Standard Life Investments

Weekly Economic Briefing

US

A tale of two credits

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The trends in mortgage and motor vehicle debt could hardly have been more different over the past 14 years. In the seven years between Q1 2003 and Q1 2010, mortgage debt increased by close to 80% (see Chart 2), more than twice the growth in households’ personal disposable income. Auto lending was much more restrained; increasing by just 10%, less than a third of the growth in disposable incomes. Although lending standards were too easy in both segments of the market, 90-day delinquency rates on auto debt peaked at a little over 5% in 2011, worth around $36 billion, while mortgage delinquencies peaked at 8.5% in 2010, worth $750 billion. These enormous bad mortgage debts combined with the financial engineering that had converted pools of securitised low-quality housing loans into speculative assets, were a major cause of the financial crisis.

Autos drove the current cycle... ...but a correction now taking place

In an all too familiar story, these relative positions have almost completely reversed over the past seven years. Thanks in part to a significant tightening in lending standards which saw mortgage originations to individuals with credit scores below 720 falling to just 18% of the total by 2012, mortgage debt is still some 4% lower than it was in early 2010, though it has been growing at a similar rate to disposable incomes over recent quarters. In contrast, a relatively brief period of tightening in auto lending standards during and immediately after the recession was followed by significant easing. Today, lending to people with credit scores below 720 make up 56% of all auto loan originations and the level of auto lending is 64% higher than at the start of 2010 – double the increase in disposable incomes.

How concerned should we be about what has been happening in the auto market? From a macro perspective, we think only modestly. Auto lending has been excessive and underwriting standards sometimes lax. That helps to explain why auto delinquency rates have started to edge up even though the unemployment rate is coming down and disposable incomes are growing at a healthy clip. We are now beginning to see a correction with auto lending standards having tightened for three quarters and auto demand dropping off (see Chart 3), highlighted by the drop off in light vehicle sales over recent months. It is too early to tell if sales will continue to drop, but at the very least autos are unlikely to be a significant positive economic driver through the rest of the expansion. If there are further outright declines in sales, some correction in domestic and foreign light vehicle production is unavoidable given that there appears to be a modest inventory overhang in the sector. That has the potential to cause some pain to the auto companies and their investors as well as those that have financed the lending excesses, particularly if delinquency rates continue to pick up. The Federal Reserve will therefore need to watch the sector carefully. That said, the sector’s challenges are not large enough to be systemic. The outstanding stock of auto debt is $1.1 trillion. Auto debt rolls over more quickly than housing debt and even if delinquency rates increased to double those seen in the aftermath of the financial crisis, the value of those delinquencies would be less than a seventh of the value of bad housing debts in 2010. Critically, lending standards and delinquency rates in the much larger and more systemic mortgage sector continue to improve.

Jeremy Lawson, Chief Economist