Cyclical Performance of Consumer Credit

Given that the peak of the most recent business cycle was reached in March 2001, how has the market for consumer credit behaved since that time—especially after September 11? Did outstandings grow more slowly, or even decline? Did delinquencies rise?

Declining interest rates

One of the tactics that the Federal Reserve used to counter the effects of the slowing economy was to lower interest rates. As we learned in Economics 101, lowering the price of a consumer good or service normally causes consumers to purchase more of that good or service. For example, we noted in an earlier Spotlight that finance subsidiaries of auto manufacturers cut their financing rates to 0% for some consumers in order to support sales. Also, many credit card programs have tied the interest rates on their credit to some general index of interest rates, such as the prime rate. Therefore, as the prime rate fell, so did the financing rates on many credit cards.

The accompanying table shows how interest rates on various types of consumer credit changed from the first quarter of 2001, which marked the beginning of the recession, to November 2001, the last period for which data are available.

Growth rates of different types of consumer credit

Note in the following table that the annualized rate of growth of consumer credit dropped from 10.3 percent in the first quarter of 2001, when the business cycle peaked, to 4.6 percent in the second quarter and 1.3 percent in the third quarter. The lowered price of consumer credit encouraged consumers to "buy" more credit than they would have chosen to use at higher interest rates. Of course, consumers use credit to buy goods and services, so the Fed's tactic moderated the negative effects of the recession. By October the Fed's efforts were rewarded with a growth rate of 8.3 percent.

There was a significant difference between the growth rates of nonrevolving and revolving credit. In the third quarter and October, the percentage increase in nonrevolving credit more than offset the decline in revolving credit. Finance companies accounted for most of the growth in nonrevolving credit. Between the end of the first quarter of 2001 and October 2001, finance companies' holdings of consumer credit rose by 10.8 percent, while outstandings of other creditors fell by 2.6 percent.

Declining credit quality

On the one hand, the lowered cost of credit partially offset the effects of the recession by facilitating consumer's' purchases of goods and services. On the other hand, as consumers responded to the lower cost of credit, delinquencies and credit losses rose. The efforts of lenders to maintain volume by lowering interest rates attracted some consumers who found it difficult to repay their loans.

Two independent sources document the increase in delinquencies and charge-offs. Moody's latest report shows that delinquencies and charge-offs on bank credit cards have continued to rise, although profits on card portfolios have not declined, as might be expected. Moody's analysis is based on more than 225 securitized credit card portfolios with outstanding receivables of $335 billion. Moody's reports that in October 2001, delinquencies of 30 days or more reached 5.30 percent of outstandings, up from 4.83 percent in October 2000, and the highest level in more than three years. Charge-offs amounted to 6.37 percent of outstandings. Nonetheless, profit margins remained stable because the banks' cost of funds had been declining with the series of cuts in the Federal funds rate. Moody's anticipates an improvement in the quality of bank credit card portfolios over the next year.

The Federal Reserve reports that from mid-2000 to the end of the third quarter of 2001 (latest data available) charge-offs by commercial banks on residential real estate loans rose by almost five times, from 0.12 percent to 0.57 percent. Over the same period, charge-offs on credit cards rose from 2.35 percent to 2.76 percent. Charge-offs on other consumer loans grew from 3.97 percent to 4.77 percent.

Auto finance companies paid a high price for cutting their finance rates in order to support their automobile sales. As we noted in earlier issues of Spotlight, both Ford Motor Co. and General Motors offered zero percent financing to qualified applicants. Danny Hakim reported recently in the New York Times that Ford Motor Credit's losses in the third quarter were 1.37 percent of total loans, up from 0.87 percent in the same quarter of last year. It is worth noting, however, that banks have cut their market share of automobile loans because they cannot afford to compete with the low rates charged by the finance subsidiaries of the manufacturers.