Will the debt avalanche engulf us all?

published 15 August 2006

More and more people are in debt that they can't repay, and are turning to bankruptcy or IVAs to bail themselves out, says Graham Buck. Is a crisis in the making?

Consumer debt: how big a problem is it?

Bad enough to take much of the shine off the record first-half profits reported by the big banks. Increased bad-debt provisions ranged from £361m for HSBC, still 36% higher than a year ago, to Barclays hiking its figure by 50%, to just over £1bn. The Department of Trade and Industry says that a record 26,000 people became insolvent in England and Wales between April and June a rise of 66% on the same period last year. Meanwhile, the Consumer Credit Counselling Service (CCCS) says that those with debt problems are increasingly resorting to Individual Voluntary Arrangements (IVAs). The total number of IVAs arranged in the second quarter was 11,105 up 153% year-on-year.

IVAs enable those who have lived beyond their means to reorganise their debt and pay off a set amount monthly in return for creditors freezing interest. Debtors agree to pay back a proportion of the total, usually a minimum of 25%, and when an IVA ends typically in five years the debtor is declared debt-free. The big difference between IVAs and bankruptcy is that someone taking out an IVA is able to keep their home. For this reason, IVAs aren't generally available to people with large amounts of equity in their property. IVAs have been around since 1986, but the recent boom is an inadvertent consequence of the 2004 Enterprise Act, says Bill Jamieson in The Business. The act aimed to boost "enterprise Britain" by helping entrepreneurs recover more quickly from the trauma of bankruptcy. Bankrupt businessmen could be discharged after just one year, instead of three.

The aim of IVAs was laudable, but they seem to have become a "lifestyle" choice for those who have run up huge loans or credit-card debts that they have no hope of repaying, says Lisa Buckingham in The Mail on Sunday. For them, an IVA is preferable to bankruptcy and home repossession. But IVAs are deeply unpopular with banks because they typically get back only 40%-60% of the loan. Banks now claim that firms are aggressively marketing IVAs; Northern Rock's chief executive even claimed firms that advertise them on TV are "ambulance chasers", says Paul Farrow in The Sunday Telegraph. Buckingham agrees that unscrupulous financial advisers have encouraged IVAs and says the area urgently needs regulation.

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Some firms are giving people misleading impressions of IVAs and how much debt they'd be able to write off by using one, say Emma Lunn and Patrick Collinson in The Guardian. An IVA is definitely not for everyone. Debtors should first approach a debt counsellor, such as the CCCS, which says that it recommends IVAs in only 3% of cases. A debt-management plan is, it claims, often a better option. Such a plan involves an informal arrangement that gives those deeply in the red extra time to repay their debt. While it doesn't write the debt off, it won't have the same negative impact on an individual's credit record that an IVA or a bankruptcy will.

No. IVA firms aren't creating debt problems out of thin air there are a lot of people out there who are in significant debt and the responsibility for their borrowing and spending habits lies with them. The rise in IVAs reflects a genuine problem among a financially overstretched population. Moreover, it is rather hypocritical of the banks to complain about this state of affairs, when they themselves have done so much to create the problem, says Farrow. Three years ago, banks embarked on an aggressive marketing mission, spending £652m in 2003 on direct mail and £621m in 2004 £500m more than the retail sector splashed out in both years. Banks urged their staff to lend, and lend they did "sometimes without proper tests of affordability", agrees the Financial Times. As unemployment has ticked up from 4.7% to 5.4% in the past year, some of these loans inevitably turned bad.

Apart from grumbling about IVAs, the banks are also taking more productive action. Britain's banks are finally tightening their lending criteria, says Farrow. HSBC caps the amount that its advisers can lend without referral and Nationwide insists that borrowers wanting an interest-only loan also arrange a repayment vehicle. Barclaycard now rejects about half of the loan applications it receives. Banks are also marketing a little less frantically, although the industry still spends more than any other on pedalling its wares. But the tougher lending standards apply mainly to unsecured loans. Banks seem to be competing to hand out ever-riskier amounts of cash on mortgages, with loan terms becoming longer and salary multiples ever higher.

It looks highly unlikely, and the Bank of England's quarter point interest-rate hike this month won't help. Barclays' chief executive, John Varley, admits things are likely to get worse before they get better. This means that IVAs, bankruptcies and repossessions are likely to keep rising and banks' complaints and calls for regulation will grow more shrill. However, another dangerous consumer-debt squeeze to match that of the early 1990s seems unlikely for now, says Edward Hadas on Breakingviews.com. Growth is strong and unemployment, although rising, remains low by historic standards. The ingredients of a crisis "aren't really present at least not yet".

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