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Investors watch for cracks in US consumer loan market

Investors are watching closely for hairline cracks in the US consumer loan market as lower-income borrowers feel the squeeze of high prices and rising interest rates.

US household debt levels have skyrocketed this year as Americans borrow more to pay for increasingly expensive homes and cars.

It’s not just big-ticket items: rising rents as well as higher prices at the petrol pump and in the grocery store have pushed consumers to rely more on credit cards. Research from the Federal Reserve Bank of New York shows that US households held a record-breaking $16tn in debt as of the second quarter of this year, an increase of roughly $2tn since before the pandemic.

For now, overall delinquencies — debts past their due date — remain historically low at around 2.7 per cent and big lenders including banks have not yet registered a significant uptick in losses on consumer loans. Unemployment has been steady at pre-pandemic lows and Americans have continued to feel the benefit of early pandemic stimulus. 

But while overall delinquencies did not rise in the second quarter and are still 2 percentage points lower than they were pre-pandemic, the composition has changed. A growing share are now in the early stages of delinquency, according to the New York Fed data, which could signal developing problems. These are particularly notable in credit card and car loans, where delinquencies are picking up in lower-income areas and among subprime borrowers.

Analysts and economists warn that these problems could proliferate as the US Federal Reserve rapidly lifts interest rates to rein in price growth that continues to run at 40-year highs.

Column chart of Quarterly (per cent) showing Recent delinquencies on US consumer loans are ticking up

The central bank’s tightening has not yet hit the US labour market, with the unemployment rate at a half-century low, but economists expect it to do so eventually as companies scale back hiring. Tighter monetary policy is also expected to make new credit harder to access, all while borrowers face higher debt payments on credit cards and other variable-interest loans. 

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Figures from Dv01, a market data platform that tracks consumer loans offered by financial technology companies such as SoFi, LendingClub, Prosper and Marlette, showed that new credit impairments which were not fixed within 30 days exceeded pre-Covid levels for the first time in May.

An impairment occurs when negative information about the borrower — late payments, defaults, delinquencies — are added to their file. 

The trend was driven by borrowers with low credit scores but Dv01 data also indicated rising impairments among households that earned up to $120,000 a year.

The pool of loans outstanding that is tracked by Dv01 sits at roughly $30bn. That is a much small number compared to credit cards or mortgages, but still notable because these fintech loans are likely to be “charged off” — a delinquent loan flagged by the lender as unlikely to be paid off — faster than more traditional consumer loans, said Jason Callan, head of structure products at Columbia Threadneedle, potentially revealing problems in the sector sooner.

“Most high-level data still looks incredibly low. But these problems start from somewhere. And as you tighten lending standards, you cut off access to credit, you charge more for that credit, which leads to worse and worse outcomes,” said Callan.

Line chart of Quarterly (per cent) showing 30+ day delinquent balances by loan type

Delinquency rates have begun to pick up in car loans as well, driven by subprime borrowers — with the rate in June at 2.7 per cent, up 0.8 percentage points from a year ago, data compiled by Moody’s show. While that trend is still well below historical averages, those rates are expected to continue to rise as the last of the Covid stimulus savings are drawn down, the Moody’s report said. 

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The rise in delinquencies so far has been too low and limited to signal growing risk of recession. But each of these data points suggests that despite an unemployment rate that is at 3.5 per cent and a still-robust consumer, economic strains are building for lower-income households. Those strains began as inflation eroded pandemic savings and will worsen as the Fed tightens monetary policy in a deliberate effort to cool the US economy. 

The Fed is due to raise interest rates by between 0.5 and 0.75 percentage points at its next meeting in September. Evidence of a slowdown in the world’s largest economy — a second consecutive quarter of contraction in gross domestic product reported in July — had initially prompted investors to bet that the Fed would slow its pace of rate rises in September after two 0.75 percentage point increases in June and July. However, a strong jobs report released last Friday, showing a continued rise in wages across sectors, has changed the outlook for now. 

“I think that we are very likely to see a sustained period of very slow growth,” said Eric Winograd, an economist at AllianceBernstein. 

“In that sort of environment, I would expect to see an increase in consumer delinquencies. I suspect that the labour market will weaken. And as the labour market weakens, people are going to struggle to stay current (on their debt payments).”