Downgrading the American Consumer's Credit Rating ~ market folly

Wednesday, March 25, 2009

Downgrading the American Consumer's Credit Rating

Downgrading the American Consumer's Credit Rating:
A Potential FICO Score Nightmare
by market folly

We're here to point out a potential unforeseen consequence of credit cards as the next credit crunch. The developments of credit card companies raising interest rates, cutting credit lines, and closing inactive accounts altogether has many consequences: Firstly, consumer confidence and consumer spending could drop off. Secondly, as such, the economy as a whole would continue to suffer. Lastly, and most unforeseen, FICO (credit) scores most likely will be reduced and many American consumers will essentially be 'downgraded' by way of their new, lower credit scores, further inhibiting their access to future credit. Many people are focused on how these actions will affect consumer spending (and this could be a legitimate concern). But, we also want to turn the focus to the decrease in consumer liquidity and how overly reliant consumers are on credit cards for cash-flow management.

Credit Cards Are the Next Credit Crunch

We'll break this down in the piece below, but first, some background. If you don't know who Meredith Whitney is, then shame on you. She has been one of the best analysts on all things financial, nailing the trouble at Citigroup (C) when no one wanted to believe it. She is the dominatrix of doom and she has recently put out a report on credit card companies, stating that financial institutions could cut up to $2.7 trillion in lines of credit that have been typically available to consumers. The bulk of her message was that this could happen by 2010 and that it would severely dampen consumer spending. Not only would it affect consumers, but it would affect small businesses as well, who often rely on credit cards to actively finance their day to day activities.

We've been harping on this issue for a while under the notion that credit cards are the next credit crunch. Companies like Bank of America (BAC), American Express (AXP), and Capital One (COF) have reported increase after increase in charge-offs and delinquencies in their credit card units. Obviously, rising unemployment and a hell of a recession are only going to add to that. Head of JPMorgan (JPM) Jamie Dimon has even flat out admitted that credit cards are going to be a house of pain for his company in 2009 and possibly beyond. We've posted on this issue back in August of 2008 and will continue to harp on it until we see material improvement. But, while more people seem to be coming around to the fact that credit cards will indeed be a big problem going forward, the possible magnitude of the issues still needs to be highlighted.

Many American consumers were living on a debt binge by purchasing everything on credit cards and slowly paying them off over time (or not paying them off at all). America = consumerism. You also have a second tier of consumers who would typically pay with cash or debit card, who have now been struck by hard times. When push comes to shove and you've got to make the essential purchase of food, you fall on the credit card for emergencies. And, with this economy, there are a lot of consumers pushing the big red 'emergency' button. The problem here is that the credit card companies are trying to fight off rampant delinquencies and non-payers by all means necessary. The best example of this would be American Express offering you $300 to pay off your bills and close your account (to a limited number of accounts). This is the deleveraging world. Markets are deleveraging, hedge funds are deleveraging, and consumers are deleveraging. The credit card companies are no different. They simply took on too many customers (especially of poor credit quality) and offered everyone credit lines that were much larger than necessary. They are now correcting their errors.

But, as such, the consumer suffers and their purchasing power now decreases exponentially. If you didn't have enough money for that flat screen TV, you put it on your credit card with your $10,000 line of credit. But now, that $10,000 line of credit might be chopped down to only $4,000 and you've already racked up a lot of charges on there. Where do you turn now? How do you purchase your sacred flat screen TV? You can't. (In the end, that might not necessarily be such a bad thing as it brings consumers back to a realistic level of spending, as well as a realistic level of saving. But that's a topic for a whole 'nother post).

Available lines of credit were cut by almost $500 billion in Q4 of 2008. Whitney acknowledged that and says her estimate might be too conservative given how fast credit lines are shrinking. In the US there is about $5 trillion in credit card lines and $800 billion or so of that is being drawn upon right now. This affects overall consumer liquidity as consumers become even more squeezed in an already penny pinching environment. And, its not the reduction in credit lines that affects things. Creditors are also shutting down credit card accounts completely, due to inactivity (which, by the way, is their legal right). Additionally, they are raising interest rates on numerous accounts in an attempt to recoup whatever losses they can. Unfortunately, this move will put many borrowers even further underwater, decreasing the chances they pay off their cards. But, there is also something else that could be an unforeseen consequence: a nightmarish decrease in consumer credit ratings (FICO scores).

What is a FICO Score?

