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Washington shouldn't exacerbate the looming problem in consumer credit lines.
Wall Street Journal, March 10, 2009
By Meredith Whitney
Few doubt the importance of consumer spending to the U.S. economy and its
multiplier effect on the global economy, but what is underappreciated is the role of
credit-card availability in that spending. Currently, there is roughly $5
trillion in credit-card lines outstanding in the U.S., and a little more than $800
billion is currently drawn upon. While those numbers look small relative to total
mortgage debt of over $10.5 trillion, credit-card debt is revolving and
accordingly being paid off and drawn down over and over, creating a critical role in
commerce in America.
Just six months ago, I estimated that at least $2 trillion of available
credit-card lines would be expunged from the system by the end of 2010. However, today,
that estimate now looks optimistic, as available lines were reduced by nearly
$500 billion in the fourth quarter of 2008 alone. My revised estimates are that
over $2 trillion of credit-card lines will be cut inside of 2009, and $2.7
trillion by the end of 2010.
Inevitably, credit lines will continue to be reduced across the system, but the
velocity at which it is already occurring and will continue to occur will result
in unintended consequences for consumer confidence, spending and the overall
economy. Lenders, regulators and politicians need to show thoughtful leadership now
on this issue in order to derail what I believe will be at least a 57%
contraction in credit-card lines.
There are several factors that are playing into this swift contraction in credit
well beyond the scope of the current credit market disruption. First, the very
foundation of credit-card lending over the past 15 years has been misguided. In
order to facilitate national expansion and vast pools of consumer loans, lenders
became overly reliant on FICO scores that have borne out to be simply
unreliable. Further, the bulk of credit lines were extended during a time when
unemployment averaged well below 6%. Overly optimistic underwriting standards made more
borrowers appear creditworthy. As we return to more realistic underwriting
standards, certain borrowers will no longer appear worth the risk, and therefore lines
will continue to be pulled from those borrowers.
Second, home price depreciation has been a more reliable determinant of consumer
behavior than FICO scores. Hence, lenders have reduced credit lines based upon
"zip codes," or where home price depreciation has been most acute. Such a
strategy carries the obvious hazard of putting good customers in more vulnerable
liquidity positions simply because they live in a higher risk zip code. With this,
frequency of default is increased. In other words, as lines are pulled and
borrowing capacity is reduced, paying borrowers are pushed into vulnerable financial
positions along with nonpaying borrowers, and therefore a greater number of
defaults in fact occur.
Third, credit-card lenders are currently playing a game of "hot potato," in
which no one wants to be the last one holding an open credit-card line to an
individual or business. While a mortgage loan is largely a "monogamous" relationship
between borrower and lender, an individual has multiple relationships with
credit-card providers. Thus, as lines are cut, risk exposure increases to the remaining
lender with the biggest line outstanding.
Here, such a negative spiral strategy necessitates immediate action. Currently
five lenders dominate two thirds of the market. These lenders need to work
together to protect one another and preserve credit lines to able paying borrowers by
setting consortium guidelines on credit. We, as Americans, are all in the same
soup here, and desperate times are requiring of radical and cooperative measures.
And fourth, along with many important and necessary mandates regarding fairness
to consumers, impending changes to Unfair and Deceptive Acts or Practices (UDAP)
regulations risk the very real unintended consequence of cutting off vast
amounts of credit to consumers. Specifically, the new UDAP provisions would restrict
repricing of risk, which could in turn restrict the availability of credit. If a
lender cannot reprice for changing risk on an unsecured loan, the lender simply
will not make the loan. This proposal is set to be effective by mid-2010, but
talk now is of accelerating its adoption date. Politicians and regulators need to
seriously consider what unintended consequences could occur from the
implementation of this proposal in current form. Short of the U.S. government becoming a
direct credit-card lender, invariably credit will come out of the system.
Over the past 20 years, Americans have also grown to use their credit card as a
cash-flow management tool. For example, 90% of credit-card users revolve a
balance (i.e., don't pay it off in full) at least once a year, and over 45% of
credit-card users revolve every month. Undeniably, consumers look at their unused
credit balances as a "what if" reserve. "What if" my kid needs braces? "What if" my
dog gets sick? "What if" I lose one of my jobs? This unused credit portion has
grown to be relied on as a source of liquidity and a liquidity management tool
for many U.S. consumers. In fact, a relatively small portion of U.S. consumers
have actually maxed out their credit cards, and most currently have ample room to
spare on their unused credit lines. For example, the industry credit line
utilization rate (or percentage of total credit lines outstanding drawn upon) was just
17% at the end of 2008. However, this is in the process of changing dramatically.
Without doubt, credit was extended too freely over the past 15 years, and a
rationalization of lending is unavoidable. What is avoidable, however, is taking
credit away from people who have the ability to pay their bills. If credit is taken
away from what otherwise is an able borrower, that borrower's financial position
weakens considerably. With two-thirds of the U.S. economy dependent upon
consumer spending, we should tread carefully and act collectively.
Ms. Whitney is CEO of Meredith Whitney Advisory Group, LLC.
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