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Aviva Investors: Consumer debt: tipping point?

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25 Aug 2017

Aviva Investors: Consumer debt: tipping point?

Many recent headlines harken back to the start of the Global Financial Crisis nearly ten years ago, with news about out-of-control housing bubbles, problems in subprime lending and rising delinquencies among over-extended borrowers.

With the mental scars of the last credit-induced downturn still fresh for many investors, it is perhaps unsurprising these stories have stirred worries about a fresh crisis.

We asked Aviva portfolio managers and corporate analysts in the US, Canada and the UK for their perspectives to answer the question: are the latest reports on consumer debt a cause for greater concern?

US: As good as it gets?

Is the US consumer tapped out? The question is a critical one for the US economy, which depends heavily on consumer spending for much of its growth. The weight of the evidence—at least according to the financial media—suggests yes. Household debt, including mortgages, credit card balances, auto and student loans, reached an all-time high of $12.7 trillion in Q1 2017, according to the Federal Reserve Bank of New York.1 Excluding home-related borrowing, student loans account for the biggest chunk of this debt load, but auto loans and credit card debt have also expanded significantly over the last three years.2

George Rudawski, Head of US Securitized Products at Aviva Investors in Chicago, sees reasons to be concerned but not alarmed. “It’s likely we’ve already seen as much improvement in the consumer picture as can be expected,” he says. “If late payments and delinquencies begin to rise, that wouldn’t be surprising.”                  

The slower rate of US GDP growth for Q1 2017 was blamed primarily on a drop in consumer spending; in particular a 14 per cent annual decline in vehicle purchases by US consumers for the quarter, as reported by the Bureau of Economic Analysis.3 Underpinning the general weakness in the auto sector is a pullback in lending: big banks aren’t courting borrowers as fervently as they were a few years ago. Starting in Q3 2016, more banks have tightened auto loan underwriting standards than relaxed them, according to data from the Federal Reserve Bank of St. Louis.4

Rudawski currently does not see much deterioration in securitised auto loan performance, especially in higher quality tranches. Currently, auto loan charge-offs don’t appear to be rising significantly. Data from Bloomberg show net charge-offs remain at the low levels seen throughout the post- financial crisis years. In fact, current net charge-off rates are lower now than they were in the years leading up to the crisis. (See figure 1 below.)

Figure 1: Net charge-offs for auto loans remain at low levels


Market stresses are emerging at the fringes, Rudawski notes, among riskier borrowers with low credit scores. Smaller lenders who focus on these less creditworthy borrowers are seeing a rise in delinquencies and defaults in the auto loans they’ve made. Fitch Ratings reported an annualised rate of net losses on securitised subprime auto loans at 10 per cent in late 2016, the highest level since the crisis.5

“Investors should bear in mind that unlike subprime mortgage-backed securities that paralysed money market funds at the start of the global crisis, auto asset-backed securities (ABS) are largely a contained market,” Rudawski says. “Auto ABS are collateralized with assets that are easy to value, mobile and have short average lives compared to mortgages. Unlike foreclosed houses, cars can be repossessed from delinquent borrowers, moved across the country, and sold quickly at auctions at fairly transparent prices.”

Concerns about credit card lenders in the US have also garnered headlines in recent weeks. Firms with significant exposure to consumer loans, including JPMorgan Chase, Synchrony, Capital One and Discover, announced higher charge-offs and increases in delinquent payments in Q1 2017.6 Share prices for many of these lenders suffered after these announcements.

But looking at the recent data over a longer time horizon shows only slight upticks in charge-offs and delinquent payments, with recent increases coming off of multi-year lows (see figures 2 and 3 below.) In addition, while Americans may be spending more on credit, they’re also paying off more of their balances. Payment rates for both bank-issued and retail-issued consumer loans are at 20-year highs (see figure 4 below.)

Figure 2: Bankcard charge-offs at multi-year lows (%)

Figure 3: Credit card delinquencies rise, from multi-year lows


Figure 4: Consumers paying off credit card balances


Rudawski is not particularly alarmed by the incremental increase in charge-offs from retail store lenders like Synchrony and Capital One. “Lenders in that market always have higher charge-off rates because they serve a lower-credit borrower base. But these borrowers also get smaller credit lines and tend to carry smaller balances. We are watching the overall health of the credit card market and presently it appears to be quite healthy.”

In recent Federal Reserve Senior Loan Officer Opinion surveys, lenders in general have reported tightening standards for credit card borrowers starting in the second half of 2016, although for Q1 2017 more banks had loosened these underwriting standards.7 Reports for the upcoming quarter bear watching to see if this uptick in delinquencies was an outlier or the beginning of what could become a long-term trend.

Canada: bubble trouble?

Canada’s economy has boomed of late, leading all other G7 nations for growth in Q1 2017. Much of the credit for this growth belongs to Canadian consumers, who boosted their household spending earlier this year, mostly through auto purchases.

