current debtlevels pose a threat to the continuation of the present economic expansion. However,although balance sheets are sound overall, the trends affecting different household groupshave been uneven. As a result, we might expect, and are seeing, increased caution on thepart of lenders regarding further extensions of credit. Lenders are, and should be, onheightened alert for potential signs of increased financial stress among households. In my remarks, I would like to begin with an overview of the economic factors thatare likely to have contributed to the rising levels of consumer debt. I shall then turn to theemerging--and still well contained--consequences that these developments are having onthe banking organizations that are most affected and on the industry, overall. Finally, I shallconsider some of the potential economic ramifications of the current levels of consumer debt.Reasons for Higher Debt Levels Economic developments in the United States have, in recent years, been favorable togrowth in both spending and borrowing by the household sector and to strong growth inconsumer lending by U.S. banks, making both supply and demand factors conducive toconsumer credit expansion. On the demand side, rising levels of employment and incomecoupled with the dramatic increases in stock and bond prices, and thus aggregate householdwealth, have led to both a greater ability and a greater willingness of consumers to spend. During this same time period, rates and fees on consumer financing products havebeen coming down. For example, average credit card rates which stood at about 18 1/4percent in late 1991 declined to less than 15 1/2 percent by May of this year. At the sametime, annual fees on credit cards were dropped by many institutions. In addition, decliningresidential mortgage rates throughout most of this interval contributed to a significantreduction in monthly payments on such debts. The relatively low mortgage rates of the early1990s precipitated a refinancing boom that allowed many consumers to reduce significantlytheir monthly mortgage obligations and to pay down higher cost consumer debt. Combined, these generally favorable developments have given consumers theconfidence and financial foundation to incur additional debt in order to finance majorpurchases. The net effect is that we have increased our spending faster than we haveincreased our income. Since the second quarter of 1991, when the present expansion began,real per capita disposable personal income has risen $1264, while real per capita expenditureshave gone up $1389. Essentially, for every $1.00 our income has gone up, we've spent$1.10. This extra spending has been particularly concentrated among big ticket items, whateconomists call "durables". While real spending per capita has risen about 8.5 percentoverall, real per capita spending on durables has risen more than three times as fast (27.3percent). It is not unusual for consumers to borrow to finance these durable purchases. Highrates of durable purchases and consumer confidence usually occur during business cycleexpansions. So, much of the higher level of consumer debt could be attributed to acquiringadditional assets, a normal development at this stage of the business cycle. The growth in nonmortgage consumer debt has been particularly robust in the past twoto three years. As the economy emerged from recession in 1991, growth in nonmortgageconsumer debt was much slower than typical, reflecting sluggish spending on durable goodsand lingering fears about long-term layoffs and other threats to job security. However, by1994, consumer confidence had recovered considerably and demand for autos and otherdurable goods had strengthened. Nonmortgage consumer debt grew about 15 percent thatyear and the next. Revolving credit--primarily credit card debt--has been, by far, thefastest growing component of consumer debt, averaging annual increases of 20 percent overthe past two years. In part, the rapid rise in credit card debt is part of a long-standing trend. In 1977,when first reported separately to the Federal Reserve, revolving debt of U.S. consumerstotaled $30 billion, or 14 percent of all consumer debt. In July of this year, the amountoutstanding was $454 billion (preliminary), or nearly 40 percent of the total. Some surveysshow that 80 percent of U.S. households now have at least one credit card. In addition,some of the increase in consumer debt is merely a reflection of the greater prevalence ofconvenience use of credit cards as a substitute for cash or check payment. Convenience userstypically pay their card balances in full each month. The increased convenience use of creditcards has been reinforced in recent years by a variety of incentives, such as the availability offrequent flier miles. But the Federal Reserve's Survey of Consumer Finances suggests thatthe convenience share of outstanding credit card debt, defined as credit extended to peoplewho always pay their credit card bills each month, has not risen markedly in recent years,and still accounts only for roughly one dollar in seven of aggregate credit card debt. The particularly rapid growth in the demand for unsecured credit coupled with changesin both legal and social attitudes raises another potential, albeit disturbing, factor affectingdemand: the increased incidence of personal bankruptcy. Late last month, the AmericanBankruptcy Institute reported that personal bankruptcy filings in the second quarter neared the300,000 mark, and had exceeded one million in the previous twelve months for the first timein history. On the basis of available information, it is hard to refute the observation of SamGerdano, the head of the Institute, that "Today's bankruptcy boom