How To Think About The Great Consumer Debt Plunge

Over the next few days you’ll likely hear lots of theories trying to explain today’s news that consumer credit card debt plunged at an annualized rate of 9.7%–the biggest drop ever recorded. Beyond the blather though, there’s a simple truth: Consumer debt declines are very normal during a recession and this fall is steeper because during our last recession, the Fed and structural market changes prevented this normal slide from occuring.

Declines in household debt usually lead a recession by several months. The decline continues steadily through the recession for about a year, and then it begins to climb again as consumers and lenders begin to regain confidence. This is not necessarily a healthy pattern–lots of waste happens in the boom preceding the recessions–but its end product is desirable: a less levered public and financial sector that is able to move away from the bad decisions in the past.

Something very different happened in the recession that followed the dot com bust.  The Federal Reserve held interest rates very low, housing prices climbed and securitization of consumer debt grew at a rapid pace. The result was the household debt kept growing, as did consumer spending and credit card use. Consumers kept on  increasing debt loads despite the fact that their asset holdings were declining in value. Soaring real estate values only partially offset the effect of declining stock values, leaving household net worth $4.2 trillion lower at the end of 2002 than it was at the start of 2000. But consumer debt kept climbing.

The chart below illustrates how different the last recession was from the historical pattern.



Banks during this period were convinced that a “consumer credit revolution” was under way. New computer driven models for estimating borrower risk coupled with more sophisticated consumer credit scores convinced them that this increased debt could be managed and priced accordingly. Increases in the amount and sophistication of securitization gave lenders both the ability and impetus to develop and implement sophisticated risk-based pricing strategies that they could sell to investors. The myth of the “resilent American consumer” grew up to support all this new consumer lending.

If this sounds familiar, congratulations. You’ve been paying attention. The growth of consumer debt mirrored in many ways the growth of mortgage debt. Unfortunately, the risk models were flawed in the very same way that mortgage risk models were flawed. Basically, both assumed that borrowers burdened with a higher level of debt than historically precedented would continue to behave like borrowers had with lower levels of debt. Additional mathematical modelling, based off of things like CDS pricing, only compounded this initial error.

The reason we’ve seen such a head-turning pullback in consumer credit is that we’re actually correcting not just for this recession but the last one as well. We’re in double correction mode, making up for a credit boom in the early years of this decade that only pushed off the inevitable deleveraging and most likely made it far more painful.

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