If you’d told our experts on January 1, 2023 that inflation would continue skyrocketing due to a red-hot economy, the Federal Reserve would raise interest rates four separate times by a total of 100 bps, and unemployment would retain its downward trajectory, we probably would have thought you were still enjoying a New Year’s party. However, all of that happened in 2023, and will be researched and discussed for years to come.
Looking Forward to 2024
As 2024 begins, the credit risk landscape is fast moving and always changing, with even more volatility expected given the dynamic trends seen in consumer credit during 2023. Here are the major trends that we are watching for in 2024:
- Risk is still rising: After normalizing for origination risk score, there is a worsening of risk in more recent vintages across asset classes and risk bands. Increasing delinquencies throughout 2023 and increasing roll rates across delinquency buckets indicate credit performance continuing to deteriorate as 2023 concludes and 2024 begins. Risk scores also continue to be impacted due to continuing data-based blind spots in the Buy Now Pay Later (BNPL), Credit Builder trade, and student loan payment spaces respectively.
- Resumption of Student Loan (SL) repayments: As mentioned in previous 2OS content, a first look at the resumption of SL payment showed 40% of the 22 million borrowers hadn’t made the October 2023 payment by mid-November 2023. These missed payments won’t show up on credit reports until September 2024, due to the 12-month on-ramp period, which will likely further degrade credit risk scores.
- Fee cuts: The Consumer Financial Protection Bureau (CFPB) is planning to decrease credit card (CC) late fees. Banks are likely to be impacted and may pull levers such as raising APRs (annual percentage rate) on CC products (where possible) to mitigate those impacts or identify other revenue sources to offset costs, which could add additional market volatility.
- (Dis)inflation and potential rate cuts: The Federal Reserve has indicated at least three rate cuts in 2024, assuming inflation continues to ease. If rate cuts occur, payment amounts across all asset classes will be affected. Of course, this will depend on the expected continuation of disinflation (i.e., reduction in the rate of inflation). Should inflation continue to rise, subprime customers will likely be impacted the most.
- Rising unemployment rate: While unemployment hit an all-time low in 2023, the rate is trending up going into 2024. Historically, when unemployment rises, prime customers are impacted more.
2023 Year in Review
Having looked forward to some of our initial expectations for the coming year, it’s important to understand what happened in 2023 that gave us these expectations.
We at 2OS are focused on credit risk, and the credit risk story was significantly less positive than the overall economic news of 2023. With some wobbles throughout the year, most indicators slowly worsened, especially for lower income borrowers and for lenders who were the slowest to tighten underwriting. We captured that in our quarterly Credit Risk reports that review observed trends within each quarter in a State of the US Consumer Credit. As of this post, 2OS has reported on the credit risk space for three quarters: Q1 2023, Q2 2023, and Q3 2023.
Each linked report provides a quarterly snapshot view; this post will attempt to combine all our yearly analysis to review the overall credit trends of 2023. Q4 2023 performance won’t be fully available until February 2024, so we are focusing on data until November 2023. Keep watch for our Q4 Credit Risk report coming out in a few weeks!
- Elevated and increasing delinquencies: As 2023 progressed, delinquencies were increasing or elevated across all asset classes, driven by performance worsening across various consumer segments. Prime and super-prime worsened in Q2 2023, while prime and subprime worsened in Q3 2023. However, subprime delinquencies in CCs and personal loans (PLs) showed some flattening due to lender-based actions, specifically broad-spanning tightening of underwriting standards.
- Increased minimum payment amounts: In addition to increased delinquencies, minimum payment amounts increased across all asset classes throughout 2023 due to increased balances and higher interest rates. This was most noticeable for auto loans. This trend is expected to continue as student loan repayments resume after a three-year pause. There were historic increases in consumer debt levels throughout 2023.
- Warping and spoofing of risk scores: Some risky subprime customers are appearing as near-prime due to several factors, including student loan deferrals, BNPL trades not being reported and their invisibility in a consumer’s credit score, Credit Builder trades, and COVID-19 data degradation. This warping of risk scores was highly prevalent coming out of 2022 and going into 2023. To combat this, financial institutions implemented different acquisition policies for neo-banks. However, as 2023 progressed and the rise in risk increased (i.e., rising delinquencies, utilization, balances, etc.), there was an overall score inflation plateauing.
- Low consumer personal savings rate: Consumer personal savings rate was up in 2023 after hitting historic lows but was trending down as of October 2023.
- Low unemployment rate: Unemployment rate, which is a historic driver of consumer credit risk, hit a 54-year low in Q1 2023 at 3.4%. While unemployment rate did slightly climb throughout the year, unemployment remained low, despite layoffs in some industries, and remains low going into 2024.
- Tightening of underwriting: Underwriting was already tightening for CCs and PLs as 2022 ended, and continued to tighten as 2023 progressed, disproportionately affecting subprime consumers more. Companies who tightened underwriting policies earlier have seen better performance sooner.
- Easing of inflation: In 2022, inflation disproportionately impacted lower-income consumers as their effective income was reduced while also increasing risk for consumers at all income levels. The high inflation was forcing consumers to reduce savings, which led to a historic low in personal savings rate across U.S. consumers. However, not all consumers were strapped for cash, as some still had some excess savings accumulated from the pandemic. The overall outlook showed an increase in accounts and balances as consumers deal with inflation and stress. This inflation has eased throughout the whole of 2023, down to 3.1% in November 2023 from a high of 6.4% in January 2023.
