Increasing Consumer Lending; Decreasing Quality of Loans

The New York Fed recently released their report on consumer credit trends through the third quarter.  The data show that aggregate borrowing by households in the U.S. increased $127 billion from the second quarter. This 1.1% increase was the largest since the first quarter of 2008.  Part of this lending is comprised by loans of poor credit quality.  The low interest rate environment has created a search for yield by investors, which has allowed for a deterioration in loan underwriting standards and an increase in lending.  Auto sales have been one of the stronger aspects of the U.S. economy over the last year, however these sales are being increasingly made up of sub-prime borrowers (27% of overall car loans), which is the highest since 2007. Another example of declining credit standards is the proliferation of junk debt issuance, and a growing proportion of this issuance coming in “covenant lite” structures, meaning lower legal protections for creditors.  $225 billion of such bonds have been sold this year, more than double the $100 billion sold in 2007, and now represents more than 55% of new issuance.  Some analysts predict that a rise in rates will increase defaults in these riskier sectors.  While increasing lending is a positive sign for the economy and potential growth, the deterioration in quality of loans could become a material risk to investors chasing yield.