The Debt Domino Effect

The credit industry’s aggressive improvident lending is starting to reap the same brambles we saw with the subprime mortgage industry.  “Let’s punish the lenders of easy credit” is the title of a recent article by Liz Pulliam Williams on MSN money.  My collegues, Jill Michaux  in her article,  and Kurt O’Keefe in his article have already commented on this on the Bankruptcy Law Network.

The title of the MSN article is something of a misnomer.   If present trends continue, nobody needs to punish these lenders – they’ve already got plenty of rope to hang themselves, and are still busily adding to their supply.  Moreover, there are a few other unsteady dominoes in the personal debt lineup in the form of educational loans and underinsured medical expenses.  When these creditor-vultures come home to roost, they’re going to find there’s not much meat on the carcass of the American consumer.

The statistics are plain enough.  Credit card companies selectively market to customers they hope will accumulate large balances and make minimal payments.  Credit card defaults rose 30% between the first half of 2006 and 2007, and the upward trend continues.

Part of the explosion in overextended credit is tied to huge increases in home prices in recent years.  Homeowners who borrowed money they could not realistically hope to repay from their incomes were persuaded to take out home equity loans to pay off credit cards.  This figured into the calculations of lenders who extended credit to borrowers who otherwise would have been high default risks.

Now, with housing prices stagnant or falling and increasing numbers of consumers unable to make mortgage payments, this escape hatch is shutting down.  Furthermore, many home equity borrowers have fallen back into the credit card trap.

Economists differ on predictions of the size of this trickle-down credit crunch.  At present, much of the credit card debt is securitized.  If the default rate continues to rise, secondary investors will be reluctant to purchase securitized credit card obligations, and lenders will be forced to retrench.  To the extent that people are now borrowing to underwrite an already lean budget, further credit retrenchment will push them into bankruptcy sooner.  Take away the credit lines, and consumer discretionary spending is bound to plummet.  The only question is, how rapidly and how far.

Housing and consumer credit card debt are not the only dominoes in the stack.  American higher education is heavily dependent on personal debt, and there are many signs that we have already overshot the level of educational indebtedness the current economy can bear.

As the ranks of uninsured and underinsured grow and the population ages, an unsustainable level of medical debt looks inevitable, barring radical reform of our health care system. With respect to transportation, increasingly large numbers of people are “under water” with car loans, and the high cost of gas and insurance feeds credit card borrowing for other expenses. This leaves food as the only necessity of life which is still a pay-as-you go proposition.

The Federal government is, of course, massively in debt itself, severely limiting its ability to bail out either consumers or the finance industry.  For a bankruptcy attorney, all this bad news may be good news, but it’s not looking good for much of the rest of the population.