Balances and delinquencies will rise quickly for all borrowers. By the end of 2022, more accounts were delinquent than at any point since 2010. The percentage of credit card delinquency eclipsed the previous post-financial crisis high-water mark set in December 2019, a period often used to represent the last “normal” times before the pandemic sent economic data out of whack. Lenders had hoped the credit card market would return to normal, but recent trends show troubling signs.
The rise in delinquency was rapid. The number of delinquent accounts increased by almost 45% over the last year and is up more than 5% compared with the end of 2019. Smaller, riskier accounts are always the first to show signs of distress, and they are flashing warning signs. Prudent lenders maintain limited exposure to these accounts and are quick to cut lines when there is trouble. However, it is much harder for lenders to reduce risk in larger lines, as it is difficult to identify who suddenly will not be able to pay. Because of this dynamic, delinquent balances typically lag delinquent accounts. Delinquent balances have been increasing since last year, up more than 60%, and are still accelerating.
The record growth in delinquent balances is concerning because the record pace of balance and account growth of the pandemic recovery has only started to roll over. Lenders have begun tightening standards to rein in smaller, risky accounts, but reducing risk in more creditworthy accounts with more significant balances is more complicated. The quality of these larger balances plays a role in determining exactly how worrisome they are to creditors and whether losses surge above average. Given the amount of stimulus and credit score inflation, it is difficult to determine how risky these borrowers are. As economic growth slows in 2023, delinquent balances will continue to grow, and lenders should remain on guard.
Economic forces driving balance growth and delinquencies higher
The growth in credit card balances can be initially attributed to the growth in spending. The pandemic took a large bite out of U.S. consumer spending that lasted about a year. Consumer spending roared back in the pandemic recovery as consumers exorcised their substantial pent-up demand after lockdowns. As the recovery slowed, real spending receded to its pre-pandemic trend, but nominal spending is much higher. This distinction is not semantic: Inflation is detrimental to consumers as it essentially absorbs all income growth. Though nominal wage growth is above where the Federal Reserve would like it to be to cool inflation, the change in real disposable income is still negative year over year. With incomes down, consumers tap into savings or lean on credit to finance spending.
The impact of inflation on spending, at least so far, has been less than might be expected. That is because of excess savings accumulated by consumers during the first year and a half of the pandemic, thanks to generous stimulus payments and a lack of services to spend on. Consumers are using those savings now to limit the impact of high inflation on their spending. How much longer they will be willing and able to do this remains an open question. A heavier reliance on credit may be necessary for consumers who depleted their excess savings, an ever-increasing share since September 2021, when Moody’s Analytics estimates excess savings peaked. Even consumers who have not depleted their excess savings or those who are treating them as illiquid wealth are increasingly leaning on credit to offer short-term flexibility in trying financial times.
Households are not saving, and it will only get worse. In mid-2022, the U.S. savings rate hit its lowest level since the financial crisis. Though the causes differ from then, this savings rate cannot be sustained without increasing risk and hardship. Eventually, the pandemic-generated excess savings will be exhausted, and increased borrowing will drive up balances and utilization. A greater share of credit card accounts are fully utilized today than were before the pandemic, even with the extraordinary account growth since. Credit card payment rates have also declined from their recent record highs, indicating consumers may not be able to keep up as well with the extraordinary debt growth as they were before. Until spending returns to sustainable levels relative to income, credit card usage will continue to increase.
Credit card debt has become very expensive, and this will drive credit card usage up. Along with inflation spending, the other main driver of the increased debt burdens is extraordinarily high interest rates. Credit card interest rates, in particular, are the highest on record. Still-climbing card utilization rates will reach levels not seen since the early 2010s when assessed credit card interest rates fell below 14%. Today, the average assessed credit card interest rate is 20%, and rates are not expected to peak until early next year. The extraordinary levels especially pressure vulnerable borrowers who revolve their credit card debt and carry a balance from month to month.
Inflation impacts all types of borrowers
An odd feature of this recovery is the rapid balance growth among prime borrowers. Whether it is satisfying pent-up demand, maintaining a lifestyle, or negative wage growth, prime borrowers continue to spend remarkably. The average prime consumer’s balance has been growing at almost 10% since last year, a rate that is only starting to roll over after the sudden reopening of the economy. Further, the share of accounts with a balance has grown faster in the prime space, eclipsing pre-pandemic levels. Subprime borrowers are borrowing heavily too, but that is more expected than the prime borrowers’ growth.
