There is a seemingly unlimited number of disconnects in financial markets these days, not the least of which is the shocking divergence in recent years between the ever plunging unemployment rate in the United States and stubbornly rising delinquencies on consumer debt. In fact, according to a note published earlier today by UBS strategist Matthew Mish, that divergence continues to soar to all time highs with each passing month...but why?
As it turns out, the answer to the enigma above may just have something to do with the fact that, despite declining unemployment levels, wage growth remains completely non-existent at a time when consumer leverage, particularly in the form of student loans and auto debt extended to the most financially vulnerable cross sections of the American public, is soaring. Let's explore the data from UBS...
Per the charts below, when you break out rising consumer delinquencies into their individual buckets the catalyst for the trend above suddenly becomes more clear. While delinquency rates on mortgages, HELOCs and credit cards are improving, or at least not deteriorating rapidly, delinquency rates on student loans and auto loans are a completely different story.
90-day delinquency rates on consumer loans are up 20bp to 7.61% Y/Y, led by deterioration in auto loans. Trends in recent loan vintages suggest a negative outlook on balance, but incremental deterioration is shifting from autos to credit cards and student loans. This is worrying as it indicates broader weakness in non-prime consumers.
For one, auto and credit card loan default rates bifurcated by credit quality (e.g., prime, subprime) continue to show sequential deterioration on average. This worsening performance in part can be explained by weaker underwriting standards and risk layering: i.e., higher loan-to-value ratios and longer loan terms. For example, negative equity was a contributing factor explaining home mortgage defaults, and is now one factor influencing rising auto loan delinquencies. Further, multiple interest rate hikes by the Federal Reserve have increased average interest rates in particular on new car loans from finance companies (from a low of 4.4% to 5.6% on 60m loans)) and for rates on credit card balances (from a low of 12.7% to 14.9%, Figure 5).
And who took on all those $40,000, 0%, 80-month loans all so they could drive around in a brand new BMW they couldn't afford? Well, if you guessed millennials in the lowest quintile of wages earners in the country then you're absolutely right! As Mish points out in Figure 7 below, the median debt-to-asset ratio for Americans under the age of 35 has surged over the past couple of decades from ~40% to a staggering 100%.
Second, aggregate consumer credit metrics mask substantial inequality across consumers. Leverage metrics, e.g., debt to assets, are at or near record levels for lower income and millennials, and the literature draws a clear linkage between lower savings and higher defaults. While interest coverage has improved, it is overstating consumer health. We do not believe these metrics are adjusting for inequality in individual income/ wealth, a decline in the US homeownership rate, and student loans in deferral status.
First we calculated median leverage levels based on debt to assets across income and age cohorts; for lower incomes (0-20, 20 – 40th percentile by income) and younger ages (less than 35, 35-44) the results suggest ratios are at or near record levels (Figures 6, 7). Median leverage measured by debt to incomes (DTI) are also at record levels for lower income households (0 – 40th %ile), while millennial (under 35) debt-to-income ratios are in-line with 2007 levels. Strikingly, DTI ratios for 3544yr olds are materially lower even though prior leverage metrics are near record levels, likely reflecting the reality that middle age households have deleveraged via mortgage debt defaults but now currently have low asset bases (Figures 8, 9).
So what does this all mean for future credit growth? Apparently, absolutely nothing as UBS figures that banks will just continue with their reckless lending practices until something breaks.
Second, the supply side of credit to consumers is supported materially by federal credit support, primarily mortgage and student loans. We estimate roughly $825bn in net loan creation this cycle in mortgage and consumer-backed loans (2010 – 2017); however, the share of non-government backed loans has actually been negative to the tune of $677bn (vs. government backed loans at $1.5tn, Figure 21). The implication is consumer lending to a large extent is essentially on autopilot, with changes in loan standards likely to be inelastic and lagging severely any rise in delinquency rates.
Third, the supply of credit in consumer loans less impacted by government credit support (e.g., auto, credit card and personal loans) remains relatively accommodative. The rise in delinquency rates has triggered some tightening in underwriting standards (e.g., autos, credit cards), primarily from more conservative lenders including banks. But the magnitude of tightening has been modest (Figure 22) and competition has attracted new lenders to largely fill the void – e.g., in autos finance companies and credit unions13. And any stabilization in delinquency trends should support stable credit supply trends.
Conclusion, lenders will continue to bury their heads in the sand and ride the ponzi wave in student and auto loans until it once again blows up in their faces.