I started my banking career in the mid-80s, but only recently came to realize how dramatically our industry has changed in the past 20 years. Sure, there’s been deregulation, new technology and innovative competitors, but that’s not what I’m talking about. There’s been a more fundamental shift that could gravely impact us all in the future: the thrift-focused mentality of our parents’ generation has been replaced by a rabid and seemingly unstoppable love of debt.
The most striking evidence I can offer to illustrate this shift comes from the folks at Gabelli Asset Management. The chart below tracks the total debt in all sectors (federal, state, local, corporate, consumer) relative to the size of our economy. It brings an uncomfortable feeling of nausea to my gut. In the past 20 years, we have doubled the relative amount of debt in our society to levels that exceed those reached during the Great Depression.
For bankers, debt expansion has been most pronounced in the consumer sector, and our industry can no longer ignore this important strategic question: Is consumer debt reaching its final limits?
What, Me Worry?
Everything is peachy keen if you listen to the powers that be. Just listen to a few recent quotes concerning the American consumer:
“We don’t expect the current level of consumer debt to cause a recession nor to slow the recovery. In fact, consumers seem quite healthy from a financial perspective to us.”
–Doug Duncan, Chief Economist of the Mortgage Bankers Association
“Consumer markets are self-correcting… in the macroeconomic sense, there is very little to worry about.”
–Michael Staten, Director of Georgetown University Credit Research Center
“… household finances appear to be in reasonably good shape.”
–Alan “Mr. Magoo” Greenspan (addressing America’s Community Bankers in October 2004)
The Bears Are Waking Up
If we listen to economic leaders, it seems we can pour another glass of Australian Shiraz and kick back to watch Desperate Housewives. However, there’s a clan of growling bears beginning to rear their heads. Here’s the basic warning from the bears:
The national savings rate has hit an all-time low, dropping from 6 percent-8 percent in the early ‘90s to less than one-half percent today.
Outstanding mortgage and consumer debt levels as a percentage of personal income are hovering at all-time highs.
Consumer debt levels have grown at more than twice the rate of personal income in the past 15 years.
The Federal Reserve’s debt service ratio [which measures consumer debt payments as a percentage of disposable personal income] stands near an all time high despite the fact that we are in the lowest rate environment in 40 years. When rates go up, debt service levels will spike even higher.
The number of consumers with credit cards has rocketed from 82 million in 1990 to 144 million while average outstanding balances have tripled to more than $8,000.
Americans have been using their homes as ATM machines, refinancing their mortgages to fund their spending. During the 2001–2004 refinance boom, one-third of all homeowners used “cash-out” mortgages. According to Washington Monthly’s Benjamin Wallace-Wells, Americans have gained $1.6 trillion in cash refinancing in the last five years.
Speculation has emerged in the housing market and this signals trouble. Due to artificial stimulation, housing prices have soared even during a down economy. This appreciation has created a wealth effect more dangerous than the Internet bubble of the ‘90s. Economic studies indicate that a 20 percent drop in the housing market has the same negative economic consequences as a 40 percent drop in the stock market.
In sum, the bears are warning bankers that the acceleration of our lifestyles with additional debt could soon snap like a rubber band.
The Bulls Say “All is Well”
While the bears spread a doom and gloom scenario, the bulls have their own set of counterpoints to offer. They argue that:
Consumers have used low rates to strengthen their balances sheets. They have used their cash-out mortgages primarily for home improvement and consolidating debt into lower-rate, tax-deductible mortgage loans.
The significant growth in credit card debt is partly explained by rising usage of credit cards to replace cash and checks. Cards are being used as payment vehicles more than financing sources.
Home ownership is at an all-time high in America, hovering near 70 percent. The accelerated growth in mortgage debt has been skewed by the replacement of renters with new, mortgage-holding home owners.
While the bears worry strongly about a housing bubble, even the New York Federal Reserve jumped hard into the bull camp recently with a study that concludes, “Market fundamentals are strong enough to explain the recent price of home prices … no bubble exists.” Even Greenspan jumped on the “love your debt” bandwagon when, in February 2004, he encouraged consumers to consider switching from fixed rate to adjustable rate mortgages. Bond guru James Grant called this comment, “The strangest bit of advice ever to be proffered by an American Central Banker.”
Will We Hear a Popping Sound?
