Sky-High Credit Delinquencies Amid an Exceptional Recovery

Summary

• Sky-high delinquency and charge off rates on banks’ credit card lending seem inconsistent with the exceptional recovery.
• Yet they reflect:
  • Weak bank business models.
  • Households’ inability to wean themselves off exceptional government transfers.
  • The moral hazard created by the Federal Reserve (Fed) that weakens the transmission of policy tightening.
• The Fed faces pressure to cut rates because higher rates have disproportionately hit lower-income households.

Market Implications

• I still expect a first cut in June.

Weak Bank Business Models

In this note, I discuss the apparent inconsistency between sky-high credit card delinquency rates and one of the strongest recoveries on record. I show it reflects a combination of weak bank business models, a ratchet effect due to very high pandemic transfers, and moral hazard created by the Fed.

The Fed’s recently published Q4 banks’ credit cards (CC) charge off and delinquency rates shows these are higher than before the pandemic and, at small banks (i.e., banks other than the largest 100), higher than during the GFC (Chart 1).

Putting this data in perspective, a spike in small banks’ CC charge offs also happened during the GFC and the 2001 recession. In addition, banks’ overall loan book quality remains strong: banks’ average charge offs and delinquency rates are back to pre-pandemic levels and remain well below GFC levels (Chart 2). Sky-high CC delinquencies are not signaling a systemic credit crisis.

Rather, the high delinquency partly reflects weak banks’ credit standards. The Fed SLOOS shows that on net, the share of banks tightening standards on CC loans has been falling since Q3 2023, though more banks are still tightening than easing standards.

Also, the growth in CC lending has been sustained at both the 25 largest banks and at other banks. Unfortunately, the breakdown of commercial banks’ balance sheet data between large and small banks does not overlap with that of charge offs and delinquency rates (Chart 3). In addition, the 25 largest banks have been increasingly dependent on CCs to grow their loan books, as shown by an increasing share of CC loans.

The bottom line is that banks have been unable to grow their CC lending without worsening its quality. This suggests weaknesses in banks’ business models and underlying fragility, especially at small banks.

Yet, borrowers have also played their part.

Pandemic Transfers Dependency

The New York Fed’s analysis of high CC delinquencies shows that they are broad-based across income groups but disproportionately driven by millennials, low income households, those with auto and student loans, and those with higher credit card balances. In other words, delinquencies are higher when borrowers have higher consumer debts.

I think this reflects households struggling to adjust to normal income after the end of generous pandemic-related transfers. The decline in the savings rate to currently 3.8% of disposable income, well below the pre-pandemic 7-8%, shows this.

The savings rate decline to near post-WWII lows could reflect a ratchet effect from pandemic transfers (Chart 4). During the pandemic, exceptional government transfers boosted household income, allowing households to reach exceptional levels of consumption.

Despite the end of pandemic programs and the normalization of income, consumption has remained higher than pre-pandemic by about 2ppt of income. Also, households have offset higher interest payments with lower savings rather than lower consumption.

Consequently, the weaker households have become over-extended and are struggling to remain current on CC debt.

In addition, of all forms of consumer borrowing, delinquencies are highest on CCs (Chart 5). This could reflect, for instance, that delinquent student borrowers are automatically moved to forbearance programs and that households prioritize mortgage and car loan repayments to avoid repossession.

That said, the average household remains on a strong footing, suggesting limited demand impact from the spike in delinquencies and a few quandaries for the Fed.

Fed Quandaries

On average, household leverage is roughly unchanged from pre-pandemic (Chart 6). Also, household foreclosures, bankruptcies, and delinquent balances remain lower than pre-pandemic (Chart 7).

Therefore, on average the risk that households could be forced to raise their savings rate to repair their balance sheets appears low. Such a rise would be negative for growth since it would reduce the share of the wage bill recycled in the economy as demand for business goods and services.

Sky-high delinquencies amid an exceptionally strong recovery creates a triple jeopardy for the Fed. First it looks like tight monetary policy has raised delinquencies without slowing consumption much. There is risk the Fed may be much more aggressive to slow consumption, which in turn could create financial instability.

This is not an issue now as disinflation is proceeding with strong growth, but this regime may end. If the Fed eventually needs to slow demand growth to reduce inflation, it could face a tricky tradeoff between economic and financial stability.

Second, banks’ loose credit standards could reflect the moral hazard the Fed created through multiple pandemic facilities and due to the implicit guarantee of deposits and liquidity provision provided since the banking crisis of March 2023. In effect, Fed support to the banking system could be weakening monetary policy transmission.

Third, while Fed Chair Jerome Powell says at each policy meeting that those inflation hits hardest can least afford it, the same could be said about the Fed’s high interest rates. Rising delinquency rates, especially among low-income households, pressures the Fed to ease.

Market Consequences

The financial stability considerations and the distributional impact of Fed tightening are pushing the Fed towards easing, inflation permitting.

I still expect a first cut in June. For full discussion please see my Fed preview.

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Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

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(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)