BY ASSET CLASSES
Credit cards (CC) generally saw increasing trends across multiple areas, which delineated worsening conditions for consumers:
- Increased risk: Going into 2023, CCs saw increased risk, at levels higher than those seen in the pre-pandemic period, which continued to impact subprime, lower-income, and (some) prime consumers throughout 2023. However, this increased risk didn’t affect super-prime consumers to the same degree, due to the low unemployment rate and savings buffer from the pandemic.
- Increased delinquencies: Delinquencies increased year-over-year (YoY) across all quarters in 2023, even after adjusting for risk level at origination, and has begun to move beyond pre-pandemic trend lines.
- Increased balances: There were record increases of balances, which were more pronounced for subprime and near-prime going into 2023, likely in the face of the economic uncertainty due to macroeconomic conditions (i.e., inflation, interest rates, etc.). Balances continued to increase as the year progressed, but, despite the increase, still fall within pre-pandemic trend lines across all quarters in 2023.
- Increased credit lines: Average credit limits have increased and are back to pre-pandemic averages.
Origination volumes were lower in 2023 after reaching record levels in 2022. This drop was most sharply seen in subprime CC originations.
The personal loans (PL) asset class can be a bellwether for upcoming trends in other asset classes. Unfortunately, PLs observed worsening conditions for the consumer, as populations were being squeezed by inflation:
- Rise in risk: Risk was rising coming out of 2022 and continued to increase throughout the first half of 2023. However, due to tightening of underwriting, the risk and delinquencies showed some flattening in the second half of 2023.
- Low prepayment rates: Going into 2023, prepayment rates were dropping rapidly. Rates recovered a bit in 2023, but remain well below pre-pandemic levels, most sharply seen for lower-income and subprime consumers.
- Higher origination loan amounts and durations: On average, origination loan amounts and durations were higher in 2023 relative to levels seen in the pre-pandemic period.
Auto loans revealed a widening rift between the performance of used and new auto loans in two main areas:
- Worsening delinquencies for used auto, but not for new auto: Coming into 2023, auto delinquencies were trending at pre-pandemic levels, but were demonstrating worsening performance in late 2022. Throughout 2023, used auto loans increased in delinquencies (much higher than pre-pandemic levels), primarily driven by increased payment burden and rapid fall-off of used auto prices from record highs in Q2 2022. New auto loans performed better, showing lower delinquencies than used auto loans.
- Loan-to-value ratio (LTV) trends differ between used and new auto loans: While LTV is a key risk differentiator for both used and new auto loans, it has been and continued to trend higher than pre-pandemic levels for used auto loans. LTV for new auto loans, on the other hand, has become aligned with pre-pandemic LTV values.
However, while performance is diverging for used and new auto loans, both loan types have been experiencing and continue to experience high payment amounts, which were high in 2022 and continued to be high in 2023. A new peak of $1k+ monthly payments was reached in Q2 2023, consisting of many consumers who had signed up for longer terms and higher APR loans.
Mortgage performance, relative to other asset classes, has been stable. While delinquencies came into 2023 trending upward and continued to trend up throughout the year, the levels remained below pre-pandemic levels as the year progressed. The stability is likely due to the position of mortgages on the payment hierarchy, as well as the fixed rate component of many mortgages, resulting in reliable payment burdens regardless of current interest rates.
However, this apparent stability will be an area to watch in 2024, as higher interest rates and increased payment burdens have resulted in worse performance for newer vintages in comparison to vintages from 2019 to 2021:
- Drop in mortgage origination volumes: Partly due to the higher interest rates, mortgage origination volumes dropped coming out of 2022 and into 2023, which is seen as a reversion-to-mean (RTM) to pre-pandemic levels. This drop in origination volume has continued throughout 2023, with a slight increase in volume in the second half of 2023. However, origination volumes are still below pre-pandemic levels due to high interest rates and low inventory.
- Increase in home equity line of credit (HELOC) origination volume: Like in 2022, HELOC origination volumes remained elevated in 2023. Consumers were borrowing more and may be dipping into their home equity as an alternative method of borrowing, given the changing economic conditions with both home equity and interest rates increasing.
Student loans (SLs) are the largest source of US household debt besides mortgages. SLs make up approximately 30% of all non-mortgage consumer debt, totaling around $1.7T. SLs have been in deferral since March 2020, but that deferral expired September 2023, with payments restarting in October 2023. Forty percent of the 22 million SL borrowers hadn’t made their October 2023 payment by mid-November 2023. These missed payments won’t show up on credit reports until September 2024, due to the 12-month on ramp period.
Consumers with SL deferrals had an average risk score inflation of around 25 points and there is already an increase in delinquencies in other asset classes for consumers with SLs versus those without SLs (for consumers with similar credit scores). Lower-income and subprime households will more likely be affected, especially impacting their deposits, which will likely be used to make SL payments.
Other expected impacts of SL repayment include:
- Payment hierarchy: The majority of 2023 continued with non-existent SL delinquencies, but as payments resume, there is an expectation of significant increases in risk across asset classes as payment burdens rise. It’s likely that card payments will be the most impacted, as card historically falls lower in the payment hierarchy.
- Additional debt: Across credit risk scores, consumers with SLs have taken on significant additional debt over the last 3 years.
- Servicing confusion: The 3.5 years of payment suspension and change of servicers will likely lead to borrower confusion and unknown payment behavior across asset classes.
To learn more about the impacts of resuming SL repayments, see the 2OS Student Loan Deferrals white paper.