Friday, October 12, 2007

The other sub-prime debt

Pop quiz: What am I? Banks give me to people with weak credit histories. I get securitized off the lender’s balance sheet. And I carry a variable interest rate. Nope, I’m not a sub-prime mortgage.

Credit card companies wrote off 4.58 percent of distressed debt balances in the first half of 2007, 30 percent more than in the same part of 2006. Outstanding revolving debt –the lion’s share of which consists of credit card debt- amounted to about $915 billion at the end of August. With a default rate of, say, 4.5 percent, we’re talking about $41.2 billion worth of non-performing credit lines. Could credit card debt bring about another liquidity crisis?

The current level of credit card balances in distress is relatively small. The default rate for sub-prime mortgages is about 20 percent, and aggregate outstanding balances of that type of loans come to about $1.2 trillion. The level of non-performing sub-prime mortgage balances is thus $240 billion, or about 6 times as large as its credit card counterpart. This is the end of the good news.

The relative low rate of credit card defaults is a bit misleading. Mortgages are classified as bad as soon as the borrower is late for a few monthly payments in a row. On the other hand, the 4.58 percent of bad revolving credit I mentioned above does not include the balances that borrowers roll over indefinitely by making only the minimum payment. Many of those balances will eventually be in default, but that may take months or years.

Moreover, the fortunes of credit card balances and mortgages may go hand in hand. For borrowers in a pinch, mortgage payments probably take priority over credit card payments. Debtors can always postpone the latter by rolling them over. If enough people do that, cash flows from credit card balances will fall too far below projections and a liquidity problem may ensue. The investors who buy securitized pools of receivables will have a problem too as the value of their bonds drops.

Credit card debt is also more or less linked to the value of real estate. Part of the reason why the sub-prime mortgage market got out of hand is that the size of loans was implicitly linked not to the current value of housing but to its expected future value -both borrowers and lenders were expecting the price of housing to go up, and were planning to refinance the loans before higher interest rates kicked in. Alas, the real estate soufflé collapsed and borrowers got stranded with outsized mortgages that they could neither pay off nor roll over.

Likewise, credit card issuers probably extended generous credit lines to homeowners in the expectation that, if need be, borrowers would tap into their home equity to finance their card balances. In the face of falling real estate prices, credit card issuers will become stingier.

The Wall Street Journal reported in August that some lenders are tightening credit standards for auto loans, credit cards and personal loans. “We used to offer frequent, automatic line increases, and now, we’ve pulled back a little bit,” Barbara Johnson of the USAA Federal Savings Bank told the Journal. The growth of revolving consumer debt has stopped accelerating since the spring (see chart, from the same article in the WSJ).

By some accounts, the economy is tiptoeing around a recession. Reining in credit would bring consumption growth to a halt, as well as Gross Domestic Product to a large extent. Is there anything we can do?

The simplest thing that state and federal governments should do is lower or eliminate bankruptcy limits. The bankruptcy limit is the amount of wealth that a borrower is allowed to keep when she files for bankruptcy. More than one academic study (see this one and this one, for example) show that higher bankruptcy limits make lenders decrease the amount of credit they give, especially to low-wealth borrowers. And those are precisely the debtors who are most likely to be caught in sub-prime debt with adjustable rates. Lower limits would increase the amount of credit available, lower its cost, and foster responsible borrowing.

Here’s a more difficult quiz: who is going to convince the government and consumer associations that less consumer protection is better for borrowers?

How likely is a credit card meltdown? Could it set off a recession? Who is to blame for the high default rates in the sub-prime and credit card markets? Leave your answers in the comments.

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