is the natural result ofthree years of sustained consumer spending increases that far outpaced income growth in anera of greater social acceptance of bankruptcy." A recent survey of the causes of consumer bankruptcy by VISA indicated that beingover-extended was the most commonly cited reason. Interestingly, it exceeded event-specificreasons such as medical emergencies, unemployment, and divorce. While rising levels of consumer debt may be contributing to the climb in bankruptcies,bankruptcy law may also be contributing to rising debt levels. Several factors are said to becontributing to higher rates of personal bankruptcy, including greater social acceptability ofthe practice, changes in law that have made bankruptcy less onerous for individuals, andincreased advertising by bankruptcy attorneys. To the extent that bankruptcy is perceived byconsumers as an easier option, the demand for credit, and particularly the willingness to takeon high levels of credit, is enhanced. With the consequences of bankruptcy reduced,individuals, other things equal, may be more willing to borrow than would otherwise be thecase. One may not wish to foreclose the possibility of renewed credit access to those whohave been forced by uncontrollable circumstances to seek the protection of bankruptcy, but itshould be recognized that undue generosity on this score only encourages greater use of thebankruptcy remedy and consequent chargeoffs. In sum, a variety of macroeconomic and socioeconomic factors have contributed to therise in the demand for consumer credit. The lower cost of credit is certainly a factor.Higher income and wealth, and the consequent increase in consumer confidence haveincreased the willingness to both spend and borrow. A long-term trend toward greaterwillingness to use household debt, particularly credit card debt, has also played a factor. Thereduced consequences of personal bankruptcy may also have played a role. Accompanying the increase in demand for consumer credit have been developments onthe supply side of the market. As a percent of total bank loans, consumer debt (includingmortgages) has been increasing steadily for some time--from 33 percent of total bank loansin 1980 to roughly 40 percent five years ago and about 44 percent today. Credit card debthas been a particularly fast growing segment of bank portfolios. Since late in 1991, creditcard debt has risen about twice as fast as total loans. If one adds back estimates of theoutstanding securitized credit card debt of banks, such credit has risen almost three times asfast as total loans at banks. The industry's total increase in credit card loans has been supported by the aggressivemarketing of some banks. Marketing campaigns typically involve broad-based, regional ornationwide solicitations and often include pre-approved lines of credit based on the results of"credit scoring" models that statistically evaluate an individual's creditworthiness. Creditscoring and computer-based statistical evaluation have sharply lowered the cost of making adecision to extend credit. This has greatly facilitated the mass marketing of credit toindividuals who are not bank customers and who live outside banks' traditional service areas. In addition, banks' success in securitizing consumer debt instruments for resale incapital markets has increased both their willingness and their ability to make such loans.Securitization and credit scoring have necessitated heavy investments in the technologicalinfrastructure needed to evaluate, originate, and effectively manage such credits. In turn, this has changed the cost structure of the industry to favor an expansion ofvolume in order to exploit scale economies. Major competitors have increasingly used specialpromotions offering reduced fees and rates to obtain market share and maximize the scaleeconomies of their operations.Some have also been willing to take on greater risk in the interest of increasing loan volumes.Such competitive zeal all too often attracts weak or otherwise marginal borrowers. Theresultant adverse selection of credit risks has contributed to a decline in asset quality at somebanks. While these problems have eroded returns at individual institutions, a critical factorthat continues to contribute to the emphasis on such lending has been the significant, overalllong-term profitability of the credit card business. This is not irrelevant for a banking systemwhose largest institutions had been under earnings pressure through much of the 1980s due totheir exposures to developing countries, energy sector borrowers, and commercial real estatemarkets. Thus, both supply and demand factors help explain the increase in the levels ofconsumer debt that we have recently experienced.Effect on the Banking Sector One indication of the profitability of credit card lending can be seen in analyzing theso-called credit card banks (defined to include banks with more than $1 billion in assets andwith credit card balances comprising more than 50 percent of total assets). For various legal,tax, and operating reasons, most large banking organizations find it convenient to establishsuch banks, separate from their other operations, as a vehicle for booking most, if not all, oftheir credit card loans. These roughly thirty entities most recently reported an averageannualized return on assets for the second quarter of 2 percent, compared with a 1.3 percentquarterly return for all insured commercial banks. While credit card banks remained moreprofitable than other banks, their profitability has declined a good bit in recent years owing toheightened competition and the erosion of credit quality. Credit card banks also maintainaverage equity to asset and loan loss reserves to