- Fixed Income Portfolio Manager
Switzerland, Institutional
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Although the resilient US consumer appears to have delayed an economic growth slowdown in the US, I expect that the Federal Reserve’s (Fed’s) “higher for longer” policy rates eventually will lead to further softening in economic data. This degradation in economic data — nearly 20 months into the current tightening cycle — seems to indicate that the Fed’s monetary policy may be working to slow the US economy with a longer lag than in past cycles.
As unemployment increases and lenders tighten their standards and reduce access to credit, this could lead to higher delinquencies, defaults, and extensions across securitized debt sectors. However, even under this scenario, most securitized structures are built to protect against material credit degradation — save for the acute stress being experienced on office properties. I anticipate that dispersion will increase as fundamentals come under further pressure, with some parts of the market experiencing more pronounced weakness than others. Lower-income cohorts appear most vulnerable in this environment. Here we examine some of the underlying causes of deteriorating consumer health and offer some ideas on how to mitigate exposure to the most vulnerable issues.
The perfect storm: A wide-open credit spigot and FICO inflation
Consumers’ balance sheets benefited tremendously from pandemic-era stimulus, which boosted their levels of savings and enabled most to easily meet their debt obligations. But as consumer-directed stimulus normalized over the past two years, I have observed that some lenders have failed to adjust their models, overextrapolating on pandemic stimulus. Poor underwriting in late 2021 and 2022 has come home to roost in the form of deteriorating loan performance. Lender reaction will likely be a tightening of the credit spigot — even further than what they have done already — and slowdown in loan growth.
Easy access to credit was occurring at the same time as another byproduct of COVID stimulus: “FICO inflation.” In many cases, consumers used their stimulus payments to clean up their household balance sheets and improve their FICO score. They were, by definition, “better credits” than before with less debt and lower leverage. This opened up access to credit at a time when consumer finance companies were tripping over themselves to gain market share. All of this has led to increased loan performance degradation.
Consumers unlikely to change their stripes
At the risk of generalizing, many consumers tend to struggle to adapt their borrowing patterns despite evolving financial positions. This occurs for a variety of reasons in or out of their control including discrimination, access to credit, family dynamics, health, education, specialization, and willingness to budget. As a result of the balance sheet cleansing mentioned above, some subprime borrowers got a boost to near-prime quality and some near-prime borrowers got a boost to prime quality. There are now signs that some borrowers in these categories are reverting back to conditions and/or behaviors that are more normal for them. This skews the performance degradation higher as not all consumers were properly risk-based priced because they looked better on paper than their typical behavior might suggest. A similar dynamic played out in 2017 when the auto companies widened their credit boxes. I suspect this will correct itself over time if it hasn’t already, leading to more normalized performance.
Financial ingenuity can mask true borrower quality
Financial ingenuity has the potential to prove more problematic. Two recent innovations are masking the true credit quality of borrowers: 1) “buy now, pay later” loans, which are too short term to be reflected to credit bureaus; and 2) secured credit cards. In the case of secured credit cards, performance metrics are being reported to the bureaus in the same way regular credit cards are, helping consumers improve their FICO score even though it is essentially a debit card. Recently, we heard from several companies that they observe underperformance in borrowers utilizing products like this and are adjusting their credit models accordingly (i.e., tightening credit when they see secured card products on credit reports).
Most consumer ABS structures can withstand expected weakness
On balance, consumers are returning to a more normal state, which will likely be characterized by slowing savings rate, stronger demand for loans, and normalizing delinquencies. However, balance sheets (especially for upper-end consumers) are robust, which will continue to support the economy. Some of the persistent inflation pressures will be offset by wage gains in a tight labor market but I expect pressures to increase as removing some of the tightness of the labor market remains a focus of the Fed. Credit contraction should impact the consumer in a higher unemployment scenario, but the pace at which this unfolds will determine the amount of stress on the consumer and therefore the economy (the slower the better).
Across the consumer asset-backed securities (ABS) universe, I think the most compelling investment opportunities are at the top of the capital structure. In my view, investors should consider focusing on collateral for which priority of payment is high, including handsets, autos, and general-purpose credit cards.
I believe the bottom of the capital structure is only attractive for select issuers where structural enhancements have been put in place in response to consumer performance deterioration and underwriting has materially improved from late 2021 to early 2022. Sponsor risk is elevated during credit-tightening environments, so it is critical to focus on strong sponsors with skin in the game. For example, I think it is prudent to avoid consumer loans, revolvers, or lower-tier sponsors that are not prepared to manage through a recession.
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