Consumer Debt Looks Set to Keep Soaring

The Bad News

Economic watchers can breathe a near-term sigh of relief, but the lack of urgency consumers feel in getting their finances under control raises some serious concerns about the long-term health of the economy. In particular, experts worry about a domino effect of insolvency, as aggressive banks with loose lending standards will be forced to write down bad loans.

"When you take a financial company and push for growth, well, you can go insolvent overnight," said Jeff Auxier, who manages the Auixer Growth Fund and invests in the space. "It's hard to say if we'll see more of that in 2003, but it all depends on the institutions. Balance sheets are better than they were in the early '90s, but I'd be wary of the ones who are pushing for lots of growth."

Trouble has already turned up for subprime lenders. This year, Federal regulators forced Capital One (COF Quote) to increase the cash reserves backing its loans by $247 million. Later, the company revealed that 40% of its loan portfolio was in the subprime market, twice what was expected by Wall Street. As a result, its stock dropped 40% in 2002. Bad loans have also pushed Conseco into bankruptcy.

"The biggest bubble could be growing in single-family homes," said Auxier. "More than 60% of those mortgages require two incomes. What happens if people get sick? Or housing values drop?"

The spate of cash-out refinancing, in which homeowners receive cash for their home equity, is especially dangerous because consumers own less of their homes and are that much closer to foreclosure if something goes wrong. But nothing has gone wrong yet, which is one reason why banks are more than willing to allow homeowners to get a loan without a down payment.

Even though banks wrote off $3.9 billion in credit-card debt in the third quarter, lending is still a very profitable business, with the Federal Deposit Insurance Corp. also reporting that bank profits were up 34.8%. The reason? Banks can buy their money from the Federal Reserve at a low rate of 1.25% and mark it up to consumers at 22%. The huge profit margin ensures safety for the banks because the profits roll in as long as people keep making minimum payments.