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The Bumpy Road Ahead for Consumer Credit

Credit behavior in the US is already changing on account of covid-19. In a May report, the Consumer Financial Protection Bureau found:

"..between the first and last week of March, auto loan inquiries dropped by 52 percent, new mortgage inquiries dropped by 27 percent, and revolving credit card inquiries declined by 40 percent compared to usual patterns."

Though it’s too early to establish a trend from one month’s worth of data, a permanent constriction in consumer and small business credit on the scale of the 2008-2009 financial crisis or greater is a real risk.

In the coming months, how demand- and supply-side credit trends interplay will determine how accessible credit becomes. Here are the trends to watch:

\\ 3 demand-side trends to watch: personal income, government transfers, and consumer spending \\

Personal income: a record 20.5 million Americans lost their jobs in April. The 8-week total in new unemployment claims is 36.5 million, showing Depression-level damage to labor markets. Whether this shock proves temporary or lingers will determine the level of demand for personal credit to make up for income reduction, the ability for households to service existing debts, and the ability for lenders to underwrite people for new loans based on ability-to-repay principles.

Government transfers: the CARES Act provides both a $1,200 one-time stimulus check and $600 per week on top of state unemployment benefits - including gig workers and self-employed contractors for the very first time. For many workers, these transfers will be larger than their previous take-home salary. Whether these government transfers represent a one-time bump or a permanent income source will weigh heavily on household finances.

Consumer spending: Spending is down overall, though particularly for categories which often coincide with strong demand for credit. Auto purchases, for example, are down by 49% in April compared to February. Consumer confidence is currently down by 25% in 2 months, its lowest since 2011. Even for consumers with income, whether people feel confident will weigh on whether wallets open for big ticket items, often aided by credit, or wait.

\\ 3 supply-side trends to watch: delinquency rates, interest rates, and bank solvency \\

Delinquency rates: a representation of consumer risk, delinquency and forbearance rates over the coming months are expected to rise. Already 4 million homeowners, representing 7.9% of all mortgages, have delayed mortgage payments. Higher levels of non-payment rates risks a lower supply of credit overall.

Market interest rates: the Federal Reserve has unleashed a massive injection of liquidity into the economy, including cutting its benchmark interest rate to 0%. These programs are beginning to take effect for consumers with 30-year mortgage rates falling to 3.40%, a record low. Likewise, rates on high-yield savings accounts have also fallen. How fast and the level to which interest rate shifts filter to consumers through banks and markets will influence how expensive credit becomes.

Bank solvency: US banks entered the crisis well-capitalized. Further, the Federal Reserve has an establish playbook from the previous 2008-2009 financial crisis that it is redeploying to support smooth functioning of financial markets. However, the deeper and longer the current crisis, the more vulnerable lenders and banks become. Increases in solvency risks will result in contractions in credit availability as banks hoard capital.

Together, the price of credit is determined in large part by credit, market, and solvency risks. While market interest rates present a downward trend, consumer and solvency risks represent an upward force on credit prices and availability.

The Most Likely Scenarios

How will these forces play out? Here are 3 scenarios, from worst to best case:

1. A downward spiral as uncertainty and bankruptcies mount, impairing credit access

The adverse shocks to households and small businesses compound and metastasize into something far larger - a financial crisis triggered by a wave of defaults affecting the solvency of banks and other lenders. Current likelihood = low.

2. Prolonged pandemic and slow recovery leads to lower credit availability

Though the crisis becomes contained and bank solvency risks averted, unemployment nonetheless remains elevated and the Congress is divided on further stimulus and financial support for households. This depresses income, raises delinquency rates, and impairs the ability for consumers to service debt, leading to lower overall credit availability, particularly for subprime consumers. However, whereas in 2008-2009, credit contractions left subprime, thin-file, and other often overlooked borrowers without credit access, fintechs step in where other lenders retrench to keep credit flowing. Current likelihood = high.

3. Rapid recovery brought about by strong government action leads to normalized credit markets

The initial shock to the labor market subsides as the pandemic and economic shock fade on account of strong government action on testing and stimulus. The Federal Reserve keeps credit and money flowing, allowing for credit markets to remain healthy. Current likelihood = low.

Overall, we are in for a bumpy ride in consumer credit. It seems that the worst-case scenarios have been averted; although, the chances of a V-shaped recovery also seem more slim. Most likely, we will see a replay of 2008-2009 where banks and other institutional players retrench as fintechs expand and serve populations in need.

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