Black Friday: Shop now, pay later, default sooner

US credit card balances reached $930 billion in the third quarter of 2022, according to the Federal Reserve Bank of New York's latest household debt report, up fifteen per cent on a year earlier. That is the biggest annual rise in more than twenty years, and it matters as Black Friday opens the holiday season. Malls and online shops are busy and retailers sound upbeat, but a good share of the spending is being done on credit. Add the rapid growth of unregulated 'Buy Now, Pay Later' (BNPL) loans and it is plain that Americans are borrowing heavily to hold on to their standard of living.

The timing is bad. For the past decade carrying a credit card balance was expensive but manageable. Since then the Federal Reserve has raised rates at an exceptional pace, and the average rate on card balances has passed nineteen per cent, the highest ever recorded. Shoppers who pay for holiday gifts at twenty per cent compound interest are doing more than putting off payment. They are turning a seasonal treat into a lasting strain on their finances.

From paying down to piling up

The swing has been fast. During the pandemic, stimulus cheques and curtailed spending let households pay their cards down, and balances fell sharply in 2020. They have since recovered all of that ground and more. Total household debt reached $16.51 trillion in the same report, with mortgages making up most of it, but card debt is the part that reprices fastest when the Fed moves, because almost all of it carries a variable rate.

The cushion of savings built up in lockdown is thinning at the same time. The personal saving rate has fallen to its lowest since 2008, as households spend more of their income to keep up with prices that are rising faster than wages. When savings run low and real pay falls, credit becomes the last way to hold consumption steady, and the card balances show that many households have reached that point.

Credit nobody can see

The weakest point lies outside the banking regulators' reach, among the fast-growing Buy Now, Pay Later platforms. They let a shopper split a two-hundred-dollar purchase into four interest-free instalments with one tap on a phone. That gives fintech lenders easy access to financially vulnerable customers, especially younger shoppers and subprime borrowers who cannot get an ordinary credit card.

BNPL loans are usually left out of credit bureau reports, so they form a layer of household debt that lenders cannot see. A shopper already at the limit on several cards can take out five or six instalment loans at once without setting off a single alert in a credit scoring model. The ease of borrowing hides how stretched households really are and lets them keep spending long after their cash flow has run dry.

Regulators have noticed. In September the Consumer Financial Protection Bureau published a report on the sector and said it would look at applying protections similar to those on credit cards, such as rules on disputes and refunds. The credit bureaus have only begun to work out how to record instalment loans. Until they do, the debt that grows fastest in a squeeze is the debt that underwriters see least.

Defaults are coming

The arithmetic of revolving credit is unforgiving. Groceries, fuel and gifts bought on a card are added to an existing balance that compounds at punishing rates. As minimum payments rise with both higher benchmark rates and bigger balances, more of each month's income goes on servicing debt and less is left for essentials later on.

Card delinquencies among subprime borrowers have already started climbing and are now above their pre-pandemic levels. BNPL lenders are reporting fast-rising provisions for bad debts, and several well-known ones have had to seek emergency equity or cut back their merchant advances. Klarna, the largest European provider, raised new money in July at a valuation of $6.7bn, down from $45.6bn a year earlier. Holiday spending is running on a short fuse. When card statements and instalment bills land in mid-January, the picture of a resilient consumer will start to fade.

For now the lenders are the winners. Card issuers earn more on every balance carried at higher rates, and retailers accept the higher merchant fees that instalment providers charge because offering the option lifts the size of the average basket. Both gains last only as long as borrowers keep paying. Interest income arrives month by month, while credit losses tend to arrive together once the job market turns.

The resilient-consumer case

The counterargument is that American households are in better shape than the headline suggests. Unemployment is close to a half-century low, and the share of income that households spend servicing their debts remains below where it stood before the 2008 crisis. Part of the rise in balances simply reflects inflation: the same basket of goods costs more, so the same habits produce bigger card bills without any change in behaviour.

That argument holds for the average household, and averages are the problem. Card debt is concentrated among younger and lower-income borrowers, who have smaller savings buffers and whose real wages have fallen furthest. In the last recession charge-offs on credit cards more than doubled, and the losses were heaviest among exactly those groups. A job market that softens even modestly would expose them first.

What to watch in January

The first evidence will come from the big card-issuing banks, which report fourth-quarter results in mid-January and will set aside provisions for expected losses. The New York Fed's next household debt report, due in early February, will show whether balances kept rising through the holidays and whether delinquencies spread beyond subprime borrowers.

Black Friday 2022 probably marks the point where the consumer credit cycle hit its limit. American shoppers are using twenty-per-cent card debt and opaque instalment plans to make up for falling real wages, borrowing next year's spending to flatter this year's retail figures, and the bill arrives in January. When that credit runs out in the early months of 2023, the retail hangover will probably be sharp and long, and shares in consumer-facing companies will take the worst of it, with subprime card lenders and instalment providers first in line for losses.