American consumers and businesses are finding it increasingly difficult to manage credit card, auto, and commercial real estate debt.
In response, U.S. banks are shoring up their reserves to prepare for potential loan losses. CEOs from major financial institutions have voiced concerns during recent earnings calls, noting that high prices and interest rates are creating significant financial strain for Americans.
The rising difficulty banks face in collecting debts has led them to adopt more cautious approaches. According to Federal Reserve data, the proportion of past-due debt across credit card, auto, and commercial real estate categories has surpassed pre-pandemic levels. Simultaneously, the charge-off rates for credit card and auto loans have surged to heights not seen in over a decade. These trends have prompted large financial institutions to boost their reserves, setting aside funds to cover anticipated loan defaults.
While it's common practice for banks to increase reserves as loan portfolios expand, the rate at which reserves are growing now stands out. Major banks like Wells Fargo, Bank of America, JPMorgan Chase, and Citigroup are all seeing reserves gradually take up a larger share of total loans. Since mid-2022, Wells Fargo and Bank of America alone have boosted their reserves by $1.8 billion and $2.4 billion, respectively. However, the scale of these reserve increases still pales in comparison to levels seen during the Great Recession.
Three Key Areas of Debt Distress Recent data from the New York Fed reveals growing concern among Americans about their ability to meet debt obligations. Each month, about 1,300 consumers are asked to assess the likelihood they will miss a debt payment within the next three months. Outside of the pandemic period, consumer pessimism hasn't reached such levels since 2017.
Three areas of debt are proving particularly troublesome: credit cards, auto loans, and commercial real estate. Consumers are grappling with inflation and high interest rates, while businesses face challenges linked to the lingering effects of remote work and elevated rates.
Credit Card Debt The percentage of credit card accounts with past-due balances climbed to over 3% by the second quarter of this year, up from under 2% in 2021. Bruce McClary, senior vice president at the National Foundation for Credit Counseling, attributes this rise to growing difficulties among consumers trying to manage credit card debt. As inflation and high interest rates persist, people are exhausting what little credit they have left, which is driving many into the hands of debt collectors.
David Schiff, senior managing director at FTI Consulting, warns that prolonged struggles to repay credit card debt could pose a broader risk to the economy. He points out that increased bank reserves signal growing concern over the health of certain asset classes, particularly revolving credit card balances and their rapid growth.
Auto Debt Auto loan delinquencies have also seen a notable increase, surpassing pre-pandemic levels by late 2023, largely due to rising monthly debt payments. Many Americans now owe more on their cars than the vehicles are worth, according to a report from Edmunds. Stephen Biggar, director of financial services research at Argus Research, notes that if banks are forced to repossess these vehicles, the losses can be substantial. Though the increase in auto delinquencies isn't dramatic, it raises questions about future trends in this segment.
Commercial Real Estate Commercial real estate loans are another source of concern for banks. High office vacancy rates, exacerbated by the remote work trend, have pushed some businesses into financial distress. Despite many companies bringing workers back to the office, vacancy rates have continued to rise over the past year.
Elevated interest rates are adding another layer of difficulty, as businesses with loans coming due must refinance at much higher rates. This trend is affecting properties across office spaces, retail outlets, hotels, and apartment buildings. While the current situation isn't dire, there is growing apprehension that if the broader economy weakens, banks could face more significant loan losses in the commercial real estate sector.
Current vs. Crisis Levels Although debt delinquencies and charge-offs are increasing, they remain within historically normal ranges. Many banks are still in the process of replenishing reserves that were depleted during the pandemic. However, if economic growth slows and unemployment rises, the strain from delinquencies could intensify, potentially leading to a larger issue.
Acknowledgment from Wall Street Throughout the most recent earnings season, banking executives have largely maintained a positive outlook on the U.S. economy. However, they also acknowledge the ongoing pressure high prices and interest rates are placing on consumers.
Jane Fraser, CEO of Citigroup, noted that while their customer base remains healthy, signs of financial stress are emerging, particularly among lower-credit-score consumers. Brian Moynihan, CEO of Bank of America, highlighted that while consumer spending remains strong, there's a growing unease about the cost of living and rising interest rates. Wells Fargo's CEO, Charles Scharf, observed that although there hasn't been a dramatic shift in delinquency rates, financial strain is becoming more evident among customers with lower deposit balances and fewer assets.
Jeremy Barnum, CFO of JPMorgan Chase, commented that discretionary consumer spending has normalized after several strong years, especially among lower-income individuals who have been hit hardest by inflation and interest rates.
Lower-income consumers, in particular, are facing difficulties in making ends meet. Stephen Biggar noted that a significant portion of this demographic is struggling to keep up with rising living costs and debt obligations.
What Lies Ahead for Banks Looking forward, Biggar expects that many banks will continue to bolster their reserves, especially if the unemployment rate ticks higher. While the jobless rate has recently stabilized after a brief uptick, any significant increase could prompt further reserve accumulation. However, Biggar doesn’t anticipate a dramatic rise in reserves unless unemployment trends worsen considerably.