Inflation is regressive, as lower-income consumers must spend a greater share of their incomes on price increases for essential goods and services. Incomes are correlated with credit scores, so subprime borrowers need to use a higher percentage of their incomes to deal with inflation than prime borrowers. Lower-income segments also have less in the way of excess savings to offset these price increases. This buffer is deteriorating fast and, by one estimate, has been eliminated at the lowest income levels. Perhaps unsurprisingly, balances are fastest in the lowest income cohorts as these households feel the brunt of inflation. That these segments have not blown past pre-pandemic delinquency rates in the face of bleak conditions is a good sign. Employment is still substantial, and wage growth has been highest among the lowest-income individuals.
Another reason prime borrowers have been somewhat insulated from inflation and contracting real income is their considerable excess savings. High-income consumers and prime borrowers accumulated the most excess savings during the pandemic because their foregone spending on travel and other services during lockdowns, which instead translated into savings, far outstripped that of any extra government transfer payments to lower-income and subprime consumers. Excess savings have allowed higher-income consumers to keep spending in the inflationary environment, but the reserves are drying up quickly.
The prevailing narrative has been that the pandemic recovery is a K-shape. Higher-income consumers continue to power economic growth through considerable spending, while lower-income consumers struggle comparatively more to keep up amid rising inflation. The rising balances and card usage rates suggest there may be more risk in the prime space than previously thought. Lenders may have trouble identifying the risk to this population.
Lenders compete for borrowers with poor results
As debt burdens and associated risk are expected to continue rising, lenders must remain guarded against the increased risk in the market. Lenders are beginning to pull back, as evidenced by the deceleration in account growth reported by senior loan officers. Tightening standards on new loans is the easier part of the battle. It is difficult to detect who among large, existing accounts will lose the ability to pay. The crop of existing loans has run up balances at a historic pace, yet utilization is still below pre-pandemic levels at both ends of the credit score spectrum. In aggregate, the supply of credit grew even faster than the demand for it over the past three years. Borrowers are likely to catch up soon, especially utilizing existing credit now that it is tougher to access new credit. With increased line sizes, lenders need extra care to manage risk, as troubled borrowers have more room to run up balances.
While lenders are no doubt tightening the credit spigot for subprime borrowers, prime growth remains resilient and broadly supports credit growth. However, prime borrowers look riskier than previously thought, as they are not immune to inflation. More spending is required to keep up with lifestyle and exorcise pent-up demand. Though prime borrowers are not financially stressed in the same way for various reasons, they are financing their spending with credit cards nonetheless. The share of credit cards with a balance is growing faster in the upper end of the credit score spectrum than at the lower end. As most of the volume is in the prime space, this represents a significant upward shift in card usage.
Though a feature before the pandemic, another kind of inflation, credit score inflation, took off during it. The average credit score has fallen below 700 after eclipsing the mark for much of 2022, more than 10 points higher than the plateau late in the 2010s. The share of consumers considered prime and near prime widened noticeably as those considered subprime fell. While it is true that most consumers were in better financial shape during the pandemic, other measures have shown a much more significant deterioration in credit conditions over the past year. If lenders were not careful about the shifting credit score distribution, they could overestimate the creditworthiness of certain parts of the distribution.
Lenders must remain guarded against consumer credit-specific risks, as their competition for borrowers yields poor results. Post-pandemic cohorts are performing much worse than all other groups in the last five years, which include several cohorts seasoned during periods not characterized by abnormally low delinquency rates. That bankcard account and credit-line originations broke records in 2022 should give lenders further pause, as these underperforming cohorts are large.
Cannot ignore macroeconomic risks
Most of the risks mentioned above have begun materializing in a year of decelerating yet still-positive growth, though they warrant prudence in any climate. However, most forecasts, including that of Moody’s Analytics, expect a further economic slowing in 2023. Many economists and business leaders are now outright expecting a recession. Moody’s Analytics still hopes the economy can avoid a recession over the next year, but the odds are about 50/50 now. Of course, the economy also faces many other risks not as directly related to consumer credit, and a recession would exacerbate the effects above. A policy misstep by the Fed or an unexpected economic or geopolitical shock are top-of-mind risks and could tip the economy into a recession. The typical recession is accompanied by job and income losses, which directly lead to significant credit defaults in their own right.