We should preface this section with a disclaimer: We're by no means FICO experts and FICO calculation is almost like a mad-science. We've simply done a ton of research and are presenting theoretical examples that could potentially lower credit scores of many consumers. Feel free to chime in if you're an über-expert on the matter. If you are unfamiliar with FICO scores, it is essentially your credit rating as a consumer; a number slapped across your forehead that tells creditors how likely you are to pay them back. The pure definition of a FICO score:

"A FICO score is a credit score developed by Fair Isaac & Co. Credit scoring is a method of determining the likelihood that credit users will pay their bills. Fair, Isaac began its pioneering work with credit scoring in the late 1950s and, since then, scoring has become widely accepted by lenders as a reliable means of credit evaluation. A credit score attempts to condense a borrowers credit history into a single number. Fair, Isaac & Co. and the credit bureaus do not reveal how these scores are computed. The Federal Trade Commission has ruled this to be acceptable. (And more info per mtg-net if you want it)"

Why FICO Scores Matter

Quite literally, your FICO score is one of the biggest factors determining your access to credit. The FICO score ranges from 300 to 850; the higher the score, the better (with 850 being the ideal score). You can essentially break down the FICO score range into four tiers:

  1. Excellent credit: 700-850. People with this score will receive the best interest rates, aren't likely to default, and should have no problems accessing future credit.
  2. Good/Decent credit: 600-699. People with scores in this range will pretty much get a normal loan and usually won't be denied.
  3. Poor credit: 500-599. This is not the worst part to be on the ladder, but banks start to get you in their back pocket here and credit availability could be an issue.
  4. Dismal credit: 499 and below. Terms for people with these scores will be absolutely brutal, if they are even given credit at all.

We've kind of generalized the list of tiers, but you get the picture. So, why do FICO scores matter here? Well, if you look closely, you'll see some big differences in terms of interest rates offered on loans and overall availability of credit as you move from one FICO score category to another. After all, don't forget that a sub-600 credit score was deemed as sub-prime by many. Let's take a look at a theoretical $200,000 30-year fixed mortgage (national average as of March 24th) across the range of credit scores to see the various APR's offered thanks to a graphic from

(click to enlarge)

Keep in mind that this graphic only encompasses an 'upper tier' of FICO scores. You'll notice that they only go down to a score of 62o on their list. And, even so, a consumer who has a score of 620 is paying 1.589% more in APR than someone with a 760 score. You can only imagine what the APRs are going to be like on FICO scores lower than 620 as you fall into the 'fair' and 'poor' credit ratings. So, not only does a lower FICO score mean you'll be paying a higher APR, but you'll also have less overall access to future credit as lenders will be more inclined to turn you down in this environment of tightening credit standards.

Why FICO Scores Will Decrease

Now that you've got an overview of how a lower FICO score is "bad-news-bears," let's examine why cutting consumer credit lines will essentially downgrade consumers' credit ratings. Your FICO score is determined by a myriad of factors. But, this chart breaks down just how the score is calculated:

(click to enlarge)

Now, as you can see, the two biggest pieces of the pie are 'on-time payments' (35% of the FICO score) and 'capacity used' (30% of the score). On-time payments are obviously in the hands of the consumer themselves. And, many pundits have already accounted for the fact that consumers will be delinquent on their bills or flat-out won't pay them due to economic hardship, etc. This is the well known part of the credit card crunch. What hasn't really been talked about is the second biggest piece of the pie: capacity used.

Capacity used is simply a calculation of how much of your available credit lines you are using. This utilization ratio can be affected by two inputs: how much you're charging to your cards and how high your credit limits are. So, a lower ratio of capacity used is obviously better. The lower your utilization ratio, the better your FICO score can be. You can achieve such a ratio by having either lower balances or increasing your available credit; or both. Now, we've already seen from above that creditors will be cutting available credit lines all over the place and even closing down some accounts completely. This immediately increases a consumer's utilization ratio even if their rate of spending remains constant.

An example: You spend $1,000 on your credit card each month and your available credit line is $10,000. Currently, your utilization ratio (capacity used) is only 0.1, or 10% each month. Fast forward to next month and you're still spending $1,000 on your credit card. Then, the credit card company comes through and axes your available credit down to only $4,000. Even though your spending rate has stayed the same, your utilization rate is now .25, or 25%. Once again, even though your spending was constant, the credit card company's actions have now just sent your utilization rate up 2.5x. And, as such, that 30% of your FICO score determined by capacity used (the second largest component in computing your score) has just sent your score down (possibly even to a lower-tier of ratings).

