The big news this week was Federal Reserve Chairwoman Janet Yellen testifying before the Senate Banking Committee.
Investors were interested to hear what the Fed’s leader would say about the economy and the chance of another interest-rate hike at the March Federal Open Market Committee meeting. And based on Yellen’s comments, a March increase in key interest rates is still unlikely … but not off the table entirely.
There are reasons for skepticism, of course, given the previous years of all talk and little action on higher interest rates. But given the continued strength of the U.S. economy and the political climate in Washington, a path of tighter monetary policy seems likely in 2017.
That could come at a very bad time for borrowers who can’t afford higher interest payments, and a nation already on the edge of a debt crisis.
The mortgage crisis of 2007-2009 came about for many reasons, and there’s plenty of blame to go around. But in a nutshell, things fell apart when loans were made to unqualified borrowers incapable of making payments — or in select cases of “strategic default,” unwilling to make those payments.
With the weight of car loans, student loans and mortgages already hard to bear for many consumers with poor credit, a boost in interest rates may push the cost of those loans over the edge for many households.
At best that will result in losses for lenders, and at worst we could be facing another debt crisis.
The situation in 2017 may not be as severe as 12 million subprime mortgages with a value of nearly $2 trillion in 2006. Still, consumer debt loads have a real chance of seriously impacting the U.S. economy and the stock market in the next year.
Here are three key debt problems we’re facing right now:
Subprime car loans
The amount of total open car loans just topped $1 trillion, according to credit ratings firm Experian. But is that a sign of consumer confidence … or a cause for alarm?
According to the latest data, from the third quarter of 2016, about 1 in 5 car loans are made to subprime borrowers, at an average interest rate of almost 11%. And broadly speaking, the average car loan in the U.S. is for a balance of almost $30,000 and a monthly payment of about $500. With stats like that, it’s no wonder the default rate on car loans is rising.
A study by lending analysis firm Lending Times recently found that auto loan delinquencies are up over 21% compared with 2012 levels. A senior vice president at TransUnion, one of the three major credit rating bureaus, recently said he expects “a modest increase in delinquency” for auto loans going forward, too.
Just image what would happen if rates tick a bit higher.
After all, if homeowners who were “underwater” on their homes in 2007 could shrug off the impact of a foreclosure on their credit report and simply walk away from a big mortgage, then why in the world would they stick with a double-digit interest rate on a car loan — especially as that car ages or breaks down?
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The real weight of these loans continues to hit the balance sheets of lenders, with net subprime losses continuing to march upward in December to 8.52%. Standard & Poor’s U.S. Auto Loan Tracker noted that while some of the acceleration was seasonal, “the year-over-year increases indicate that 2017’s losses could surpass last year’s levels.”
No wonder the New York Fed called subprime auto debt a “significant concern” at the end of last year.
Hedge-fund guru Bill Ackman has said “I think that the government’s going to lose hundreds of millions of dollars” on student loans.
And while that may sound like hysterics, when you consider that there is roughly $1.4 trillion in outstanding student debt, according to the Federal Reserve, that number doesn’t seem so far-fetched. Most of that is owned by the federal government via subsidized loans, too, with a recent Bloomberg report estimating the government owned some $850 billion in student loan debt as of 2014.
Even a modest default rate would quite literally eat up hundreds of millions of dollars in a hurry.
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The losses for the government are disturbing, but at least can be made up with higher taxes or cuts elsewhere in the budget. There’s no relief for the millions of young Americans who are stuck paying for their college degree instead of spending on consumer goods.
Recent data shows 7 in 10 college seniors who graduated in 2015 did so with debt, averaging a balance of more than $30,000 per student. That works out to about $300 a month over 10 years!
Student loans are particularly troublesome, too, since many 18-year-olds tend to take on financial obligations they don’t fully understand … such as variable-rate loans that are particularly at risk when interest rates rise.
After the collapse of subprime mortgages during the financial crisis, banks learned a hard lesson about these risky home loans. But if you think that means they avoided all loans to less-than-stellar borrowers, think again.
The New York Fed recently juxtaposed the rise of government-insured mortgages vis-à-vis the decline in subprime lending to find that “government insurance programs rapidly expanded and more than filled the void.”
That mirrors a report from ProPublica back in 2012 that estimated 9 in 10 mortgages issued at the time were being guaranteed by taxpayers via government-sponsored enterprises such as Fannie Mae and Freddie Mac.
And while standards are moderately higher for loans with this government backstop than precrisis loans to subprime borrowers, “they are not low-risk loans,” write the New York Fed economists. “The combination of high leverage and low credit scores documented above translates into extremely high default rates.”
The five-year default rates of government-insured residential mortgages issued in 2010 are particularly alarming for those with lower credit scores; borrowers with a FICO score of 625 to 649 defaulted at a rate of 17.2%, those with a score of 600 to 624 defaulted at a 19.8% rate and those with a score under 600 defaulted at a staggering 26.4% rate.
And that’s for mortgages issued in 2010, with much tighter lending standards thanks to proximity to the Great Recession, and spanning rapid appreciation in home values for most markets over the following five years. What will the five-year data look like in 2021 for mortgages issued last year under less stringent lending standards, especially if the housing market runs out of gas?
Housing market is thriving. So is home flipping
The housing market is back, and so is home flipping. WSJ’s Kirsten Grind joins Lunch Break and explains how the number of investors who flipped homes in the first nine months of 2016 reached prerecession levels. Photo: Dave Franco
By the latest tally at Bloomberg, the bailout of Fannie Mae and Freddie Mac during the financial crisis cost taxpayers $187.5 billion. While the organizations have returned to profitability in the intervening years, the housing market remains incredibly dependent on these entities to function given their large role in mortgage origination.
That means a meltdown would not just create a big financial burden for taxpayers and the individuals facing foreclosure, but result in another housing crisis that affects home values nationwide.