NCI: US Consumer: Debt Boom & Inflation Squeeze

[00:00:00] Welcome to Non Consensus Investing. I'm Ram Ahluwalia, your host and CIO at Lumida Wealth, where we specialize in the craft of alternative investments. At Lumida, we help guide clients through the intricacies of managing substantial wealth so they don't have to shoulder the burden alone. Through this podcast, we draw back the curtain to reveal the strategies employed by the best in the business for their high net worth clients so that you too can invest beyond the ordinary.

All right, there's so much happening around the U. S. consumer. We've got delinquency rates are up, provisions are building, we have the bank set to report soon, and I've got a very special guest, an old friend, Will Black. So Will is an expert in the world of consumer credit. He's the founder of Black Analytics, a leading consulting firm on consumer credit and structured finance.

He spent. 25 years at Moody's leading consumer structure finance, the ratings team, for the U S covering everything from student [00:01:00] loans to auto leases to Tesla securitization, maybe even SoFi securitizations. And he was also part of Morgan Stanley's treasury team where he managed multi billion dollar issuances around the world.

Structured finance products. Will, great to see you again and thank you for joining Lumida Non Consensus Investing. My pleasure, Ron. Great to see you too. Looking forward to this. Likewise. Let's dig in. What's the health of the U. S. consumer? We see debt going up, we see auto insurance premiums go up, we see DQs going up, we're hearing headlines about people are being tapped out.

Lay it out for us. Yeah, there's a lot to dig into here. I think I'll start off first by just saying that It's a bit of a paradox, some of the deteriorating, the degradation in credit performance that we're seeing, at least when you zoom out and you look at the economy as a whole in terms of some of the headline macroeconomic statistics, there are some [00:02:00] things to point to that are quite strong.

Again, I think we're going to talk about big picture and averages at least to start out with. Thanks. And obviously something's getting lost in the averages or the headline numbers, so to speak, because If you look at GDP growth, the US economy is punching above its weight. We know that, two thirds of the economy is built on consumer spending.

A lot of that is done on credit, right? Nobody likes to spend money they don't have quite like Americans, I like to say. And a lot of that done is through the securitization market, Which is my wheelhouse and is a good kind of vantage point to see how, companies interact with consumers and, and how they finance those activities through the capital markets in a very granular way.

So again, Zooming out, GDP growth, punching above its weight, like I said, the labor market. You might say it's picture [00:03:00] perfect. You'd really have to squint hard to see something that was negative there. Even with respect to the dreaded wage inflation, wage, and income inflation, which has not materialized, in a worrisome way.

What I mean by that is, of course, I don't think economists have been too concerned about a wage price inflation death spiral in recent months. That seemed to see that concern, which is a legitimate concern, and it has seemed to have abated. I think the last time I looked at wage inflation data that we're getting pretty close to where we were pre pandemic.

So we can put that also to bed. Again, you really have to look hard at I was looking at some jolt data, some job, layoff announcement data from the Challenger report. Really nothing to point to other than maybe you might call it a normalization at best, but you certainly wouldn't call it a softening of the job market.

And the reason I dwell on the job market is because this is ground [00:04:00] zero of the health of the consumer. If you have a job, you're much more likely to pay back your debts. So that's strong. It's true that consumer credit, consumer debt levels are at record high. They're at 17 and a half trillion dollars.

That is the highest they've ever been. I'm talking about mortgage, credit cards. Autos, all this, all the consumer credit categories stacked up on each other. That is, very high, but I like to look at that not as an isolated nominal figure, but look at that in context of personal disposable income, which is, a good Fed statistic they call the debt service ratio.

That ratio, which is, I think, more intuitive, right? It's more how maybe, Credit professionals, but also kind of person on the street may view their financial resilience, their financial profile strength on a relative basis is, can I make my monthly payments given my income? And that ratio [00:05:00] is at historic lows right now.

And I think there's actually a lot of gravity to that, that, ratio that I, what I mean by that is, I don't think that leverage ratio, that Debt service ratio is going to go up. I think it will go up, but I don't think it will go up by much over the next probably several years, and why do I think that it's because it's largely anchored by something that we saw happen during the pandemic.

And that's what I refer to as the pandemic mortgage refinancing boom. And so yeah. I would like to introduce a few things. So one is, labor markets healthy. That's one. So incomes are good and we're not seeing wage price spiral. That's healthy too. Yep. But we are seeing delinquencies go up. So how do you, how do I reconcile strong labor market?

And the other thing that I would point out is, I'll get there. The other thing that I would point out is that underwriting by various [00:06:00] soft and hard data points that I follow are also indicating at least for the last couple of years have been tightening. So you're right to point out the fact, what is this?

Why are we seeing, we've been seeing delinquencies rise. I've been writing about it for about a year and a half now. You see an inflection point in the delinquency rate, in autos and credit cards. And I will tell you. Again, the data that I focus on is coming from the Fed shows that there was an inflection point, like I said, about a year and a half or so ago.

