Saturday, March 22, 2008

Risk Of Growing Consumer Debt: When Will It Pop?

The Philadelphia Federal Reserve’s Winter 2007 Payment Card Center report notes that total household debt exceeded $13 trillion in 2006. This means that an average household had $11,647 in debt as of 2006 (this is based on a total of 111,617,402 household). The report goes on to further state that banks sold an estimated $128 billion in non-performing consumer debt, of which approximately $88 billion was in defaulted credit card debt, to collection agencies in 2005. If this figure holds true, then 9.85% of all outstanding household debt may default in 2008.

Currently, according to the Federal Reserve Charge-off and Delinquency Rates for 4Q 2007, seasonally adjusted, the total consumer loan charge-off rate is 2.55% (Credit Cards charge-off was 4.17%). Total consumer loan delinquency rate was 3.39% (Credit Cards delinquency rate was 4.55%) for the same period.

That means that the 4Q 2007 total consumer loan delinquency and charge-off rates as reported in the Federal Reserve report of 5.26% is far below the level in 2005. Given the declining economic condition, this is difficult to believe. Most economic reports coming out all indicate a slowing economy with increasing potential for increasing consumer debt defaults.

Based on the current economic trend of a slowing economy, the likelihood that consumer default rate will increase is more plausible. If the Philadelphia Federal Reserve’s Winter 2007 Payment Card Center report’s estimation of 9.85% in non-performing consumer debt in 2005 is extrapolated to 2008, then expect an additional 4.59% increase in consumer loan delinquency to occur. The only question is when.

What The Charts Tell Us
Perhaps the following charts will provide an understanding of when (source of the charts: St. Louis Federal Reserve, National Economic Trend, February, 2008).

Consumer Consumption makes up 65% of GDP. Knowing this, it is important to gauge the financial health of the American consumer. However, the American consumer has not been frugal. Since 1992, American households have been taking up more debt with corresponding higher debt service. Household debt service went from approximately 10% of their disposable income in 1992 to approximately 14.25% in 2007. Given that CPI has increased 4% from February 2007 to February 2008 while consumer sentiment has been dropping, the consumers would probably look to cut back on most purchases going forward.

The reason why the consumers will cut back on consumption is clearly evident in the following set of four charts. Real disposable income has been decreasing with steep drops in November and December 2007, precisely the months that one would not want to see disposable income drop. Correspondingly, personal savings rate went negative in the same months. That does this mean? It means that consumers went into debt to buy holiday cheers in November and December 2007. Quite an expensive holiday; a holiday that consumers will be paying for sometime.

So the consumers went into debt in November and December 2007. So, what did they buy? My guess is: just the basics. The next two charts, both labeled “Real consumption” by the Fed. The bottom left Real Consumption chart indicates that real consumption is declining from 2006. What is more revealing is the lower right chart of Real Consumption, which indicates that for the first two months of 2008, the real consumption was close to 0%. Look real close because the lower right chart is for the first two months of 2008. Any guesses on what the third month will show? How about “stays the same around 0%?”

What is driving the consumers to really slow down on their consumption? Ah, well, people have to have income to pay for their consumptions. However, if you look at the historical trend of compensation, it does not look pretty. In fact, it looks pretty grim. The gray bars on the charts correspond to the recession periods of 1982, 1990-91, and 2001. Except for the 2001 recession, all previous recessions had, either prior to or immediately after, a period negative compensation growth. Well, we have entered into that period once again.

People are consuming less and selectively because of a simple fact: their real incomes have been dropping and are lower now than a year ago.

What Can You Do?
One can console oneself by knowing that all through the recession periods, companies have been able to generate profit (see below). Even in the worse recessions of 1982 and 1990-91, the corporate profit did not take a major hit. Yes, there were pockets of industries that got hit harder than other but overall, corporate profit has been steadily climbing. Hopefully, you are one of those who are benefiting from the increasing corporate profits.

If not, then join the growing line at an unemployment office because the employment picture does not look bright. In fact, employment trend is once again dipping down, close to zero growth. This means that unemployment rate will increase. If 1990-91 recession is any indication, we may be headed toward 7% to 8% unemployment rate:

So knowing that consumer debt default rate will increase further, perhaps as much as 4.59% over the current level. Perhaps even more. The consumers, who make up 65% of the GDP, are unable to spend because, as we have seen above, they are making less while their overall debt service has increased. Moreover, there are indications that the slowing economy will lead to higher unemployment. So, with increasing prices coupled with lower income and negative savings rate, it is abundantly clear that the consumers will have to resort to borrowing. Be it in credit cards, home equity loans, or other debts, they will borrow more until the debts overwhelm them.

That’s when the consumer debt bubble will pop, taking down a lot of banks that are under capitalized. My guess as to exactly when? I am sort of marking mid-January 2009 as my guess. That way, Mr. Bush can declare “Mission Accomplished” while leaving office.

May your trading be profitable!
Ed Kim

Sphere: Related Content

No comments: