In terms of outstanding debt as a percentage of personal income, consumers hold more debt than ever before. In terms of debt burden, i.e., debt payments as a percent of disposable personal income, the consumer is more burdened today than prior to the last recession in 1990/91 (even though current interest rates are much lower). This suggests that if the economy slips into recession, consumer credit performance will deteriorate sharply, and delinquencies and losses in many consumer sectors could suffer as much as (or more than) in the last recession.

Consumer credit cycles

When one examines the rise and fall of delinquency and loss rates in various consumer finance sectors, it becomes clear that credit performance is determined as much (or more) by changes in underwriting standards as it is by changes in the economy. For example, one of the steepest increases in losses on credit cards occurred in 1996/1997 after card companies engaged in the self-destructive competition of 1994/1995. We used such credit episodes, as well as past recessions, to measure the amount of deterioration that might occur if, indeed, a recession develops.

ABA Composite Index

The chart opposite shows the ABA index for the past twenty years. Several things stand out. Peak delinquency rates of 2.75% during the last recession (1990/91) matched the peak reached in early 1980's recession. The credit crunch associated with that latest recession caused many banks and finance companies to cut back their lending sharply, and they provided loans only to their best credits. A result of that tighter underwriting was the superior credit performance of 1994 (shown in chart). Because that low level of delinquencies is associated with a period of severe credit tightening, we doubt that credit performance will attain that level in the near future.

The outstanding performance of 1994 was also followed by a loosening of credit standards and a corresponding increase in delinquencies. By 1997, delinquencies climbed back almost to 1990/91 recession highs - and this was within a strong economic environment. Many lenders to the poor performance by once again tightening lending standards, and again, performance improved. There are presently some indications that credit in general has started to slip again - but only slightly. The ABA Composite Index seems to indicate that credit performance today is roughly comparable to what it was just before the last recession.

From its 1988/1989 level to the peak in 1991, the ABA Composite Index rose about 15-20%. If the economy slips toward a recession in this cycle, delinquencies may again increase to underwriting nearly the level reached in 1991, i.e. rising by around 20% downturn.

Credit card delinquencies

The credit cycle of 1994-1997 was more severe in the card industry. Delinquencies increased more in that cycle than they did in the 1990/91 recession - a testament to how far card companies lowered underwriting standards in their drive for market share.

The 1994-1997 credit cycle was not as severe as in cards, but current levels are well above the level prior to the1990/91recession. Since auto performance numbers are not that far below the peaks reached in either the 1990/91 recession or the credit cycle of 1994-97, it seems possible that in a recession, delinquencies and losses could surpass previous highs by a modest amount.

Mortgage delinquencies & foreclosures

Delinquencies in the mortgage sector differed from other consumer debt sectors. Delinquencies in the 1990/91 recession or in the credit cycle of 1994-97 did not approach levels achieved in the mid-1980s. That was the peak of the S&L crisis, and it seems unlikely we will revisit the conditions that period was noted for. However, performance over the last several years has been very good. Coming off of that base, we suspect that in percentage terms, the increase in home mortgage delinquencies may be greater than in other sectors. A rise back to the levels of the 1990/91 recession (for an increase of 45-50%) would not be surprising.

Our guess is that foreclosures, along with delinquencies, could increase by 40-50% in a cession. This would take them both back to levels prior to the last recession.

Personal bankruptcies

Personal bankruptcy rates soared from 1994 to 1998. This helps explain the 1994-1997 credit cycle. Delinquencies and losses on many consumer finance sectors are tied closely to bankruptcies. In the credit card sectors, they account for 40% of some issuers' charge-offs. In the hi-LTV sector, they account for over 50% of losses. We think the steep increase in personal bankruptcies between 1994 and 1998 was a one-time event, as the country became more accepting of bankruptcy. Much of the stigma once associated with bankruptcy is no longer in the national psyche. However, we doubt there will be another outsized increase from current elevated levels. Hence, we look for only about a 35-40% increase in bankruptcy rates if a recession develops.

Overall picture

In general, a change of 50% (in consumer credit deterioration) appears to have covered most of the deterioration in the last recession. That percentage also seems to be a reasonable average of what to expect if a new recession develops. In the event of such a scenario, we need to ask the $10 million questions of, "How will increased losses impact cash flows in various structured product categories?" and "How might a recession impact spreads?".

Enhancement vs. losses

One way to address the first question is to compare expected recession losses to credit enhancements. Credit losses will be much greater in some sectors than others, but credit enhancements required by the rating agencies take into account precisely such possibilities.In the case of Jumbo loans, current cumulative loss rates are extremely low compared to historical norms. For home equities, they are high.

While on average our analysis suggests a 50% increase in delinquencies and losses, the increased level of stress would be relatively short lived, say, a year or so. Peak loss periods shown for the 1990/91 recession and the 1994/97 credit cycle for instance, lasted only about 1 year. So the increase in total cumulative losses for these asset classes would not be nearly as great as the increase in period losses from valley to peak. Hence, using a 50% increase in cumulative losses appears to be a very conservative estimate.

AAA bonds on all of the sectors (including the hi-LTV) have a good amount of protection even in a recession. However, there is a large difference in the amounts of protection. Jumbo MBS AAAs have an enhancement-to-expected-loss ratio of 10, com-pared to a ratio of 3 for home equities and 1.8 for hi-LTVs. While not always the case, this particular ranking is also a good indicator of how spreads on these classes are likely to behave in a recession.

Prospects for widening

One of the remarkable aspects of Q4 2000 was the widening in corporate bonds and the limited widening in structured products. We(and others) have often made the case in recent years that the ABS market, because of its inherent structural protections, was likely to hold up much better than corporates in a recession. The recent episode seems to confirm that belief. But as good as that performance has been, it has come at a time of very strong credit performance in consumer finance. We suspect that ABS and other structured markets cannot remain forever immune to the consequences of a sharp slowdown in the economy.

So far, there has been little change in the employment picture, which is the key to consumer credit performance. A shift in consumer sentiment can bring about a change in retail spending, but it takes an increase in the jobless rate to have a significant impact on consumer credit. The slowdown has so far caused little unemployment, but we suspect that will occur in coming months, what with mounting news stories of lay-offs. If the economy begins to recover without any major loss of jobs, then there will be little change in credit performance. But we think that unlikely.

The corporate market has bounced back, but spreads remain well above those reached in the credit crisis of 1998. By contrast, while structured products are not far from their 1999 wides, they are still far inside their 1998 wides. This suggests that if consumer credit begins to deteriorate - these markets are vulnerable and will tier by asset type and rating level. The steepest widening seems likely in subprime sectors (such as home equities and subprime autos), and in non-investment subordinate sectors (which are those most exposed to credit losses).

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