Those delinquency rates, 30 plus delinquency rates for autos and credit cards are now past where they were pre pandemic and on a trajectory that, at least in the case of auto delinquencies, puts them in danger of hitting where they were during the great financial crisis. Which is absolutely remarkable given, again, the strengths in the economy, and even by indications, the strengths in underwriting that have [00:07:00] been in place for a long period of time.

The income generation is there. Why isn't, and you just shared that the debt service coverage ratios, meaning the income required to support the debt, Yeah, that's at a manageable and in fact a low level, but yet we see these DQs increase and you just said the underwriting is tightening, improving, right?

How do you explain the rising DQs? There are a few things we can point to, I'll start off again, broadly how I would paint the picture. I call them, intersections of risk. These aren't novel risk factors, but I think if you look at them Kind of, again, as intersections, if you look for transactions or asset classes or sub asset classes that have these features, you're going to find where the risk is most pronounced or most amplified, right?

So first intersection of risk is, the age of the borrower. Okay. So here I've written about this, [00:08:00] name your asset class, but I've written about this a few times in my newsletter. The Gen Z and millennial cohorts, which are, sizable cohorts in terms of their age categories, are showing, they, look, they're always riskier, those cohorts, why are they riskier?

Because they haven't hit their peak earning years yet. They haven't built up the kind of reserve or call them buffers to navigate the choppiness that sometimes accompanies that stage of one's life. But what in the delinquency data is that again, a huge separation, that you really have to go back to the great financial crisis for between, For example, those younger cohorts and the older cohorts now in terms of delinquency rates.

So again, why is that happening? They're riskier. Okay, this, the credit stacking ordinal ranking makes sense, but the distance between them and the other cohorts is a bit of a head scratcher. And I think the answer really goes back to that point I started to make about the mortgage refinance boom during the pandemic [00:09:00] years, right?

And the fact that we know these cohorts, Gen Z and millennials. The half mine is what is referred to as delayed, delayed household formation. They've hit those milestones much later in their lives if they've hit them at all relative to some of the older cohorts. So they were not then able to participate in the refinanced boom to these very low levels that took place during the pandemic.

They couldn't tap the home equity appreciation from having an investment in a house. Which for many Americans is their largest investment. They have it on leverage through a mortgage. Yep. 65%. We, this country now has a 65 percent home ownership rate. So that leaves a very large percentage, 35 by my estimate, that, that doesn't, they don't know their homes.

And so they have been, subject to the prevailing winds of shelter inflation, which of course has been going up. The main complaint you hear [00:10:00] from millennials and Gen Z is, hey, I can't buy the 40, 000 house that my parents did in 1977, and I'm priced out, and now they're forced to rent, rents are going up, and they're choosing to remain single for longer, which makes it even harder to purchase or qualify for a mortgage because you don't have the dual income support. That's right. And just to put a finer point on just how much benefit these homeowners, so I think I said 65 percent of, households, have home, own their homes. I think that, I think the number is 60 percent of them have a mortgage outstanding because some people have paid off their mortgage and they don't have a mortgage at all.

But 60 percent of them have a mortgage. So it's still a great number, a great proportion of Americans were able to take part in this refi boom. How good was this refi boom for these borrowers? 75 percent of them refi during this period of a window of just a couple of years. [00:11:00] 80% of them have a mortgage rate below 5%, 60% below 4%, 25% below 3%.

Those lucky folks. Yeah. What's that? I'm in that bucket, the two and a half billion. Oh, good. You're lucky, so you're not gonna move anytime soon. No. Everybody in the every, I'd say every, pretty much everybody in those buckets is gonna be locked in unless you know some external force pushes you out.

Death, divorce. There's one other driver, relocation for a job. All of the above and look, if the economists are right, and we're in a higher for longer rate environment, that's going to add again, kind of gravity or an anchor to everyone's current home and mortgage situation.

Again, this is a great tailwind in many respects, it's also, it also has negative consequences. We can talk about that in terms of affordability and other, creating this kind of. Sometimes referred to as a tale of two cities where you really have a distinction growing between, homeowners and non homeowners.

So that, I, so that, [00:12:00] that is one of the intersections of risk. So I pointed that one out. It's, that's one of the drivers is that the population that didn't benefit from the mortgage refinance, their DQs are going higher and they're younger. So that's driving some portion of the increase in delinquencies that we're seeing.

Sorry, can you rephrase that? Is the increase in delinquencies coming from that population that did not participate in the mortgage refi? An outsized proportion, more than normal, yes, that is a contributing factor for sure, yes, to answer your question. Okay. So the other intersection, so number two out of three, is, is what I refer to as basically the subprime, component here.

Okay. Now again, you might say, yeah, subprime always performs worse. True. That's certainly what you would expect to see and in fact what we have always seen. The data that I'm looking at, shows when you look at the FICO [00:13:00] ranges organized by subprime, and in this case, fICO is below 620. And then the rest of the range above that is divided into near prime and prime call it, or sometimes it's referred to as prime and super prime.

It doesn't matter the nomenclature, but those that are much higher credit quality obligors. Again, the separation between the delinquency rates, is widening where you see the delinquency rate of that riskiest strata. The growth of borrowers by FICO score is far and above, in this case, it's even above where it was during the great financial crisis.

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