total loan ratios well above industryaverages. The strong earnings profiles of the credit card banks, and their associated capital andreserve allocations, are reflections of the risks associated with this form of lending. Higherrisk and higher return go hand-in-hand, and the higher capital and reserves associated withthis form of credit are required to balance the risk. Put another way, lenders active in thecredit card business are conscious of higher potential loss rates and expect returns that willfully absorb these losses and still provide an adequate profit margin. They also are aware ofthe necessity to take steps to ensure that the variance in returns on these loans does not createsignificant solvency concerns for their organizations. Generally speaking, delinquency rates on nonmortgage consumer loans have beentrending up for the past year, with some of the increase in delinquency rates merely the resultof the "seasoning" of recently underwritten loans, a typical pattern. However, for creditcards, the widely followed statistics of the American Bankers Association show that thenumber of delinquent accounts is historically high. The more comprehensive figures from theofficial bank call reports based on the dollar volumes of loan balances, however, show amuch milder upturn in delinquencies--but still one warranting our attention. Recently, our supervisory activities, surveys of examiners, and discussions withbankers all have supported the view that banks are recognizing weaknesses in the consumerlending market and are actively adjusting their underwriting and monitoring procedures forthese loans. Some banks have also increased their levels of reserves for these loans in recentmonths. Since March 1995, the Federal Reserve has also been conducting a quarterly survey ofits most senior examiners to track their assessments of conditions in the banking market,including their assessments of any changes in lending terms and conditions for consumerloans. To supplement these surveys, regular discussions are conducted with bankers andsupervisory officials at the Reserve Banks to ascertain their opinions on current lendingconditions. In the most recent Federal Reserve Senior Loan Officer Survey, nearly half ofthe respondent banks, on net, had tightened underwriting standards for approving new creditcard applications, up from about a quarter in the two previous surveys. More broadly, theproportion of respondents less willing to make consumer installment loans slightly exceededthe proportion that was more willing to lend, for the first time since 1991. Such a revisitingof current credit standards and practices seems well considered, given the length of thecurrent period of economic expansion and the signs of weakness in some elements ofconsumer finances such as rising delinquency and bankruptcy rates.Potential Economic Ramifications Reduced Willingness To Lend The survey results on banks' willingness to lend tofinance consumer purchases raises a natural macroeconomic question. Could a pullback inbank willingness to lend create potential difficulties for the sustainability of the economicexpansion? Figure 1 provides some historical detail on this issue. The shaded areas in thefigure represent business cycle recessions. As the figure indicates, there seems to be adegree of coincidence between pullbacks in banks' willingness to lend and economicdownturns. Nonetheless, it would be premature to expect that any current pullback in thewillingness to lend to consumers would necessarily precipitate a recession. First, although the chart does indicate an apparent relationship, it is not at all clearthat a cause-and-effect relationship exists, or in which direction any economic causality mightrun. On theoretical grounds, one could argue either that a pullback in credit leads to lowerspending and thus to a recession, or that recessions produce a deterioration in credit qualitywhich causes banks to be less willing to make further extensions of credit. Second, as the data on delinquencies and bankruptcies makes clear, a good case can bemade that reductions in credit are appropriate responses to past excess credit extensions. Inthis regard, they increase the long term health and viability of the economic expansion byending potential economic excesses before they adversely affect the banking and creditdelivery system. Third, the development of computerized credit scoring models offers the potential formore discerning and carefully targeted reductions in the willingness to extend credit oradjustments in the terms on accounts. In this regard, a reduced willingness to lend may bemore narrowly focussed than in the past. The adverse impact of a reduction in creditavailability might therefore be less in the present expansion than it has in the past. Still, the potential for a systematic and widespread pullback in credit access issomething that needs careful monitoring. Our first concern is that banks engage in safe andsound lending practices. As I mentioned earlier, we believe that they are. Thus, anyregulatory or legislative mandate to reduce bank credit extensions to consumers isunnecessary. We also do not believe that the reduced willingness to extend credit at thecurrent time is sufficiently widespread to create any significant macroeconomic risk to theexpansion. Excessive Debt Service Burdens A second potential economic concern involves highdebt service burdens (i.e. the amount a household must pay each month to cover their debtobligations). At some point, one would imagine that the cost of servicing rising levels of debtwould absorb such a large chunk of consumers' disposable income that they would have nochoice but to reduce current consumption. However, neither