The Cracks In US Households’ Finances

US credit scoring is facing a revamp. Fair Isaac (FICO) recently announced changes to consumer credit scoring that will raise the credit core of highly-rated borrowers and lower that of lower-rated consumers.  While lenders have a choice of ratings methodologies and could take time to adopt the new FICO scoring, Fed surveys show a gradual, but steady, tightening of consumer loans standards is already underway.  With household balance sheets starting to show signs of strain, this trend could have a negative and significant impact on consumption, the main, and already-slowing, engine of US growth.

Healthy consumer balance sheets are often cited as one of the strengths of the US economy.  Average household leverage ratios look good: relative to the crisis peak, debt is down by more than 20 percentage points of GDP and continues to slide lower (chart 1).  The debt service ratio is lower than before the crisis and default rates are back to their pre-crisis levels.  The one–well known– exception to this positive picture, is auto loans, about 9% of total household debt, where delinquencies are nearly back to their crisis peak.

Yet, a detailed look at consumer finances shows cracks starting to appear.  While average mortgage delinquencies are still falling, credit card delinquencies have been rising since 2016 (chart 2).  At small banks, accounting for about 20% of consumer lending, credit card delinquencies are now well above their crisis peak.  In addition, Discover, the US largest independent credit card network,  has seen a 10% decline in its stock price caused by investor concerns over its classification of compromised loans.  The performance of Fintechs, small but fast growing, could also come under pressure.  Fintechs offer mainly unsecured personal loans,  the fastest growing segment of the consumer credit market, that are used largely to repay or consolidate other debts, especially credit card debt.   Lastly, personal bankruptcy filings increased in 2019 for the first time since 2010.  These weaknesses are puzzling in view of the decline in unemployment to a 50-year low.

Table 1: Income, Assets and Liabilities of US Household by Income Quintile, 2018 Q4

Source: Federal Reserve Board, Census Bureau

Table 2: 2018 Report on the Economic Well Being of US Households (SHED)

Source: Federal Reserve Board

Raghuram Rajan, Chicago professor and former Governor of the Reserve Bank of India, who famously predicted the crisis, asserts that widening income inequalities were a major driver of the unsustainable leveraging of low -ncome US households before the crisis.  Since then, income inequalities have increased, with most of the income and wealth gains accruing to higher-income households (table 1).  Indeed Federal Reserve and Census Bureau data on income and debt distribution show that a large share of American households cannot cover their basic expenses out of income (table 2).  For instance, one-third of Americans in the lowest income quintile cannot pay all their bills, even after skipping needed medical care.  This income shortfall could explain low income households high leverage.

Of course, relative to the crisis the scale of bad consumer debt seems much more limited.  In addition, regulatory tightening since the crisis has pushed risk out of the banking sector.  Risks however are more likely to have been displaced than eliminated altogether.  It may well turn out that consumer credit risks are now concentrated in fintechs.  In any event, those are less systemically important than large deposit taking institutions.

The cracks in household balance sheets are still likely to add to downside risks to growth.  The pre-crisis household debt overhang and subsequent deleveraging were major causes of the recession and weak recovery.   This time around, while the debt overhang is smaller, it also seems concentrated within low income households that have a higher propensity to consume.  Against this backdrop, a continued tightening of consumer credit standards could force low income households to increase their savings.  Consumption growth, that is already slowing and is the US economy main growth engine, could slow further and bring GDP growth below potential.