Consumer credit: where did it all go wrong?

Evidence on both sides of the Atlantic suggests more and more consumers are hovering at the brink of insolvency. But why did lenders let their lending criteria become so lax?

Financiers have, over a long period of improving economic conditions, dramatically loosened their criteria. In the early stages loans are prudently arranged. However, strict credit criteria limited their business growth. It was only a matter of time before one of them, in an endeavour to widen his business, became more lenient and so the loan books grew. Lowering the barrier to entry seemed to put no pressure on the loan book whilst significantly increasing profits it caught on fast.

Consumer credit: consequences of looser lending criteria

The consequence of loosening lending criteria is that assets and businesses purchased by less credit worthy borrowers, rise in value. The rise in value attracts the interest of other investors who, assisted by further credit laxity, drive asset prices higher still. A point is finally reached where superficially it appears that, by virtue of what has happened, lending to almost anybody is very profitable and seems to be risk free. The deals get bigger and the lending gets braver. All of this took place on Tony Blair's watch.

The lax credit practices eventually reach a point of absurdity as was recently illustrated by Scot Perling, President of Thomas H Lee Partners, a large Boston private equity company, he said "I can't think of the last time we had real covenant in one of our deals" a deterioration of financial underwriting, unthinkable at any other time.

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The extraordinary and ever repeating paradox is that early in the cycle when asset prices and businesses are relatively cheap, only the financially strong can obtain finance, the terms and conditions financiers impose are at their most strict. Late in the cycle, when prices are in bubble territory, both lenders and borrowers have the least concerns about risk - just another version of the buy-high/sell-low mentality forever prevalent in the human psyche.

Consumer credit: personal insolvency rates

UK's personal insolvencies in the first quarter of this year exceeded 30,000 for the very first time a record. In many cases bankruptcy was a direct result of running up credit to fund lifestyles that incomes could not afford. Nobody knows the scale of this activity but we have, on a number of occasions, suggested that there are huge numbers throughout the developed world doing just that who are still getting away with it - A good time for Tony Blair to depart.

Central Banks by increasing interest rates to choke off inflation will also, in financial terms, choke these imprudent over-borrowed consumers to death.

There are two recent statistics that give evidence to this. The first is in the UK where Barclays say that half the applicants for Barclaycard are refused. Many of those refused by Barclaycard will be in deep financial trouble and if they can't extend their credit lines, they are frighteningly close to joining future insolvency statistics. That process will have accelerated now that the Bank of England has increased rates by 0.25% and are expected to repeat that later this year.

The second data came from the US and is a little more subtle. In April, consumer credit increased by $13.46 billion to a new record high of $2.426 trillion, an annualised 9.2%. Separately, we hear that April was a disastrous month for American retailers. The logical explanation of record consumer credit linked to poor retail sales is that at the margin many consumers are desperate and need cash from somewhere to finance their day-to-day living expenses. For these, time is running out.

The latest poor retail sales from America followed very closely the disappointing jobs number, only 88,000 new jobs were created in March and the poor GDP growth figure for the first quarter 2007 at 1.3%, which has been put under further pressure by the larger than expected trade deficit for March. Peter Kretzmer, Senior Economist at Bank of America, says it will trigger a revision of that figure down from 1.3% to 1%.

Consumer credit: credit cycle is turning

What nobody knows is just how many consumers are vulnerable, how many are out there, as yet, uncounted because they haven't yet fully exhausted their credit facilities. However, their eventual financial demise cannot be avoided now the credit cycle is probably turning.

We have already said in this issue that Central Banks do not control all credit which makes the whole business of tracking what's going on more difficult. However, basic principles sustain and historic behaviour is repeatable, the contagion that occurs as credit criteria becomes more lax is just as contagious when credit tightens. Central Banks are tightening and certain sectors, particularly in the personal finance area, as evidenced by Barclaycard and the American mortgage market, is being far more restrictive.

Contracting credit is starting to unfold and will leave those who are financially secure not only untouched but, in due course, presented with huge investment opportunities.

By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.

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