economic theory nor empiricalevidence provides any good indication of the level at which debt service constraints begin toreduce spending. Figure 2 shows the level of estimated debt service as a percent of disposable personalincome over the past thirty years. While high, the current level of debt service payments isnot out of the range of past experience. As conventionally measured, the level is now 16.9percent, up from a cyclical low of 15.3 percent at the end of 1993, but below its peak of 17.6percent at the end of 1989. A number of developments have taken place recently which have affected thismeasure. First, the level of mortgage debt service has fallen by a full percentage point ofdisposable personal income, from 6.8 percent at the end of 1989 to 5.8 percent currently.This has been partially offset by a higher level of consumer installment debt. Second, the use of auto leasing has expanded rapidly in recent years, in part acting asa substitute for taking out an installment loan to purchase an automobile. If one adjusts themeasure of debt service burden for leasing, our staff estimates that we would now be aboutmatching the previous peak in the debt service burden. Since the previous peak at the end of1989, the effect of auto leasing has more than doubled, raising debt service payments bymore than one percent of income currently versus just 0.5 percent of income in late 1989.The Level and Distribution of Household Debt The balance sheet of the American householdsector, taken as a whole, has improved substantially in recent years. The dramatic increasein the stock market, for example, has increased the financial assets of households by $4.75trillion since the end of the recession in 1991. Overall, household assets have increased by$9.5 trillion, while household liabilities have risen $1.5 trillion. This rise in aggregatehousehold wealth has doubtless supported the level of consumption spending of recent yearsand allowed households to increase their consumption faster than their incomes have risen. From an economic point of view, there is nothing wrong with consumers increasingtheir debt, per se. Increasing debt to finance long term investments such as housing,durables, or even education, may be prudent depending on one's individual circumstances.Furthermore, taking on debt may be a prudent means of maintaining consumption levelsduring a period when income is below one's expectations of its long term trend. As I shallargue later, this may be one reason for higher levels of consumer debt at present. Suffice it to say that there are good reasons for any individual American family totake on additional debt and it would be wrong for a Federal Reserve Governor to opine thatsome particular American family is too much in debt. Individuals know their owncircumstances far better than any government official. But a look at disaggregated dataprovides insights into economic trends regarding the willingness of American families to addto their levels of debt. Figure 3 combines information from the Federal Reserve's Survey of ConsumerFinances (SCF) on the distribution of household debt with our estimates from the Flow ofFunds accounts on the debt-to-income ratio of the American household sector1. We estimatethat, on average, the household sector increased its debt-to-income ratio about 5 percentagepoints between 1992 and 1995. This was the result of a 2 percentage point increase inmortgage debt, from 59.8 percent of income to 61.9 percent of income and a 3 percentagepoint increase in nonmortgage consumer debt, from 16.9 percent of income to 19.8 percentof income. Nevertheless, the survey data suggest some interesting trends in the distribution of thisdebt. Typically, households earning more than $100,000 per year sharply reduced their debtlevels between 1992 and 1995. The share of total household debt held by these householdsfell from one-third to one-quarter and this decline was particularly concentrated amonghouseholds earning more than $250,000 per year. These upper income groups experienced adecline in both the mean and median absolute level of debt outstanding, while all otherincome groups increased their debt. The decline in the debt levels for these groups makes the rise in debt levels for othergroups more striking. For example, households with incomes between $50,000 and $100,000increased their rates of aggregate mortgage debt to aggregate income by about one-sixth andtheir corresponding consumer debt to income ratio by roughly 50 percent. Of course, some households increased their debt substantially more than this, some notat all. The Survey of Consumer Finances does indicate a striking increase in the willingnessto go into debt in the $50,000 to $100,000 income group. The proportion of surveyhouseholds in this income group reporting credit card debt rose 13 percentage points, from 51percent in 1992 to 64 percent in 1995, compared to a 4 point increase, from 44 percent to 48percent for the whole population. Those holding installment debt such as auto loans increasedfrom 52 percent to 59 percent in this income group while the proportion in the overallpopulation with this type of debt was unchanged. Nearly 60 percent of the total increase innon-mortgage debt outstanding was assumed by households in this income group. Debt increases for households earning under $50,000 were also sizable. Theincreasing attractiveness of various types of financing tied to one's home produced aparticularly large increase in the ratio of mortgage debt to income. It should be noted thatalthough the mortgage debt to income ratio increased just 7 percentage points for householdsearning under $25,000, compared to10 to 11 percentage points for households earning $25,000 