Of particular concern to credit card borrowers and lenders are record-high interest rates on credit cards. The interest rates dictate that borrowers who carry a balance month to month or fall behind on payments will have more trouble paying down debt than before. The high-interest rates are unlikely to abate until the Fed has signaled it is satisfied with the course of inflation. This could be contrary to a typical recession, in which monetary policy can become accommodative at the outset.
Prime borrowers, again though the lower risk in absolute terms, are more susceptible to the symptoms of a recession. That is to say, delinquencies and losses would increase faster among prime borrowers than sub-prime borrowers in a weakening job market. Today’s high interest rates and tight financial conditions primarily impact manufacturing, construction, and many white-collar industries. Some of the most high-profile layoffs in this business cycle have been in the high-paying tech industry. Job losses are particularly damaging when credit decisions assume a steady stream of future income.
Quantifying risk in unfamiliar territory
Though it may not be possible to quantify every risk facing the credit card market, we highlight a few of the critical dangers below. In addition to accounting for the macroeconomic impacts of a recession this year, we take steps to address some of the extraordinary conditions among borrowers today. We then forecasted losses on the portfolio using a credit-loss model that relies upon credit score, age, utilization and macroeconomic drivers.
First, we normalize credit scores to their pre-pandemic level. We calculated the average increase in credit scores over the last three years for a consumer in each of 10 credit score bands in December 2022. As consumers’ credit scores typically increase as they age, we subtract the average increase over three years using data going back to 2005. On average, credit card consumers saw an increase of more than 8 points during the pandemic era, above what they would typically expect. We then subtract each credit score bucket’s average from the consumer’s current score to get an adjusted credit score.
Second, we normalize account utilization to pre-pandemic levels. While balances accelerate, utilization has not moved as quickly, partly thanks to lax lending standards and lenders’ willingness to extend credit lines. We expect credit limits to hold steadier as lenders are more cautious in this environment, and balances will continue to rise. This would increase borrower utilization. To account for this possibility, we shocked a market portfolio of credit cards by a utilization multiplier, calculated as the ratio between utilization at the end of 2019 to that at the end of 2022, segmented by credit score band and whether the card was a bank card or a retail card. This was a 4.4% shock on average but up to about a 10% shock in the lower credit score buckets.
We then projected losses on the normalized and the base portfolio using a credit-loss model that relies upon credit score, age, utilization and macroeconomic drivers. Based on utilization and credit score normalization, we found that baseline losses were expected to rise by more than 15% through 27 months. The residual losses peak in early 2023, as the assumed utilization shock is emphasized by the typical jump in spending around the holiday season. In the short term, the normalized portfolio has higher loss rates than the base portfolio under a recession scenario, even without the associated job losses. However, the lower-quality, normalized portfolio has consistently higher losses within each economic scenario.
One way or another
The pandemic recovery was the fastest recession recovery in history. Consumers quickly returned to pre-pandemic spending levels, and credit card balance growth has followed at an unsustainable rate. Delinquencies, which lag balance growth, are rising at record levels as inflation squeezes borrowers. The heightened risk this poses to the subprime population is well understood. Still, the risks in the prime population should also be properly evaluated, particularly when the possibility of a recession that threatens white-collar jobs looms.
Recent cohorts of new credit cards are performing much worse than prior cohorts. The cause is likely a combination of the increased supply and demand of credit in the recovery. Also, the strong-but-temporary financial benefits to consumers from the pandemic may have created a false sense of security, reinforced by risk metrics like credit scores around borrowers. Lenders were eager to reestablish credit card portfolios after the drop in spending during the pandemic, and borrowers’ desire to spend and confrontation with inflation has been well documented.
Balance growth will be quelled one way or another. The Fed and tightening financial conditions should reduce spending demand eventually. The longer it takes for spending to slow, the more balance growth we should expect. The supply side is more up to the lenders themselves. Early indications are that even as lending becomes more profitable in the high-interest rate environment, credit card lenders are tightening faster than expected. This should slow growth, but it should also rein in the risk on the following cohorts to balance out the loose lending of the past year.
