Credit Where Credit is Due

Monday 02/10/14

     Following a few bad weeks, stocks were able to stop their slide. After reaching lows below 1740 the S&P 500 rebounded to just a bit under 1800. The week began with a continued plunge but eventually reversed on Wednesday in anticipation of a much better jobs report. When the employment report was released it showed that only 113,000 jobs were added despite economist expectations of 175,000 jobs. Stock futures fell briefly but quickly reversed and continued higher to end near the highs of the week. Although it is still too early to tell, two large misses in a row is concerning. What is more concerning is that the unemployment rate continues to fall much faster than many economists predicted, which is simply a function of people dropping out of the workforce. Many economists had claimed that weather was the likely cause of the poor employment reports, but I showed why that was probably not the case here. As it turns out the revisions show that it indeed was not likely the weather, but something else. The current report also shows that weather was likely not the reason for the weak number as construction jobs rebounded in January but overall job growth didn't. There will be more revisions, but for now it seems like job growth is slowing somewhat. This week I want to look at consumer debt and banks.

     Last Friday another interesting data point was released. Consumer credit expanded by much more than expected. The increase was driven largely by increased credit card spending. Credit expansion is typically viewed as a positive sign for the economy. More borrowing leads to more consumption which increases corporate profits which is passed on to workers in the form of higher incomes (In theory). Before you get to excited and begin to think that we are at the beginning of a new credit cycle there are some more things to consider.

     The most obvious consideration is that this data point was pre-taper. If it is true that quantitative easing was stimulating the economy, then we could expect to see a decline in the rate of growth now that quantitative easing is winding down. Another possibility is that it just took a long time for banks to feel comfortable extending revolving credit (credit cards and lines of credit).

     It is also important to note that while credit has been expanding, the real median income has been falling. The chart on the right shows real median household income peaked in 2000. Of course the virtuous cycle of credit expansion states that jobs and rising income should follow increased consumption. However, if job growth was slowing and people were losing access to government benefits (food stamps and unemployment benefits) then perhaps they were just tapping their credit cards out of desperation. Of course, it is dangerous to read into any one data point especially with the volatility of consumer credit.

     Another possibility is that banks are under pressure to make loans in order to combat falling net interest margins. Net interest margin (NIM) is calculated by taking a bank's income, subtracting it's borrowing costs, and then dividing by their total earning assets. Small changes in NIM can have a big impact on a bank's bottom line. As loan production has dropped since 2008, banks have been making up for this drop by raising fees on deposit accounts and charging more for services that were once free. This is seen as a low risk alternative to making loans, the worst case scenario is that a depositor will change banks, but changing banks is such a hassle that this doesn't happen very often. To increase NIM a bank can increase interest rates that it charges or just make more loans. Perhaps banks are finally starting to make loans rather than just supplementing their income with account service fees.

     Banks were also able to originate mortgage loans, because they don't have to keep them on their balance sheet, they just package them and sell them to Fannie Mae or Freddie Mac. This means that banks have almost zero default risk and these loans are essentially the same thing as fee income. Mortgage loans are extremely interest rate sensitive and since rates began rising last June, banks have cut staff and mortgage originations have dropped precipitously. A recent survey by the fed showed that banks loosened credit standards in several categories including credit card and auto loans. By lowering their standards banks can make more loans and increase NIM. However, this will be offset by a reduction in safer mortgage income.

Conclusion

     Consumer credit has been tight, but demand was restricted by banks who were wary of making loans with high default risk. Now that banks are finding it more difficult to generate fee income they will need to begin making consumer loans (a novel concept for modern mega-banks). However, if demand from quality borrowers is not sufficient, banks will begin making loans to consumers with higher default risk (i.e. higher debt-to-income ratios and lower credit scores). The two important questions that need to be asked are: Can consumers handle more debt? And, Can banks handle more loans?