But much of the economic news coming out of the country recently has centered on its housing market. Home prices in two of the largest metropolitan areas, Toronto and Vancouver, have surged in recent years; since December 2015, prices are up over 33 per cent in Toronto and 21 per cent in Vancouver.8 Talk of a real estate bubble in these markets is now prevalent, as is the fear of this bubble bursting.

Problems at Canadian mortgage lender Home Capital, related to a regulatory investigation into alleged fraudulent lending activity, stoked concerns that the high-flying Canadian housing market may crash similar to the US housing market during its subprime mortgage crisis. “Risks in the system appear to be building,” says Sunil Shah, Head of Canadian Fixed Income at Aviva Investors in Toronto. “But they don’t necessarily have to lead to a crisis.”

A generational high in household borrowing is one current risk. Total Canadian household debt exceeded the country’s Gross Domestic Product for the first time in Q3 2016.9 Some of this increase in leverage can be pinned on higher home prices. But equally noteworthy, incomes of Canadian workers haven’t increased at the same pace as their debt loads.

The Canadian housing market and its overall economy may steer clear of the problems that drove the US economy into recession in 2007. First, according to Shah, the mortgage loan origination market is dominated by large Canadian banks, even as mortgage finance companies have grown their market share in recent years. “The large banks exercise a fair amount of discipline in their product mix,” says Shah. “Some of the more esoteric mortgages that grew in popularity during the US housing boom, such as adjustable rate mortgages, aren’t particularly prevalent in Canada.”

Second, the outsized acceleration in home prices has essentially been confined to Vancouver and Toronto. While speculative activity can be found in these two markets, there is good structural demand behind the rise in home prices. Both cities are attracting new residents as workers from other provinces flock to these booming areas; particularly from Alberta, whose economy has slowed with the drop in oil prices since 2014. Plus, emigrants from other countries find Canada’s relatively open immigration policy welcoming; these new citizens typically enter the country through its two primary global hubs.

Then there are government policy efforts in both cities to control urban sprawl. This has led to an intensification of new or available housing in concentrated areas. “The increase in housing demand from new arrivals is running headlong into these cities’ limitations on housing supply,” explains Shah. “So naturally, prices can be expected to rise.”

Still, Shah insists that investors should remain cognisant of the mounting risks to Canada’s future growth. If there is to be a slowdown or crash in the country’s housing or mortgage markets, it will likely be caused by a slowdown in the overall economy.

“Even as the Bank of Canada tightened monetary policy by a quarter-point on July 12, they know they have to be extremely careful at navigating monetary policy options at this stage,” says Shah. “Too little withdrawal of stimulus would lead to stoking a house price bubble in major urban centres with increasingly dangerous consequences, and too much could tip the highly-leveraged consumer over the edge and result in a downdraft in economic growth, house prices and incomes. The risks to monetary policy error are certainly heightened.”

The future path of US interest rates may also impact the Canadian mortgage market, and by extension the broader economy. The correlation in rates between the two neighbours’ five-year sovereign bonds deserves monitoring, because the majority of Canadian long-term mortgages include five-year rate resets. A corresponding rise in Canadian five-year yields along with rising US interest rates could add more weight to Canadian homeowners’ debt burdens.

“We’re near the precipice, and we may not go over it,” Shah says. “But we also don’t know what level of interest rates would push Canadian households over the edge. That in my view is a mounting risk in the current environment.”

UK: sound the alarm?

Rising consumer debt in the UK has prompted alarmist headlines, but it isn’t just press scaremongering: the Bank of England has warned for some time that the recent rapid rise in consumer borrowing, particularly of unsecured lending, is a potential threat to the stability of the UK’s financial system. The minutes of the latest meeting of its Financial Policy Committee (FPC) on 22 March 2017 noted “UK household indebtedness remained high by historical standards and had begun to rise relative to incomes10.”

On June 27, the Bank of England ordered banks to allocate an extra £11.4 billion to protect against an increase in bad loans following the recent rapid growth of consumer lending and the uncertainty associated with Brexit. The central bank is also accelerating its assessment of stressed losses on consumer credit lending in its 2017 annual stress test. The results will inform the FPC’s assessment at its next meeting of whether it should require banks to allocate further funds as a buffer against bad loans11.

Consumer credit growth reached an annual peak of 10.9 per cent in November 2016 – the fastest rate of expansion since 2005. The annual growth rate has slowed only slightly this year - to 10.3 per cent in the 12 months to April 201712. By contrast, lending secured on dwellings (mortgages and remortgages) grew by 2.8 per cent during the same period12. This partly reflects lenders’ focus on the ability of borrowers to service their mortgage debt, according to Oliver Judd, senior financial services corporate analyst at Aviva Investors.

