US borrowers are hanging tough through COVID... or are they?

History shows that spikes in unemployment lead to spikes in credit defaults. So with 40M Americans currently unemployed, how are borrowers managing their debt burdens and is a consumer credit crisis still to come?

‍

Since it began, the COVID-19 crisis has forced major corporations into bankruptcy and led governments to default on debt or seek emergency assistance.

So, it’s only natural to fear for the fate of US borrowers. Venture capitalist Chamath Palihapitiya has predicted that “credit markets [will] roll over with increasing defaults” by the end of 2020 and Nouriel Roubini has echoed the sentiment.

If the current data is to be believed, however, it looks like American borrowers may be hanging tough, with numbers from both March and April showing that US consumer credit defaults remained at or below pre-COVID levels.

While this stat could be good news, it also raises the question: with 40 million Americans currently jobless and GDP projected to fall 39 percent this quarter, where’s the expected wave of consumer credit defaults?

A Fortune headline captured this disconnect last week: American consumers are managing their $14T debt burden — for now. The piece cites a Goldman Sachs report that notes, “defaults and delinquencies on consumer loans typically increase in lockstep with unemployment figures…[but] so far they have been less dramatic than their historical relationship with unemployment suggests.”

So what explains this apparent change in borrower behavior from past economic crises? Are American borrowers better positioned now to manage their debts through crisis? Or does the data we’re seeing mask the true extent of consumer credit distress still to come?

Let’s look at reasons the consumer credit markets might be holding up ⁠— or falling apart.

‍

The case for consumer credit staying strong

While the total amount of US consumer debt in 2020 exceeds 2008 levels, the distribution of that credit has been to more low-risk individuals. At the peak of the pre-2008 housing boom consumers with credit scores below 660 represented 15 percent of all mortgage borrowers. Today, consumers with credit scores below 660 comprise less than 7 percent of all mortgage borrowers.

Consumer discretionary spending ⁠— particularly on retail, travel, and entertainment ⁠— has cratered. For borrowers who remain employed, this drop in spending means more cash to pay down debts without increasing balances. As a result, bank deposits are up 15 percent since February and credit card debt is down $80B since March.

The government’s $2T relief package has replaced or exceeded many jobless workers’ salaries until July, which is helping millions of Americans manage their debt burdens.

Borrowers have fewer strategic default incentives today than they did in 2008. Economist Amy Crews Cutts notes that many homeowners in 2008 wound up with negative equity in their homes, which gave them an incentive to stop paying their mortgages. This time, far fewer homeowners have negative equity. Also mortgage servicers and auto lenders have been quick to grant forbearances, allowing borrowers to tack missed payments to the end of their loan terms without penalty and thereby mitigating incentives to default.

The case that a consumer credit crash is yet to come

Once COVID hit the US, the economy declined so quickly that the data may not have had time to reflect just how bad things are for American borrowers. As the New York Federal Reserve Bank acknowledged last week, there can be a lag of up to 30 days in reporting credit delinquencies, meaning that consumer data from March and April is still largely “a pre-COVID-19 view of the consumer balance sheet.”

The Government’s CARES Act has mandated that most of the individual loans in forbearance must be reported as current. But lenders are still allowed to report the total number of forbearances in their portfolios without identifying specific names — and the totals being reported are eye-poppingly high. The number of mortgages more than 30 days past due but not in foreclosure jumped 90 percent in April, three times the largest-ever single-month increase. Meanwhile, 18M borrowers are now in some kind of financial-hardship assistance program.

The $600 weekly supplement payments to Americans receiving unemployment benefits are due to run out in July. A bill to extend those payments appears unlikely to pass the Senate, and the chances are high that the economic downturn will outlast these relief efforts.

Even if the unemployment rate falls, CBO projects that joblessness will remain higher than historic averages (around 10 percent) through at least 2021. History and academic studies have repeatedly demonstrated that spikes in unemployment lead to spikes in credit risk.

While prime and super-prime borrowers have paid down balances since the onset of the crisis, recent New York Federal Reserve data shows a material increase in the number of credit card, auto and home equity loans that are seriously delinquent. For example, the number of auto loans more than 90 days past due surged 13 percent in Q1 compared to a year ago.

Eager to attract buyers, some auto lenders have been offering combinations of zero down payment, zero percent APR and 84-month loan terms. But, as The Drive points out, “a lot of shoppers drawn in by big discounts and cheap financing may end up with a car payment that will stretch their finances.”

‍

So, what does the future hold?

We’d like to believe that this time around American borrowers, helped by post-2008 reform measures and better risk models, have a built-in resilience that will shield them — and the financial institutions that lend to them — from a coming default crisis. If continued government intervention combines with a V-shaped economic recovery, this prediction may prove true.

Unfortunately, there’s a strong case that what we’re seeing now is the early stage of a slow-motion credit crash. The data from March and April largely reflect a pre-COVID world and the CARES Act is restricting the reporting of derogatory credit information, meaning that we still aren’t seeing the full extent of consumer distress.

One thing is certain: the longer it takes to re-establish public safety and reopen the economy, the more likely a consumer credit crash becomes.