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Subprime Credit Scores Reach Lowest Level Since the Great Recession

June 23, 2016

The Wall Street Journal released a report showing that the percentage of adults Americans with subprime credit reached a new low in the wake of the Great Recession recovery. Subprime borrowers now make up only 20.7%, the lowest since Fair Isaac Corp. (FICO) started tracking the data, and the sixth installment of year-over-year declines. The trend towards better credit is great news for a banking system and economy that are starved for growth. Relaxed credit controls can inject the American economy with new capital to jumpstart years of stagnant post-recession growth.

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The Financial Crisis Effect

In a nutshell, the financial crisis was a result of mortgage issuers extending loans to borrowers who did not necessarily qualify for the funds they received. These loans were packaged and sold off by the lender to investment banks that marketed the debt to the public as investments. When borrowers who could not afford their loans started missing payments and the sizzling housing market, a series of dominoes led to a severe financial recession that lasted from December of 2007 until June of 2009.

As a result, Congress passed the Dodd–Frank Wall Street Reform and Consumer Protection Act in 2010 as a means of reform. Due to the implementation of legislation, banks were forced to tighten lending standards in a move that may have restricted capital injections into the economy, stunting growth. There is room for change considering that on the whole, consumers have become more responsible borrowers.

The Numbers

The percentage of subprime borrowers in the US has dramatically dropped almost 19.0% since its 2010 high of 25.5% of adult Americans. According to the S&P/Experian Consumer Credit Default Composite Index, only 0.8% of consumer loan dollars, which includes home mortgages, auto loans and credit cards, were in default as of May.  This marks the lowest recorded level going back as far as 2004.

The WSJ report cites a FICO statistic that 11.8% of borrowers were 90 days or delinquent on debt obligation during the 12-months through April, down from 13.3% during the 12 months through October 2013.This positive trend in the data should continue as millennials enter the labor force more educated about credit and the impact of loose lending standards. According to Paul Taylor of the Pew Research Center, the millennials generation is the most cautious with money the Center has ever seen.

What it Means for Banks

An increase in the pools of creditworthy borrowers would allow banks to increase lending generated revenue without taking on more risk.  One example showing the potential growth is Loan Star Funds’ announcement earlier this month that the would issue rated bonds backed by mortgages to borrowers that average less than prime credit.

The bonds are supported by $161.7 million worth of mortgages, with Credit Suisse assigning up to an A rating as the highest rated tranche, which is an investment grade rating. This marks the first time a subprime mortgage security has been issued since the 2008 financial crisis. Private-label subprime mortgage securitization is a clear indicator that the American economy is finally returning to more normal conditions.

What to Watch For

The US economy is expected to expand at just 1.8% annualized pace during the second quarter, well shy of the country’s post WWII average of 3.2%. However, with the improvement in overall credit, look for US GDP to have upside surprise in the next couple of quarters as consumer spending continues to improve. Increased consumption will signal the Federal Reserve that a rate hike will be appropriate to accompany strengthening economic activity.