Rising inflation and low wage growth appear to be encouraging consumers to borrow more and save less to finance new purchases such as cars, as well as other spending. Real average wages for UK workers fell by more than five per cent between UK between 2007 and 2015, with only Greece among OECD countries suffering a worse decline13. Although real wages rose in 2015 and 2016, they turned negative again in the first quarter of 2017, reflecting higher inflation on the back of a falling pound14.

At the same time, low interest rates and the easy availability of credit means it is relatively easy for consumers to borrow. Meanwhile, says Judd, the “rise in house prices in recent years has left consumers feel relatively wealthy and we have a culture of instant gratification”.

Driving debt

The growth of car finance has made the biggest contribution to the growth of consumer debt in recent years. Britons borrowed a record £31.6 billion to buy cars in 2017, a 12 per cent increase on the previous year15.

The increasing popularity of Personal Contract Purchases (PCPs), a relatively new form of vehicle financing, has acted as a significant driver of car sales and financing volumes, according to the Financial Conduct Authority (FCA) 15. PCPs financed 82 per cent of new cars deals in 2017 and are also used to buy second-hand cars16.

The popularity of PCPs lies in the lower monthly payments they require compared to traditional car loans and because they price cars in bite-sized payments, rather than an intimidatingly-large one-off amount. Concerns over PCPs partly reflect the relative ease with which they can be obtained, with some providers agreeing deals as long as the monthly payments do not exceed a quarter of take-home pay. The FCA has launched an investigation into PCP finance due to concerns over a "lack of transparency, potential conflicts of interest and irresponsible lending in the motor finance industry17."

There have also been concerns that PCP loans have been repackaged and sold onto other investors, prompting headlines that the growth of sub-prime car loans could be laying the foundations for a new financial crisis. Such fears seem overblown: just under £1.7 billion of outstanding UK consumer car loans provided through dealerships at the end of 2016 were classified as sub-prime – less than three per cent of the total, according to the Finance & Leasing Association18.

In addition, Asset Finance Policy, an independent regulatory affairs consultancy, argues that a key difference from mortgage securitisations is that “investors, including banks, aren’t affected by either default or residual value risk unless the car manufacturer goes out of business. This explains why the cost of finance raised using ABS by the captives is so low and why there's no need to be terrified about car loan securitisation”. 19

Credit card concerns

The Bank of England is also concerned about the growth of credit card debt, with £68.1bn outstanding in April, 9.7 per cent up on the year and the fastest pace of growth since February 200620. “As well as new borrowings, we are seeing a return to zero per cent transfer balances in the credit card market. Lenders are keen to grow this area to counterbalance the impact of very low interest rates on margins and the limited growth potential of the mortgage market,” says Judd.

The key for lenders, he argues, is to price products in line with risk. The stress test for new lending in the mortgage market focuses on whether borrowers could still make payments if, at any point over the first five years of the loan, the bank rate was to be three percentage points higher than the prevailing rate at origination21. “Given the standard variable mortgage rate is currently around four per cent, the stress test would be currently be set at around seven per cent, which provides some confidence in the ability of borrowers to repay their mortgages,” Judd says.

There are no such stress tests in the credit card market and that is where the problem potentially lies. But Judd points out lenders enjoy much higher margins, which should compensate for the greater risk of default. Lloyds Banking Group’s acquisition of consumer credit card business MBNA for £1.9 billion highlights the appeal of the returns on offer in the credit card sector to lenders22.

The Bank’s Financial Policy Committee has supported a review launched by the Prudential Regulation Authority into the credit quality of new lending; reflecting concern the rapid increase in borrowing is unsustainable and driven by deteriorating underwriting standards among lenders.

Lenders appear to have reacted to policymaker’s concerns, according to the Bank of England’s quarterly survey of credit conditions, published in April 2017. It found that that the availability of unsecured credit to households decreased slightly in the first quarter of 2017 and was expected to decrease in the second quarter. Credit scoring criteria for granting both credit card and other unsecured loans were reported to have tightened in the first three months of the year and lenders expected credit scoring criteria on credit card lending to tighten significantly in the next three months23. Moreover, asset quality is currently at historically high levels.

That could change, however. “The economy is slowing with some analysts even forecasting a recession and that has to be a concern given the build up of unsecured lending,” says Judd. Unemployment is the key variable to watch in terms of the ability of consumers to service their debts, he adds.

While the Bank of England acknowledges that average debt servicing ratios remain low, it also believes a period of higher unemployment could challenge the ability of some households to service their debt. These households could affect “broader economic activity by cutting back sharply on expenditure in order to service their debts24”.

Overall, however, the FPC believes that despite “pockets of risk that warrant vigilance” the risks facing the financial system remain at a normal level for now and that “the resilience of the UK financial system has strengthened significantly since the (global financial) crisis”25.

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