First-Time Defaulters Puzzle Lenders

The financial crisis-induced recession spawned a new breed of consumer: "the first-time defaulter." A new report from the Deloitte Center for Financial Services identifies this new group as "individuals who have gone through at least one serious negative credit event in the last two years for the first time in their lives." It's a surprisingly large portion of Americans, and banks are struggling to figure out how to treat this new category of borrowers.

Deloitte's report says that 22% of Americans experienced at least one serious negative credit situation in the past two years. Of that group, half could be classified as first-time defaulters, meaning that 11% of the U.S. population falls into the new category.

That's incredible: this recession caused a serious credit issue for one-in-seven Americans who had never before. The reasons why aren't particularly surprising, however. With unemployment steady around 10% for over a year and underemployment around 17% for much of that time, quite a few people must have experienced trouble making ends meet. Deloitte's statistics show 49% had credit trouble in part due to reduced income, while 38% blamed unemployment as a reason for their troubles:

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But you can see that fewer had trouble paying their bills due to taking on too much debt. Just 24% cited this as a reason. That, along with the mere 22% who blamed increasing interest rates on loans or a drop in their home's equity, implies that foreclosures stemming from wacky mortgage products and underwater loans did not play that significant a role in causing credit problems among first-time defaulters.

Indeed, these defaults weren't even focused on mortgages. Here's another chart from Deloitte breaking down the credit problems that first-time defaulters experienced:

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Just 14% were habitually delinquent on their mortgage and another mere 6% experienced foreclosure, though a few other categories shown (like bankruptcy) could include housing-related troubles. It's pretty interesting that such a high proportion, 43%, had problems paying their medical bills.

The Deloitte report also notes that 60% of these first-time defaulters had credit scores above 620 before their credit problems began. In fact, 30% had scores above 700. Lenders had typically associated scores in these ranges with very good borrower behavior. Indeed, 700+ was considered virtually risk-free. So banks and finance companies must rethink their strategies.

Lenders may have oversimplified the types of borrowers that exist, however. Prior to this recession, they considered two major categories:

  • Subprime: Those who borrow too much and have a poor record of paying their bills on time or at all
  • Prime: Those who borrow only what they can afford and pay their bills on time

Now, we know of a new category:

  • Stealth Subprime: Those who borrow what they can afford when gainfully employed, but do not have enough savings to sustain their debt payments if extended unemployment hits

The first-time defaulters were really subprime borrowers in disguised by good jobs. They were responsible when it came to paying their bills, but only as long as their income remained stable. They actually weren't disciplined enough savers to have accumulated a big enough cushion to keep up with their bills when their income stream dried up. Truly prime borrowers have enough savings and/or assets to continue to pay their bills even if struck by prolonged unemployment.

The Deloitte report also notes that these first-time defaulters have become very disillusioned with their lenders. An overwhelming 63% say that they won't borrow again from the lender connected to their default. Of course, this makes sense. Most of these Americans likely believed that they were good borrowers and were simply down on their luck for a while. The unwillingness of lenders to provide indefinite extensions or payment deferrals showed the borrowers that these institutions didn't care about keeping them as customers, just obtaining their monthly payments.

Yet where the first-time defaulters manage to get credit might not be left up to them for the next several years. Now that their credit records are blemished, it will take quite a while before lenders are eager to take the risk of offering them a new loan. And when one does, they can expect to see higher interest rates and fees than they were used to before their trouble.

This is probably the route most lenders will take. They know that, in times of prosperity, stealth subprime borrowers are very good at paying their bills. But in order to cover the risk of another episode of underemployment, lenders will have to charge these consumers higher fees and steeper interest rates. To the extent that new financial regulation allows these changes, this is likely how lenders will respond. If they can't reconcile new rules with new loan pricing strategies for these first-time defaulters, then these consumers may be required to sit out of certain aspects of the credit game for a while, until the new dark spots on their credit histories begin to fade.