The recent quarterly report on US household debt published by the Federal Reserve Bank of New York showed that as of March 31, 2017, total US household debt of $12.7 trillion has surpassed the peak level in 2008. This milestone has been a long time coming, and has been touted as both a reflection of the strength of the economic recovery, and as a signal for impending economic doom. We believe this data is neither cause for exuberance nor alarm, but encourage investors to take this opportunity to think about the implications of this record household debt.
US households underwent a long period of deleveraging after the GFC, but credit growth resumed from mid-2013. Interestingly, while total household debt is back to peak levels, the composition of debt is materially different from 2008. As the above chart shows, mortgage debt is still below its 2008 peak, while student loans have more than doubled to $1.3 trillion and auto loans have also shown strong growth. This is most likely due to two factors: i) mortgage underwriting standards have risen dramatically and subprime mortgage originations are now a fraction of what they were in the years leading up to the GFC; and ii) the rise in student loans has limited the millennials’ capacity to afford mortgages.
The most obvious conclusion to draw from this data is that while total household debt has surpassed the pre-GFC peak, the short-term systemic risk in the financial system is lower than before the GFC, as the outstanding mortgage debt is of higher quality. However, these trends have some longer-term implications. It is no secret that student loans and auto loans are becoming problematic. Consider that nearly $150 billion, or 11 percent, of outstanding student loans are either 90 days delinquent or in default. Combine with the fact that the number of parents aged 50 to 64 acting as guarantors for their kids’ student loans has doubled to 2 million over the ten years to 2015, and we have a potential demographic time bomb with a growing number of millennials unable to save or invest and a growing number of older Americans depleting their retirement savings to support said millennials.
Consider also the froth forming in the auto loan market, which, unlike mortgages, did not see a tightening of lending standards following the GFC. Serious auto loan delinquency rates have been trending upwards since 2013, led by deteriorating performance of subprime auto loans (usually issued by auto finance companies) which have been masked by improvements in delinquency rates of auto loans issued by banks. The deterioration of auto loans, and particularly subprime, is set to accelerate further as a glut of used and off-lease vehicles depresses used car prices, which can push outstanding loans (further) underwater, reduce recovery values, and lower lease residual values. This will affect both vehicle manufacturers and used-car companies, and we are actively exploring several short ideas in the space for our Montaka strategy.
Finally, the WSJ earlier reported that the average FICO credit score hit 700 in April, the highest level since data was first collected in 2005. The share of US adults with FICO scores less than 600 has also declined to 20%, or roughly 40 million, from a peak of 25.5% in 2011. Higher FICO scores make credit more widely available and at cheaper rates, while also lowering lenders’ risk aversion. However, the reliability of FICO scores and the quality of new loans may become questionable over the next few years, as more than 6 million US adults will have their post-GFC personal bankruptcies erased from their credit files (foreclosures remain for 7 years and bankruptcies remain for 7 to 10 years). In effect, a wave of the most irresponsible borrowers prior to the GFC will suddenly become creditworthy, and we suspect there will be no shortage of banks and finance companies lining up to solicit their business.