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Consumers borrowing despite recession

Spending helps economy but could backfire later

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Steven Yamamoto has lots of debt. The 24-year-old apartment-rental agent, whose annual income is roughly $35,000, owes a total of $28,000 on six credit cards. He owes another $6,000 on a debt-consolidation loan he took out years ago. And he continues to rack up more debt by using credit cards to pay for gas, entertainment and vacations.

To ease his financial burden, Yamamoto, who lives in Los Angeles, recently moved back in with his parents, and he has sought the help of a credit counselor. But none of his money worries have kept him from getting new solicitations in the mail each week from banks and other financial institutions eager to give him yet another credit card.

Ten months into the current recession, consumer-credit defaults and payment delinquencies are as high as they have been since the last recession, a decade ago. This time around, however, lenders, who were quick to reduce the flow of credit during past recessions, have left the tap wide open. That's allowed Americans to continue borrowing to pay for homes, cars and other big-ticket items, bolstering the weakened economy. But the resulting growth in consumer credit — to a record $7.5 trillion at the end of the third quarter of 2001 — also has exposed a potential new economic fault line.

Rising consumer debt is typically a sign of robust spending. In the short term, consumer spending stimulates the economy. That's clearly what the Federal Reserve had in mind over the past year as it repeatedly lowered U.S. interest rates. But the unusual growth in consumer borrowing during the current recession also poses a danger: that at some point, consumers will have to divert more and more of their income away from spending on goods and services and toward repaying their debts.

Such a shift would slow the economy, reducing the chances of a speedy recovery. That is, of course, unless consumers defaulted under the weight of all that debt, packing the bankruptcy courts and spreading financial distress among their creditors. Either way, many economists argue, the current mountain of consumer debt is likely to mean trouble.

So far, easy credit has helped soften the downturn, and despite months of dire predictions, there has been little sign of a reckoning. Lenders' charge-off rates for bad credit-card debt, for example, were at 5.35 percent at the end of the third quarter, up from 4.22 percent at the end of the last recession. But even if that number abruptly shoots higher, most lenders today are far better capitalized than ever before, and thus better positioned to weather their losses.

Much of the growth in consumer debt, particularly in the mortgage market, reflects consumers' desire to take advantage of the historically low interest rates engineered by the Fed. But many economists worry that by buying now what they would otherwise be buying tomorrow, consumers are dulling one of the few major benefits of a recession. Though painful, recessions usually purge the economy, as lenders reduce the availability of credit to compensate for the higher risk that their loans will go bad.

During the first two quarters of the early 1990s recession, the average American household reacted to those tighter credit conditions by paring its debt by an inflation-adjusted $410, says Mark Zandi, chief economist at Economy.com, a consulting firm based in West Chester, Pa. That helped leave consumers in shape to borrow anew when the economy ultimately turned the corner. By contrast, Zandi says that during the first two quarters of the current recession, which began in March, the average U.S. household took on $1,420 of new debt.

Thus far, low interest rates have helped keep consumers' debt payments relatively manageable. But when rates rise, as they inevitably will, lots of debt pegged to fluctuating rates — including many credit cards and mortgages — will require higher payments, further stretching household budgets.

And if the economy takes a turn for the worse, outsized debt levels and rising layoffs could cause far more personal bankruptcies, adding a new layer to the debt debacle already affecting corporations in sectors from telecommunications to energy. About 350,000 American consumers filed for bankruptcy in the third quarter, and the total number of personal bankruptcies for 2001 appears likely to top the record of 1.4 million set in 1998.

"Consumer balance sheets are coming out of this recession significantly more tattered than in the wake of any other recession we've ever experienced," says Economy.com's Zandi.

Companies of all stripes are feeding the current debt frenzy. Automakers such as General Motors Corp. and Ford Motor Co. have bolstered their sales amid the recession by offering zero-interest-rate financing. Retailers such as Sears, Roebuck & Co., Home Depot Inc. and Dell Computer Corp. are offering similarly attractive financing deals.

Despite the surge in layoffs accompanying the current downturn, credit-card companies, led by Capital One Financial Corp. and MBNA Corp., are likely to have mailed out a record five billion new credit-card solicitations in the year just ended, up from 3.5 billion in 2000.

From his vantage point, Peter Stouder can see the current economic storm clouds as well as anybody. The 31-year-old salesman for a Denver pipe-fitting distributor says his commissions are down, cutting his 2001 income by about $5,000 to $60,000. Stouder is the breadwinner for his family of three, which includes his pregnant wife. A few months back, the company he works for made a small round of layoffs.

Yet like many Americans, Stouder doesn't have any qualms about going deeper into debt, and his lenders are encouraging him to borrow. Stouder says his mortgage lender, E-Loan Inc., recently gave him a $176,000 mortgage to buy a larger house. His new mortgage payments are nearly three times as high as those on his old house, and he says that, with that heavier mortgage burden, he will have to apply about 56 percent of his annual income to paying debt. Stouder also bought a $27,000 "thunder-gray" four-wheel-drive Toyota Tundra last year, again relying mostly on credit.

"I want to enjoy everything and not worry about cutting back," says Stouder, who regularly gets solicitations for new credit cards.

Credit counselors say they are busier than ever, in large part because many people don't fully realize the dangers of the credit that's available to them. They say many consumers know that they are acting irrationally but are convinced that the rules of the game have somehow changed to keep them out of trouble.

"People are under the impression that something is wrong with them if they aren't getting preapproved credit-card applications," says Tara McCarthy, a credit counselor at Auriton Solutions Inc., a nonprofit credit-counseling company based in St. Paul, Minn.

But "just because somebody will give you credit doesn't mean you can afford it," says Steve Rhode, president of MyVesta.org, a credit-counseling service based in Rockville, Md.

In the short run, the continued availability of credit — and consumers' willingness to use it — is one reason the current recession seems less painful than past downturns. Although retail sales dropped 3.7 percent in November, consumer spending overall continues to hold up surprisingly well. Many store chains are beginning to report that their Christmas-season sales fell by only 1 percent to 2 percent from a year earlier. Auto sales surged to an all-time high in October, thanks to those aggressive financing deals, and 2001 is expected to be the second-best year ever for U.S. home sales.

But those purchases take a heavy toll on the family budget. American households spend nearly 14 percent of their disposable income servicing debt. Though that proportion fell somewhat in the third quarter, in part because of an influx of cash linked to tax rebates, economists still consider it unhealthily high. "Everyone's telling (people) to spend, spend, spend, but it's going to be difficult for them if they're being hounded by collection agencies," says Economy.com's Zandi.