to $100,000, homeownership ratesare much lower among this segment of the population. Adjusted for the lower level ofhomeownership rates among this income group, mortgage debt to income ratios increasedmore for these lower income groups than for the $50,000 to $100,000 income group. I mightadd that the rapid expansion of mortgage financing among low and moderate income groupsis borne out by other data as well. We will not know for some time what the overall effectof this lending will be on default and delinquency rates. But these data also show that, while some of the added credit extension during thisperiod is to people in income groups that traditionally haven't owed much debt, the bulk isnot. While overall debt levels increased for all groups earning under $100,000, the onlygroup to increase its relative share of such nonmortgage debt was the $50,000 to $100,000income group. Thus, it is reasonable to conclude that the main reason for the household debtexpansion of recent years is not so much an extension of debt to new households, but anincrease in the debt levels taken on by fairly well-to-do segments of the population to whombeing in debt (albeit not at these levels) is not an unusual experience. From a macroeconomic perspective, we must therefore consider why these middle- andupper-middle-income households have increased their debt levels. Unfortunately, this is thetype of question that will only be definitively answered in hindsight. I mentioned one likelyexplanation earlier. It is not at all unusual for these households to expand their levels ofdurable purchases and debt to finance these purchases. Consumer confidence is high, and upfrom levels earlier this decade, thus increasing demand. Thus, one possibility is that what wehave experienced is a cyclical phenomenon linked to acquisition of consumer durables byrelatively affluent households. A related possibility is that households may be using their access to both mortgage andconsumer credit to finance purchases of financial assets. The expectation of high returns inthe stock market may have induced some households to borrow to finance these investments.Tax rules regarding both home mortgages and pension plans such as 401(k)s, may have madesuch purchases of financial assets with debt in which the interest is tax deductible particularlyattractive. Whatever the economic performance of such a financial arrangement, consumersare reducing the liquidity of their balance sheets by such actions. I might also add, however,that our most recent Survey of Consumer Finances found little evidence to support thisexplanation. Yet another possibility, consistent with both the data and economic theory, is thatconsumers' long-term confidence is high, but recent experience with earnings has beendisappointing. Consumers might be choosing to cover what they perceive as a temporaryreduction in their wages from their long-term trend through debt. During the three-yearperiod discussed previously, the increase in wage and salary payments has constituted asmaller share of increased GDP than is usual during expansions. During these three years,increased wage and salary payments constituted only 44 percent of increased GDP, versus47.2 percent during the 1981-1990 period. Stated differently, if wages and salariesconstituted the same share of GDP in 1995 as they did in 1990, workers would have enjoyedabout $52 billion more in income that year. Given that overall employment conditions are quite good, workers might reasonablyexpect this shortfall to be temporary. An economically rational response to this situationwould be to borrow temporarily to maintain consumption levels with the expectation that theadded debt would be repaid when wages rise to more normal levels. This theory comportswith anecdotal concerns about corporate downsizings, which also lend anecdotal support tothe sharp debt rise in the $50,000 to $100,000 income group. An open question remains asto whether this wage shortfall is indeed temporary. The comparatively poor performance oflabor productivity in recent years is not an encouraging sign. On the other hand, asChairman Greenspan has noted before this committee, there are reasons to expect that wemay not be measuring the impact of new technologies on our economy appropriately. Thus, we cannot tell for certain what the dominant reasons for the debt increase mightbe. We cannot tell how the habit of households increasing spending faster than income willbreak: will productivity increase to allow wages to constitute more normal portions of GDP,or will consumers ultimately be forced to reduce their spending? Nor can we tell when thiscurrent pattern will end. Consumers can probably continue to maintain current spendingpatterns by increasing their debt levels further for the foreseeable future. The prudence ofcontinuing to do so depends crucially on the household's individual situation. But at present the Board does not believe that current debt service levels are anecessary impediment to continued economic expansion. We also see no reason to believethat this expansion of consumer debt on the balance sheets of the nation's banks is any causeto worry about their underlying safety and soundness. Thus, the Federal Reserve believesthat the best policy is to continue to monitor and study developments in this area but that noimmediate regulatory or legislative action is warranted.Footnotes 1 The data are from 1992 to 1995 because these are the years in which SCF surveyswere conducted.Return to top1996 TestimonyHome News and events Accessibility Contact UsLast update: September 12, 1996, 10:10 AM
Though the Earning Power of Most (Step Twleve continued)
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