By Sally Kearney, Office of Public Affairs

How much is too much? What are the credit quality implications for banks? Experts discuss the level of household debt and what it means to our economy and our financial institutions.

Are U.S. consumers carrying too much debt—or has the definition of "too much" changed in recent years? Will today’s debt levels imperil our economy? How will the credit quality of consumer portfolios held by FDIC-insured institutions be affected? These were some of the questions raised at a recent roundtable held at FDIC headquarters. Experts convened to discuss their views on the situation today.

Maureen Sweeney, Deputy Director, Division of Insurance and Research (DIR), and the roundtable moderator, kicked off the discussion by noting "We’re in uncharted territory." With consumers purchasing cars and homes in record numbers, mortgage debt on the rise and a record number of bankruptcy filings, many observers are wondering where the economy is headed and what the effects will be.

FDIC Chief Economist Rich Brown found strong consumer spending, sustained income growth and abundant household refinancing all to be encouraging trends, but he also listed reasons for concern: it is unusual for debt to increase during a recession; household net worth is declining; the debt service burden is still high; and the most vulnerable households are showing signs of distress. Brown said that without strong job and income growth this year, households could cut spending or consumers’ ability to repay their loans could be threatened.

However, these trends are occurring against a backdrop of change, Brown said, citing a "revolution" in consumer lending. Widely available revolving lines of credit, the use of credit scoring, pricing according to risk, deregulation and securitization have all helped bring about a new environment for borrowers and lenders, one that is difficult to gauge accurately. This changed lending culture provides one explanation for the unusual consumer debt trends that have been observed recently. Although some features of the consumer lending revolution involve increased risks, many other aspects are strongly positive in that they allow consumers more options and flexibility in managing their finances. In general, banks have successfully adapted to the new culture and posted solid performance results, while consumers have benefited from increased access to credit. Brown does worry about subprime lending, though. The models used by economists and banks to predict losses have come up short, and many of the failures in recent years have been directly tied to subprime lending.

Senior Economist Karen Dynan of the Federal Reserve Board forecast continued brisk mortgage refinancing by households and a negligible effect on consumer spending from increased borrowing. Total real debt growth is not jeopardizing households’ balance sheets, she said. Indeed, the growth in consumer debt has been led by an increase in low-cost, tax-advantaged mortgage debt and comes as the homeownership rate is reaching record highs. "A closer look at the source of debt growth suggests that debt levels are not a risk to households’ ability to keep spending at a reasonable pace," she said.

In addition, refinancing has enabled homeowners to restructure their debt and has lessened the debt service burden, Dynan said. "Household debt levels seem unlikely to significantly restrain spending growth in coming quarters," she said.

Professor Michael Staten, Director of the Georgetown University Credit Research Center, noted that the percentage of families with high debt loads came down a bit during the period of 1998 to 2001, compared to the period between 1995 and 1998. "Even though households have been taking on more debt, the debt service burden has not increased," he said.

Staten also notes a changing consumer lending environment. Specifically, he sees the increase in bankruptcies over the past 15 years as an indication of a structural shift due to consumers’ broader access to credit. Lenders have "gone down deeper into the risk pool," he said. In doing so it’s only to be expected that loss rates will rise, and bankruptcies are one symptom of that, he said. "Having a bankruptcy safety net makes consumers less cautious," he said. "It reduces the pain of going through a protracted payments process and becomes a first choice rather than a last resort." Creditors have demonstrated a willingness to lend even to borrowers who have a former bankruptcy. "There is little political support for legislation that would substantially curtail bankruptcy rights," he said, which is one reason not to expect a substantial decline in filings. As a result, bankruptcies may have permanently trended upward, and are a less useful indicator than in the past as to whether consumers are struggling with unmanageable debt levels.

Staten said that the Federal Reserve’s Survey of Consumer Finance results from 1998 to 2001, compared with 1995 to 1998, show improvement. "We were alarmed in 1998, and are less alarmed as a result of seeing the 2001 evidence," he said. Consumer markets are largely self-correcting, with consumers taking on more debt during expansionary periods, after which delinquencies rise, creditors pull back and households slow down. "In the macroeconomic sense, there is very little to worry about," he said.

Ken Posner, Specialty Mortgage Finance Analyst, Morgan Stanley, also predicts that some type of correction will take place. He said he believes consumers will begin to increase savings over the next several years. He predicted that consumers will begin "a modest deleveraging of the balance sheet going forward." His intuition is that debt will level off given some of the risk factors. "Expectations are way down," he said. "We see that in consumer confidence numbers." If people are less optimistic about the future, he said, it would make sense that they will carry less debt.

Emphasizing cyclical factors, Posner also said his model shows a gradual deceleration in bankruptcy filings. "Bankruptcies were falling in 2000, reversed in 2001, and are still rising today," he said. "Our model looks for improvement in 2004." Considering recent economic trends, including labor market conditions and credit growth patterns, the past cycle looked to Posner like an ordinary bankruptcy cycle. Noting that he does not think consumers are irrationally exposed to credit, Posner said of consumers’ behavior with respect to bankruptcy: "This is about what you would expect." He said his forecasts suggest that the economy will be soft in 2003 and will pick up in 2004.

Christine Dugas, Personal Finance and Banking Writer, USA Today, related some of the anecdotes she hears from consumers. Examples included a person who racked up $40,000 in loans, a senior citizen who incurred unexpected medical expenses and as a result was having financial difficulty in retirement, a medical student who accumulated $400,000 in student loans, and a college freshman with $20,000 in credit-card debt. "My parents never had credit cards," Dugas said. "Today, people don’t see a reason to defer purchasing. They want big screen TVs, cars and a home."

Attitudes toward bankruptcy have also changed, she said. "Some people choose bankruptcy to avoid bill collectors. Older Americans are filing for bankruptcy in higher numbers." Dugas sees financial education as a potential antidote to bankruptcy. While schools are getting more involved, she said that financial education is still a patchwork in this country.