San Francisco Regional Outlook - Fourth Quarter 1998
Consumer Credit Portfolios Face Challenges
Can Consumer Spending Keep the Region's Economy and Consumer
Lending Going Strong?
Robust consumer spending was a major factor in the continued expansion
of the economies of the Region and the nation, particularly during the
first half of 1998. However, during summer 1998, both economies were
exposed to a series of shocks that lowered consumer confidence levels
and dampened consumer expectations. Many analysts fear that as a result
of these events, consumers may alter their spending plans. Potential
weakness in consumer spending in the months ahead could have important
implications for the economy and for lenders.
The following national economic conditions, which helped bolster
consumer confidence during the first half of 1998, may be adversely
affected by the summer shocks:
The economy recorded strong growth.
The unemployment rate dipped as low as 4.3 percent in May.
The inflation rate fell below 2 percent as inflation
The bellwether 30-year Treasury bond yield was at or near decade
The stock market appreciated considerably.
Low unemployment, healthy income growth, favorable financing terms, and asset appreciation buoyed
consumer confidence and prompted consumers throughout the nation to spend freely. During this
period, the gap between consumer spending and income growth widened (see Chart 1). To finance this gap, consumers have relied on debt
restructuring, the assumption of more debt, and appreciating asset values.
Households have been able to assume more debt relative to income in the past few years without
boosting their monthly payments (see Chart 2). They have stabilized
debt payment burdens in a variety of ways. Low and falling interest rates have allowed consumers to
refinance existing debt at lower interest rates or take on additional debt. Innovative loan products have
allowed them to restructure and consolidate high-interest-rate debt into one loan secured by the
household's residence or to take cash out to pay other bills or debts.
The strong economic performances of the nation and the Region during the first half of 1998 were
followed by a series of economic shocks after midyear.
Since the Dow Jones Industrial average reached a record high in July 1998, a series of
events has caused a sharp drop in world equity values. The outlook for corporate earnings has slipped
as earnings failed to match expectations. In the U.S. manufacturing sector, the outlook has been clouded
by a worsening Asian situation that has led to falling exports and soaring imports. This situation
presents a major challenge in the San Francisco Region because the Region is much more dependent
than the nation on manufactured exports, especially high-technology and commercial aerospace products
sold in Asia.
In August, Russia's faltering economy was hit by a massive devaluation that caused
financial market jitters worldwide and raised new concerns about the condition of Asian, Eastern
European, and Latin American economies.
By September, U.S. equity markets had lost close to 20 percent
of their value in a matter of weeks, wiping out hundreds of billions of
dollars in investors' potential profits on equity and mutual fund
holdings as well as stock options. Equity markets also appeared to have
entered a period of increased volatility in both price swings and
Will Consumer Expectations Reflect the Tranquil Spring or the Turbulent Summer?
Analysts fear that this unusual series of shocks may affect the attitudes and spending of U.S.
consumers. "Tumultuous financial markets here and abroad and unsettling political developments in the
U.S. have been major factors in curbing consumer confidence," noted Conference Board economist
Lynn Franco when the Conference Board's consumer confidence index
tumbled for the third consecutive month in September.1 The recent declines can be
observed in the two measures of consumer confidence shown in Chart
3. The first is the consumer confidence indicator, a broad measure that takes into account both
consumers' evaluation of their present economic situation and their expectations for the future. After
reaching a high for the year in July 1998, this index has fallen noticeably. The second, the consumer
expectations index, is a forward-looking measure that tracks consumers' expectations of future economic
conditions. It fell even more dramatically between July and September.
1 Christian Duff, "U.S. Consumer Confidence Drops Again," Wall Street
Journal, September 30, 1998, page A2.
Falling consumer confidence and expectations may influence consumer spending, which makes up about
two-thirds of the country's gross domestic product.2 For example, national consumer
confidence, as measured by the Conference Board's monthly survey, began to fall before the 1990-91
recession and then dropped sharply with the onset of the recession. Much of that decline took place as
consumers revised their expectations about the economy's performance and cut back on their spending.
