Will Consumer Loans Get More Expensive in 2011?

The credit crunch caused by the financial crisis didn't just affect businesses: consumers also felt the pinch. Mortgages, credit cards, and even auto loans became harder to get. And when banks and finance companies did agree to provide loans, they came at a higher price. Loans had become under-priced by banks during the housing bubble, pretty much across the consumer credit spectrum. Since the crisis climaxed, banks have become a little more comfortable making loans again. Should we expect banks' willingness to be reflected in the interest rates consumers face throughout the next year?

Interest rates on consumer products actually didn't rise as much as they could have following the financial crisis -- the Federal Reserve made sure of that. Even beyond holding short-term interest rates very low, it began a handful of asset purchase programs to target mortgages and other consumer financial products. If banks knew that the Fed would buy most asset- or mortgage-backed loans that they originated, then they could push most default risk to the Fed.

But those programs have ended. The Fed is no longer buying mortgage bonds or bonds backed by other consumer products like auto loans, credit cards, and student loans. Are investors comfortable enough with the market to pick up where the Fed left off? It depends on what kind of loan we're talking about.

With regard to mortgages, the answer is complicated. Investors are still very wary about mortgage-backed securities (MBS), since those were the ones that became extremely toxic when the housing bubble popped. Even now, more than two years after the financial crisis peaked, banks have trouble getting mortgage-backed securities done. But this doesn't affect most mortgage rates, since the government is still backing most mortgages, leaving little risk for investors to take.

When it comes to student loans, again, the government will probably keep the credit flowing. We've seen that consistently over the past year, since consumer credit has mostly shrunk, except with student loans. The government has essentially taken over that market, leaving little room for private lenders.

For most other loan markets, like those for auto loans and credit cards, however, the government is not involved. Bloomberg ran an article Sunday by Sarah Mulholland that intends to argue that the asset-backed securities (ABS) market will decline in 2011, without Fed purchases. It's hard to see how. Investors weren't really burned by auto or credit card ABS the way they were with MBS. Indeed, the article says:

Spreads for auto-backed debt narrowed 25 basis points from Dec. 31, 2009 through Dec. 24, the Bank of America index shows. Spreads for asset-backed securities linked to student loans shrank 3 basis points to 193, while bonds tied to credit card payments saw their relative yields contract 24 basis points.

Pardon the investor-speak here. "Spreads" mean the interest rate premium over benchmark rates, like Treasuries. The higher the spread, the more interest that investors want from bonds compared to a benchmark. In this case, that spread is to compensate for a higher risk premium. Spreads are declining for most consumer loan-backed bonds, meaning that investors are becoming more comfortable with them.

Now back to that Bloomberg excerpt. Student loans can be taken out of the equation here. The government is backing all but a handful of relatively risky student loans, which are all that's left for the private market. But you can see that auto loan- and credit card-backed securities have become much more palatable to investors. The risk premium has dropped by nearly a quarter of a percentage point in a year's time.

This trend should continue. Although the mortgage market is still very much in flux, auto loans and credit cards have mostly seen their darkest days. Any losses that those markets felt were caused more directly by unemployment than the housing bubble. And since unemployment is likely to begin to improve a little more consistently in 2011, loan defaults for those products should also begin to decline.

But the total cost of consumer loans is more complicated than just the risk premium that banks face. They also depend on how the benchmark interest rates change. Unfortunately, those rates are rising. We have already begun to see this phenomenon in Treasuries. While Treasury yields may be rising in part because investors don't like all of the deficit spending, nominal rates in general are likely to rise as the economy improves and the Fed continues to push for higher inflation. So even if investors provide relatively cheaper funding for consumer loans, they could still become more expensive if prevailing benchmark rates continue to rise throughout the year.