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11/14/2017

Managing Credit Default Risks in a Rising-Rate Environment

Barry Adcock November 14th, 2017

By now, most bank customers are probably aware that the Fed raised its federal funds rate earlier this year, and they’ve probably heard the rate will likely climb again before the end of the year (and multiple times next year). Following the increase, a deluge of information and opinion poured down on consumers, telling them how the higher rate will affect them financially.

But has anyone asked consumers how they feel about rising interest rates? Not so much.

The feels

In a January 2017 survey by Bankrate, consumers were about evenly split on whether they were worried about rising interest rates or not. 49 percent said yes, they were worried, and 48 percent said, no, we’re good — which doesn’t seem too bad until you consider that a year ago, just 41 percent said that rising rates concerned them.

Another survey, this one by Berkshire Hathaway HomeServices, cast light on how homebuyers and homeowners feel about interest rate increases. According to the Homeowner Sentiment Survey, 76 percent of homeowners and 79 percent of would-be homeowners/buyers viewed rising rates as a challenge to today’s real estate market. What’s more, 44 percent of homeowners and 70 percent of buyers said rising mortgage rates would make them feel anxious.

No one would turn down more surveys that give a window into consumers’ minds, but another set of numbers may provide better insight into how consumers really feel about rising rates: the number of credit delinquencies.

A more telling barometer

When interest rates rise, can credit delinquencies be far behind? It would seem the two go hand in hand.

While delinquencies for other types of credit, such as real estate loans and leases, are either staying level or even declining slightly, credit card defaults have risen significantly since the end of 2016 — from 2.37 in Q4 of last year to 2.47 in Q2 of this year, according to Federal Reserve data. In fact, American Banker reports that credit card delinquencies are at their highest levels since 2012.

Credit cards aren’t the only form of credit likely to see an increase in defaults as the year progresses. TransUnion predicts we’ll also see more auto loans fall delinquent, and while home loan and personal loan defaults will remain low, the average amount that borrowers owe will increase. As debt amounts increase, so does the risk that more consumers will decide their debt is no longer manageable — and just stop paying on it. While that eventuality may be much farther down the road, it’s still a real risk banks must consider.

Think I’m overstating the risk? Consider this: Bankrate’s survey found worries over interest rates divided along economic lines.

Those with more money to invest were worried how rate increases would affect the stock market, while those with money to save were encouraged by the possibility of getting higher interest on their savings. Half said they were as comfortable with their level of debt as they were a year ago, but a quarter are less comfortable.

Could these debt-troubled consumers be more likely to default as interest rates rise and using credit becomes costlier?

Protecting your FI from delinquencies

Of course, rising interest rates present opportunities for financial institutions, but the threat of rising credit delinquencies may feel like a more compelling and immediate risk to many banks. Financial institutions need to take steps to insulate their bottom lines from the risks of rising credit defaults.

Here are some strategies financial institutions should be incorporating into their plans for weathering a rising-rate environment:

  • If you haven’t already achieved greater security and efficiency with your account-screening process, now is the time to perfect it. The best way to avoid credit delinquencies down the road is to weed out the consumers who are at higher risk of falling into default.
  • Help customers migrate high-interest debt into lower-interest products. Yes, lower interest means less money for the financial institution. However, consumers who feel overly burdened by high interest may be more likely to default. Consumer credit card debt is high — and high interest. Use data modeling to identify the customers who might benefit the most from rolling high-interest credit card debt into lower-interest vehicles like HELOCs or personal loans. Many of the same consumers who carry credit card balances have open HELOCs with zero balances! Now is a great time to remind them that lower-cost credit is available to them.
  • When marketing purchased mortgages, look beyond basic triggers (or marketing signals) such as who’s in the market for a mortgage. Use additional qualifiers to help identify audiences who will not only be ready to buy, but will be able to repay their loan over time no matter what happens with interest rates. A combination of predictive modeling and data assets can help identify these optimum customers.
  • Many industry watchers are predicting that the auto finance market is headed for a Great Recession-style meltdown due to the growing prevalence of sub-prime auto lending. In fact, vehicle lending is historically among the most default-prone types of consumer credit. Financial institutions must either withdraw from the auto lending marketplace (who wants to do that?) or find better ways to screen borrowers in a highly risky and competitive marketplace. Look for triggers that indicate customers already have the wherewithal to repay an auto loan. For example, consumers with expiring leases need to take some action to secure a new vehicle or buy out their current one. These borrowers have already demonstrated they have the sense of responsibility and cash flow necessary to finance a vehicle.
  • Lastly, its time to start looking at how various scenarios could affect your financial institution as a whole. A tool like Banker’s Dashboard allows you to input a variety of changes to see how the changes could affect your balance sheet. We talked about this recently in a webinar called “Strategic Responses to the Rising Rates Environment,” if you want to learn more about this, I suggest you take some time to listen to it on demand.

Looking forward

Two key predictions should inform a financial institution’s risk management when it comes to the possibility of increased credit defaults:

  • The Fed says it’s probably going to raise the federal funds rate again before the end of 2017.
  • As the cost of consumer credit rises, so will the number of consumers who feel they can no longer afford to repay the credit they’ve already borrowed.

In light of those two eventualities, any plan for coping with a rising-rate environment needs to address the risks of escalating credit defaults.