2 Jonathan McCarthy, "Debt, Delinquencies, and Consumer Spending,"
Current Issues in Economics and Finance, Federal Reserve Bank of New York, (3): 3, page
The 1998 decline in consumer expectations is important because, according to the Conference Board,
the expectations measure "has a strong track record in predicting future activity." Moreover, the
declines in August and September are large, and there is now a danger of the index value falling below
the strong expectations range. If consumers begin to act on those expectations, then consumer spending,
a recent mainstay of the economy, is likely to soften.
Like the nation, the San Francisco Region is reporting a sharp downturn in consumer expectations as
measured by the Conference Board. As shown in Chart 4, both the
Pacific index (which includes Alaska, California, Hawaii,
Oregon, and Washington) and the Mountain index (which includes six San
Francisco Region states, Arizona, Idaho, Montana,
Nevada, Utah, and Wyoming, as well as two other states,
Colorado and New Mexico) have declined in recent months. Chart 4
shows that the Pacific consumer expectations index fell by nearly 21 points in August, the largest
monthly decline in more than ten years, but fell only slightly in September. The Mountain index has
fallen in five of the past seven months for a cumulative decline of nearly 24 points.
Deteriorating expectations may lead consumers to change their savings and spending patterns. For
example, consumers may:
Alter their savings behavior, which already is at historically low rates;
Postpone buying homes and other big-ticket items;
Limit discretionary travel and leisure expenditures; and
Reduce spending on nondurable goods and services.
Analysts already are monitoring retail sales and consumer spending for signs of weakness as the critical
1998 holiday shopping season approaches. Weaker-than-expected retail sales in August and September
have heightened concerns about consumer spending for the rest of 1998.
Effects on the San Francisco Region's Economy: Still Too Early to Tell?
Although job growth slowed somewhat for the Region in the 12-month period ending in August 1998
compared with the prior year, the overall deterioration in employment growth was not dramatic (see
Chart 5). However, the impact may become more dramatic as time
passes. The initial negative effects of the Asian crisis that began around mid-1997 have only recently
begun to be felt across much of the Region.
The overall strength in consumer spending and the health of the economy are important because,
although the Region's insured financial institutions are reporting excellent asset quality in most loan
categories, credit card portfolios are exhibiting some negative trends. The past-due credit card loan
ratio3 declined from 4.32 percent in June 1997 to 4.07 percent in June 1998, but a
larger percentage (almost 45 percent) of credit card loans are now in the 90 days and over past due or
nonaccrual categories. This shift to the more severe delinquency status suggests that additional losses
are likely. In fact, annualized credit card charge-offs increased from 5.32 percent of total credit card
loans at June 30, 1997 to 6.79 percent at June 30, 1998. Although credit card loans represent less than
8 percent of total loans in the Region, they account for almost 57 percent of all gross charge-offs.
3 The past-due credit card loan ratio is all credit card loans 30 days or more past
due plus nonaccrual credit card loans divided by total credit card loans outstanding.
Chart 6 shows that credit card charge-offs in the San Francisco
Region continue to accelerate, despite a slowdown in the rate of growth of bankruptcy filings. This
trend is especially relevant to the Region's 24 specialty credit card banks,4 which
hold almost 82 percent of the Region's total credit card loans. These institutions, located primarily in
Nevada, Utah, and Arizona, are generally subsidiaries of large holding companies that do business in
several regional markets, as well as nationally. The increasing charge-off levels, however, affect all the
Region's institutions, since over 75 percent of the Region's 866 insured institutions report some credit
4 A specialty credit card bank has total loans of 50 percent or more of total assets
and credit card loans of 50 percent or more of total loans.
The fact that net credit card charge-offs in the Region are increasing faster than personal bankruptcies
in both the Region and nation means that other factors likely are causing these banks' charge-offs to
increase. Chart 7 highlights two other possible explanations for the
increase. First, the Region's institutions rapidly increased their credit card loans from year-end 1992
through year-end 1996. Second, according to the Federal Reserve Bank Senior Lending
Officer Survey, banks generally loosened their underwriting standards from 1994 to 1996.
