Loan Zone: After The Golden Age
How can your credit union thrive now that consumer credit growth has likely reached its limit?

By Bill Vogeney

August 18, 2009

Editor's note: The following first appeared in the August 2009 issue of Credit Union Management.

Have we experienced the passing of the "golden age" of consumer lending? I believe there's a very good chance we're about to enter a five- to 10-year period of:

How did I come to believe that the above issues are nearly a foregone conclusion? Several things apply:

Trends in consumer credit balances. If you visit the Federal Reserve's Web site, you can see the last 65 years of consumer credit growth in the United States.

As the data shows, consumer debt in the United States has grown at levels far and above the rate of personal income over the last 20 years. From the perspective of someone who has a real-world view of the American consumer, I truly believe the ability for consumers to handle additional debt has reached its zenith. As I like to share with my staff in a very simplistic way, "people haven't found a magical way to pay bills they can't afford." However, over the last decade, consumers have been able to use home equity loans and credit cards to augment their spending habits.

The wealth factor. A second reason I'm concerned that we've seen the end of the golden age is something referred to as "the wealth factor." Typically, as households build wealth, they'll spend about 5 percent of their increase in wealth in a given year. Without a doubt, the dramatic increase in home prices from 2002 through 2007 encouraged a great deal of consumer spending. However, the wealth factor also works in reverse; the S&P 500 and the housing market both declined in value by an estimated $3 trillion in 2008. The combined loss of wealth from those two trends totals $6 trillion. What's the wealth factor's impact on consumer spending? An estimated $300 billion reduction for 2009. That's just a one-year impact. It can be argued that baby boomers through Generation Yers now realize their retirement plans, whether stock- or real estate-based, have been permanently damaged, and this could have longer-term effects.

Higher taxes. Regardless of political beliefs, many consumers think there is a virtual certainty that tax burdens will increase. The sheer cost of the economic stimulus plans and federal bailouts will reduce the amount of disposable income for consumers. There's some argument about how far down the household income ladder these tax increases will reach, but there should be no argument that a significant portion of higher-income households will be spending less on discretionary purchases, which will certainly impact our consumer loan volume.

Home appreciation and equity loans. Over the last 100 years, according to the S&P/Case ShillerÆ housing index, home prices adjusted for inflation have increased at approximately 3 percent a year, about the same level as the increase in household incomes. Such factors as low interest rates, teaser rate loans, and easy credit to subprime borrowers created the bubble for housing demand and prices from 2002 to 2007.

You've heard the jokes about the "Home Value ATM" being closed for repairs. Except it's not a joke. Not only will consumers spend less based on their home declining in value, they'll likely borrow less against their home. Lenders, whether banks or credit unions, will be hesitant to lend up to 100 percent for the foreseeable future, limiting loans to 80 to 90 percent of value. My credit union never has been reliant on these higher LTV loans, as typically about 75 percent of our home equity business has been at 80 percent LTV or below. However, reducing our maximum LTV from 100 percent to 80 percent is enough to slow our annual growth rates on home equity loans from 10 percent to close to zero.

I have some experience in dealing with the impact rising home values can have on a loan portfolio. When I left my prior credit union in Florida in early 2001, it had about 7 percent of the loan portfolio in home equity. From 1990 to 2000, typical home values in the Orlando area increased 2 to 3 percent before inflation. That slow growth in home values meant borrowers just didn't have the capacity to easily obtain equity loans. My current credit union in Colorado has about 17 percent of its portfolio in home equity loans. While Colorado did not experience 15 to 20 percent real estate price appreciation as did areas in Florida, California, Nevada and Arizona from 2002 through 2007, our market area had experienced solid 5 to 8 percent appreciation for almost a decade.

Auto lending. The challenge for the auto lending market for the next several years had its genesis in 2008, as gas prices of $4 a gallon literally drove consumers to make some extreme decisions. For some consumers, the high price of gas forced them to stop making payments on their vehicle, leading to repossession. For other consumers, the option of buying an additional vehicle with higher fuel economy became a solution. They parked their large sport utility or truck and drove a small "econo-box." Unfortunately, this reasoning was often flawed. For example, someone driving 1,500 miles a month and getting 15 miles a gallon at $4 per gallon could save $200 a month on gas by buying a Hyundai. But that smaller car might come with a $300 payment.

The $64,000 question for the auto lending market is this: Are consumers not buying vehicles because they're concerned about their job, or are they not buying because they're unsure about the direction of gas prices? Consumers looking to make a wise vehicle choice might be willing to postpone their next purchase an indefinite period of time until we see a stable trend in gas prices. Whether engine technology and alternative fuels progress as anticipated will also impact buying decisions.

Higher loan rates. As fallout from the banking industry crisis, what are the implications for consumer loan rates? In an effort to improve profitability, will banks respond with higher loan rates? Not to mention, as lenders experience loss ratios previously thought impossible across virtually all credit tiers, will consumers ultimately have to pay even higher rates? I think the answer to both questions is yes. Whether the lender holds loans for their portfolio, or securitizes them in the financial markets, the industry's historic loan losses will be passed onto borrowers in the form of higher rates.

Impact of the subprime debacle. Whether it's mortgage, car or credit card lending, the subprime market for lending isn't going to die. However, the industry will certainly shrink as it reverts back to traditional credit standards. Subprime mortgage lending existed and worked well for decades when a typical maximum  LTV was 60 to 70 percent-not 100 percent. The impact on the securitization markets, where lenders packaged loans for institutional investors, will likely lead to a prolonged period of weaker margins for lenders as investors demand a much larger return for the risk taken. Usury laws will make it difficult, if not impossible, for lenders to pass on higher rates to these subprime borrowers.

Consumers will feel the pinch as loan amounts are reduced, down payments increase, and more borrowers with damaged credit get turned down as these specialized lenders will have to work harder to find the "best of the worst loans" to approve.

HOW CAN CUs RESPOND?
I've already tipped my hand as to how I think the banking community will respond: We'll see higher loan rates, higher credit score standards and, maybe more importantly, lower quality service. The banks will call it "efficiency." How can credit unions respond? In strategic planning discussions with my lending managers over the past year, we've reviewed all the above-mentioned trends and have identified several opportunities.

First of all, superior product knowledge and consumer advice will be in short supply at the banks-we should make it the cornerstone of our lending programs. Not every consumer question will be answered on the Internet, and there's plenty of opportunity for credit unions to build market share based on this potential future void.

Secondly, CUs, including ours, will have to get better at making loans to consumers who don't have perfect credit. We should be able to capitalize on our member relationships, asking members tough questions about their credit problems, in order to do a better job of identifying who will pay. Credit scores probably won't give us what we're looking for; we need an "old school" approach with quality loan applications and an emphasis on knowing our borrower better than our competitors.

Finally, we determined our CU will have to get better at account management. Once the economy stabilizes, we'll have to do more pre-approved credit offers, as we believe the competition for borrowers in the "super-prime" credit score range of 720 and above will only intensify.

We'll also need to improve our account retention efforts. As more and more lenders concentrate on this super-prime group of consumers, they won't be content to wait for the consumer's next major purchase. They'll look to refinance every possible loan from other institutions. Being prepared to respond quickly to member inquiries and payoff requests will help us keep the loan balances we worked hard to originate.

Ultimately, for credit unions to thrive, this type of strategic thinking will be critical in the era after the golden age of consumer lending. Credit unions can no longer ignore or take for granted consumer lending in favor of mortgage or commercial lending.

CUES member Bill Vogeney is SVP/chief lending officer at $2.5 billion Ent, Colorado Springs, Colo.