While there are valid arguments on both sides of the great consumer debt debate, I fall squarely inside the bear cave. At some point, borrowing, consumption and speculation reaches a point that is bad for a society. I believe we have reached that level once again. Sociologists are observing that, in America today, individuals derive their self esteem not by what they produce, but rather by what they consume. In the award-winning book Trading Up, authors Michael Silverstein and Neil Fiske investigate the “new luxury” movement in the United States, where a large portion of society now indulges itself in things like:
In America, all of these indulgences are pursued for the sole purpose of “feeling” more rich. This mindset has launched many successful luxury brands, but it’s also ignited even higher levels of debt, debt, debt. How else can average Americans pay for all this newfound luxury?
Here’s my take, GonzoBankers. The duty of the banker is not merely to float along with the tides of society and the economy. The banker’s role is to be the skeptic, the take the long view and to prepare for the nonlinear events that rattle our country every so often. Earnings are important for 2005, but so is building some contingency plans for the more dreary scenarios that could emerge.
Credit training 101 taught us that higher debt levels mean greater vulnerability to external events. Here’s just one scenario that bankers should be war gaming right now in their executive suites:
A pitifully weak dollar and exploding budget/trade deficits finally translate into inflation.
Rates rise faster than any bank’s ALCO model has projected
Ironically, intense global competition stifles job growth even as inflation rises – a “stagflation” environment emerges. (Anyone remember Jimmy Carter?)
Consumers begin to use available credit to finance higher living expenses, thus raising their FICO scores and reducing their chances of getting additional loans approved.
Lenders tighten their standards due to rising defaults and dropping FICOs.
Consumer spending slows as disposable income and debt contract.
Home prices fall quickly on both the East and West coasts.
Fannie Mae and Freddie Mac experience financial difficulty as their aggressive push for home ownership begins to show its Achilles heal. It turns out underwriting became lax because 70 percent of all mortgage loans were simply running through Fannie and Freddie’s scoring models. Home values were also inflated by low rates and arm-twisted appraisals.
Banks and their commercial customers find themselves significantly weakened by the nation’s serious “consumer-led” recession.
Maybe this is just a terribly paranoid nightmare dreamed up by some idiot consultant. But then again, who ever thought the Red Sox would go to the World Series after a 3-0 deficit against the Yanks?
Time to Move to DEFCON 4
With the rising uncertainty concerning consumer debt levels and the housing market, bankers have four important strategies they should be pursuing:
#1: Beef up the risk-tracking metrics
Every bank across the country should be constructing a management scorecard to track consumer credit trends. This scorecard should report average FICOs, debt-to-income ratios, loan-to-value ratios and borrower liquidity. This 50,000-foot view will be helpful in spotting global trends in the portfolio.
To address the housing market, it’s also important to integrate some external statistics, such as home sales, median home prices and average sales times for market listings. In addition, a very telling ratio of housing market health is the ratio of home prices to the median household income in each market. According to Hovde Financial, a ratio of 3.0 or greater has been a warning sign. In some parts of California today, this ratio stands at more than 8.0.
#2: Stress-test before the regulators tell you to
The key question banks need to answer is, “How significantly will rising rates impact the consumers in our portfolio?” In asset-liability management terms the question really comes down to, “Are consumers positively or negatively gapped today?” If your borrowers are heavily concentrated in amortizing fixed loans with low loan-to-values, have a beer and celebrate. If portions of the portfolio contain ARMs, interest-only mortgages and floating rate loans, dig deeper.
#3: Migrate from a narrow lending focus to a wealth management focus
Soaking the consumer with more debt simply won’t be where the action is in the next decade of banking. The philosophy that should drive bankers in the future should not be “make more damn loans” but “increase our customer’s long-term wealth and get paid handsomely for it.” For some of our client base, that means discouraging debt vs. hawking it.
#4: Keep building innovative non-interest income sources
Banks that have weaned themselves off net interest margin revenue and that have built unique sources of fee income have much less risk in an over-leveraged economy. (Northern Trust, State Street, Mellon). Fee income businesses do not happen overnight, but bankers cannot lose sight of the need to build these new revenue engines. What’s in your strategic plan this year to develop new sources of non-interest income?
Who Can You Trust?
I once saw an inspiring quote from a Danish finance professor, “The work of a banker can be described as buying and selling trust.” Like it or not, consumers and businesses have entrusted our industry to keep an eye on their financial health. Banks can have a profound influence on the current and future generations’ attitudes towards debt. So far, our industry has only condoned and encouraged the growth of the new, highly leveraged consumer. Is it time to do the right thing and change our tune a bit?