While bank lenders have recently tightened underwriting standards and slowed credit card loan growth,
the high current charge-off levels probably relate to loans booked during earlier periods of high loan
Despite high credit card losses, earnings at the Region's specialty credit card banks have not suffered,
likely because of increased securitization profits. As Chart 8 shows,
the Region's credit card banks have produced more noninterest income and higher ROAs as securitized
receivables outstanding have increased. Many financial institutions have used securitization to manage
interest rate and liquidity risks, as well as to reduce the cost of funding; however, new gain-on-sale
accounting standards can increase earnings volatility from securitization if the original assumptions at
the time of sale must be revised. In particular, the value of interest-only strips and retained subordinated
interests in securitizations can fluctuate greatly depending on the related charge-off and prepayment rate
assumptions made at the time of sale (see "Gain-on-Sale Accounting Can Result in
Unstable Capital Ratios and Volatile Earnings," Regional Outlook, second quarter
Although credit card lending in the Region has slowed recently, consumers have found other
alternatives for consumer loan financing at insured institutions, in particular those that specialize in so-called subprime lending. As Chart 9 shows, subprime lenders in the
Region have generally recorded much higher asset growth than the Region's insured institutions as a
whole. While these 30 institutions do not have significant on-balance-sheet exposure as measured by
total assets, many originate and service loans at several times their on-balance-sheet asset base. Most of
these institutions specialize in lower-credit-quality auto paper, but a growing number are involved in
residential lending to borrowers with tarnished credit records or at high loan-to-value ratios. High loan-to-value residential loans have allowed consumers to consolidate existing mortgage debt, credit card
debt, and other consumer debt into one loan with potentially lower overall debt service.
In addition to faster asset growth, the Region's subprime lenders have recorded higher profitability
ratios than similarly sized institutions; however, as with specialty credit card banks, analysts and bank
examiners must consider the profitability of these institutions over the entire business and credit cycle.
As Table 1 shows, the Region's subprime lenders with assets under
$1 billion5 have used higher-yielding assets and loan sale gains to outperform
similarly sized community banks in the Region.6 However, Table 1 also shows that the subprime lenders have poorer asset quality
than their counterparts. Acting Comptroller of the Currency Julie L. Williams recently criticized high
loan-to-value residential lenders, stating that the pricing of these loans does not "cover the additional
risks these loans entail." Pricing for subprime credit should be considered over the entire credit cycle
and not just the recent economic recovery.
5 The group of banks and thrifts under $1 billion engaged in subprime lending was
derived from a Division of Supervision survey of Field Office personnel and Case Managers in the San
6 Community banks have less than $1 billion in total assets and exclude specialty
credit card banks.
The financial market shocks that have disrupted consumer confidence also have affected the asset-backed securities markets, a major source of capital for many subprime mortgage securitizers.
According to Henry Willmore, senior economist for Barclays Capital in New
York, spreads in the asset-backed market have widened already owing to the uncertain outlook. This
uncertainty, which has forced down pricing, has made securitizers more reluctant to securitize, hurting
the market's liquidity. While most of the Region's smaller subprime lenders do not securitize
themselves, they do often sell their product to entities that use securitization as a major source of
capital. Therefore, banks relying on loan sale gains for profitability and liquidity should be aware of the
potential ramifications of increasing spreads and declining liquidity in the asset-backed securities
Implications: This summer's economic shocks, while perhaps too recent to affect the real
economy, have reduced consumer expectations and could reduce consumer spending in the future. Some
of these shocks, particularly the developments in Asia, will have a more severe effect on the San
Francisco Region than on the rest of the nation. A reduction in consumer spending at this point in the
economic cycle could signal both a slowdown in the economy and a deterioration in loan quality.
Both the Region's credit card and subprime lenders have benefited from the surge in consumer
spending. While growth in the credit card market appears to be slowing, the decline in this sector has
been offset to some degree by growth in the subprime and high loan-to-value residential market. Given
the potential for an economic slowdown, credit card lenders and subprime lenders should evaluate their
portfolios and business products closely to ensure that their products remain appropriately priced.
Further, because of their reliance on securitization and loan sales to securitizers for profits, these
lenders must continually monitor liquidity and investor preferences in the asset-backed security market.
Catherine I. Phillips-Olsen, Regional Manager Gary C. Zimmerman, Regional Economist Millen L. Simpson, Financial Analyst