New lending risks consumer attitudes

RMA Journal, The, Feb, 2003 by Claude A. Hanley, Jr., Edward E. Furash

How--if at all--will the current bear market alter consumer financial behavior? Consumer expectations are the economic watchwords this year.

Heaven knows, there is no shortage of dark clouds on the horizon, given all the unwelcome developments of the past two years. Lately, the consumer is one of the more threatening clouds. But do we really need to pull out the industrial-strength umbrellas?

Consumers now use all the financial tools available to them--borrowing, making and redeeming investments, using paycheck income, and dipping into savings--to acquire and sustain their desired lifestyle. They are extremely reluctant to cut back and do not do so until their financial expectations become truly gloomy. Few lenders recognize or measure the impact of falling consumer expectations. Yet it is an increasingly important part of controlling consumer lending portfolio risk.

Lasting Effects

The severity of the decline in equity values certainly has the potential to leave scars on the consumer. The Dow Jones Industrial Average has declined approximately 38% from its peak in January 2000. The other major indexes have suffered similar or worse fates. Stock market losses now total in the trillions of dollars, including an estimated $678 billion of retirement assets. The standing joke is that 401(k)s have become 201(k)s. More than a few investors are too afraid or too depressed to open their monthly brokerage statements. They now perceive stock market rallies as a precursor to quick sell-offs rather than signs that the trough has been reached.

Because the last decline to resemble the current environment was in 1973 and 1974, investors under the age of 50 have not experienced firsthand the bottomless anxiety that a prolonged bear market can produce. Meanwhile, the percentage of households with direct exposure to the equity markets has more than doubled since that time. And whereas the economy continued to grow following the sharp, but brief, 1987 stock market crash, today's recovery is hampered by significant international turmoil and economic recession, as was the case in 1973-74.

Household Spending and Saving

It's natural to assume that such a precipitous decline in stock values will spur households to save more and spend less. However, based on experience and economic theory, it is doubtful that this bear market will reverse the decline in the personal saving rate that has occurred over the past three decades. Irrational as it may seem, consumers tend to keep up their spending levels until adversity is overwhelming. Besides, it is the wealthy who account for most savings and investments, while the majority of consumers live from paycheck to paycheck.

The wealth effect theory holds that household spending levels depend on whether wealth is rising or falling. Steep losses in investment portfolios should lead to an increase in household savings. Yet consumer spending grew during this current bear market as well as in 1987. While the personal saving rate did increase in 1973 and 1986, the increases were ephemeral. In subsequent years, the personal saving rates sank below the rate that prevailed prior to the onset of the bear market.

The explanation for this seemingly contrary behavior springs in part from the psychology of expectations. In addition to changes in wealth, household spending is strongly correlated to expected earnings. Despite declines in the stock market, household income has increased in real terms, unemployment remains reasonably low, and tax rates have declined. Consumer spending shrank in 1974 because households were pessimistic about expected income. The unemployment rate was much higher and the economic outlook bleaker than today's.

Another part of the explanation for sustained spending in the face of declining stock values lies in the appropriate measure of household wealth. The personal saving rate omits changes in home equity--the primary source of wealth accumulation for most households. Home prices rose 8% in 1987 and have increased 6.2% from the third quarter of 2001 through the third quarter of 2002. These appreciation rates exceeded the more modest appreciation experienced in 1974. So in this bear market, home values have been rising enough to offset the impact from eroding portfolios. A slowing of home appreciation could, therefore, have a severe dampening effect on consumer expectations. As long as people are optimistic about their expected future income and home values appreciate, consumption and saving patterns are unlikely to change significantly outside of those that occur from normal demographic trends.

Borrowing Behavior

The bear market has not dampened the willingness of consumers to borrow. In this respect their behavior in this economic cycle is far different from that in previous ones. Typically, consumer credit is highly cyclical, falling as the economy enters a recession and rising quickly in the expansion that follows. This time around, consumers have continued to borrow through both a recession and a severe bear market. Household debt has increased to more than 100% of disposable income (income after taxes), which is the highest percentage on record. The level of debt service burden--defined as households' required debt service payment as a percentage of disposable personal income--is currently at 14%, which approximates the record levels reached in the 1987 bear market.