Next, look at the same example wherein the consumer ramps up the amount they charge to their credit card due to emergency and economic hardship. Before, they were spending $1,000 on a $10,000 credit line. Now, their line has been chopped down to $4,000 and their spending has doubled to $2,000 due to hardship brought on by the recession. Purchases they would normally pay for in cash now have to be put on the 'emergency card.' In this scenario, their utilization rate has now risen to .5, or 50%. Their utilization ratio has now increased five-fold! Such a large increase in capacity used will undoubtedly affect their FICO score in a negative way.

So, while others may be focused on the "amount charged" input in the capacity used equation, we are focused on the "available credit" portion of the equation. The amount charged on a card is a variable input as it can fluctuate on any given month. Available credit though, is more often than not static as consumers have their credit lines in place (with a few exceptions like opening new cards). The problem is, though, that credit card companies are no longer leaving credit availability relatively static. Creditors have already started cutting available credit and they will only continue to do so, as they struggle with rising charge-offs and delinquencies. This 'fad' has already run rampant, as I can't even begin to tell you how many people I've read about that have had available lines clipped and have even had cards closed down altogether due to inactivity.

Think about that for a second. If they close down a card completely, not only have you lost that available credit line which affects the 30% of the FICO equation, but you've also lost a portion of the 15% 'length of credit history' part of the equation in the pie chart above (or all of that history if its your only card). So, when they completely close an account, you now have negative readings on up to 45% of the inputs used to calculate your FICO score, rather than just the 30% in the theoretical scenarios we've outlined above. And, this is all on top of the negative scores many consumers will receive on the 35% allocation of the score for "on-time payments" since many have missed payments and delinquencies are continually rising. If you take all of these factors into consideration, the categories with the highest weighting in FICO scoring most likely have and will be negatively affected, leaving consumers with lower scores. Just how much lower could credit scores go? Ultimately, all we can do is guess. The degree of severity lies buried within the madness known as FICO. Our inclination is that it could very well have an impact though, depending on scale.

The Crux of the Credit Card Crunch

Utilization ratios (capacity used) could potentially skyrocket and thus negatively affect the 2nd largest input (30%) in calculating consumers' FICO scores. Additionally, closed accounts could negatively affect up to 45% of the FICO calculation, possibly bringing down one's score that much more. As such, FICO scores could possibly decrease, landing Americans in a credit tier below their current status, thus further restraining their access to credit. Why does this all matter? Well, we are just recently working off the effects of a defaulting sub-prime borrower. If FICO scores decrease en masse, we could shift a whole new batch of American consumers from the 'fair' tier to the 'sub-prime' tier. Not to mention, the liquidity crunch consumers are facing becomes that much tighter as companies put the squeeze on consumers, increasing the probability that said consumers will default.

The ultimate question becomes, 'Will FICO scores decrease en masse?' That's tough to answer, given the complexities of the FICO score itself and the vast variety of household balance sheets found around the nation. And, even if credit scores decreased en masse, FICO could possibly alter the way they compute scores to take this into consideration. So, the affects of a massive theoretical downard shift in FICO scores could be overstated. But, if you take this outcome on a slightly smaller scale, its still a very real scenario. We're simply trying to provide a counter-argument to our thoughts.

So, to recap: Credit card lines drying up is bad for the consumer because it takes away their liquidity and ability to spend since many potentially use cards for cash-flow management. This decrease in consumer spending would, in turn, obviously bad for the economy. Lastly, such a reduction in available credit could negatively impact consumers' credit ratings (FICO scores), 'downgrading' consumers to lower credit tiers, raising the interest rates they are charged, and decreasing their overall access to future credit. And, all of the above can increase the probability they will default. The creditors quite literally own consumers with bad credit; it's as simple as that. We're mainly worried about the consumers who are currently teetering on the edge in terms of their credit score and tier. While they might not have 'poor' credit yet, a slight decrease in their score could shift them into that category. Add up the cumulative effect of all those who are teetering on the edge, and there could be serious implications.

While things might not turn out to be as extreme as we've laid out above, there will nonetheless be consequences. In an environment where companies are being downgraded left and right, we're downgrading the credit ratings of the American consumer. Credit just got that much harder to procure.

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