Crisis averted, or delayed reaction?

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As the weather gets colder, so Britain’s economic recovery appears to be warming up. The sense of optimism engendered by positive GDP and employment figures and by a range of business surveys is likely to be reinforced at next week’s Autumn Statement with significant upgrades to the OBR’s growth projections for the coming years. Clearly however, the path towards steady and sustainable growth is set to be a long one, and several headwinds remain. Not least among these is the constraining presence of a significant household debt overhang, built up during the growth years of the 2000s.

With the economic rebound not yet translating into recovery in earnings or incomes many families have found themselves unable to take advantage of the ultra-low interest rate environment to pay down their debt in any serious way. As the recovery takes hold, the sequencing of income growth and interest rate rises will prove crucial to the continued ability of such families to keep up with their credit commitments. The more households exposed to this risk, the stronger the headwind. Our past estimate puts the number of families in ‘debt peril’ – spending more than half of their after-tax income on debt repayments – at 600,000 today, with the potential to quickly surpass 1 million by 2017 under a range of plausible scenarios for income growth and borrowing costs.

The problem is that consideration of the recent repayment records of borrowers can only tell us so much about the potential size of this group. Loose monetary policy and widespread lender forbearance have – very successfully – limited the number of families falling into arrears or defaulting on their loans since the start of the financial crisis in 2008. There is, therefore, likely to be a significant number of families who are up to date with their repayments but who are struggling: close to the edge and liable to fall off if the cost of borrowing rises more quickly than their incomes do.

Today’s major new study from the Money Advice Service, Indebted Lives: The Complexities of Life in Debt reinforces this point. Of the 8.8 million adults it defines as over-indebted, two-thirds are included because they have missed or fallen behind on payments for three or more months in the last six, leaving one-third – or around 3.1 million – who are current or not yet in serious arrears but who are considered over-indebted because they report credit commitments to be a heavy burden.

What’s revealing is the similarities between these two groups. Asked whether living in debt is inevitable for someone like them, 70% of those in serious arrears agreed; among the up to date group the proportion rises to 73%. Similarly, 53% of those in arrears say they can’t see a situation in which they will ever be free of debt, compared with 55% of the current-but-stressed group. Perhaps most worryingly of all, 58% of those who are over-indebted and in serious arrears state that their debt means they can’t always afford basic household items. Among the up to date group the proportion is lower, but only marginally so, at 47%.

Where there does appear to be a difference between the two groups is in relation to their access to further credit. More than half (54%) of those with missed payments report finding it difficult to get credit, and more than two-fifths (43%) say they have been refused access in the past 12 months. In contrast, among the current-but-stressed group the proportions fall to one-quarter (26%) and one-fifth (20%) respectively: elevated, but much less so than for those who are already presenting as being in difficulty.

It’s impossible to tell whether the current-but-stressed individuals accessed further credit before or after they entered the over-indebted group, and it may be serving a useful purpose by allowing them to restructure their debts onto better deals. Nevertheless the fact that individuals who were either already in or approaching over-indebtedness were able to access further credit over the past year adds weight to the theory that a significant proportion of the future potential repayment problem remains hidden in the current low interest rate environment.

Identifying and supporting this hidden group is an important, but difficult, challenge for advisers, the financial industry and for government. For banks the picture is complicated by imperfect sight of the full range of loans held by any given individual. The loan they hold with Bank A may look entirely affordable when viewed in isolation, but the picture could quickly deteriorate when loans from Banks B and C are included. And there is likely to be some reluctance to proactively approaching up to date customers to offer assistance on the basis that some will resent the intervention. Wider financial awareness campaigns may help, but few are currently self-identifying: among all over-indebted adults, including those already in arrears, the Money Advice Service data suggests just one in six (17%) are seeking advice to help them with their debt and two-fifths (42%) say they are too embarrassed to discuss their financial situation.

And even where such borrowers are identified and approached, the options open to them may be limited while the cost of living squeeze continues. Most fundamentally, they are likely to need the Bank of England to resist calls for early increases in the base rate. Mark Carney has once again reiterated that the 7% unemployment threshold established under forward guidance is a staging post not a trigger. As the threshold approaches, there may be some merit in extending the range of measures covered by forward guidance to include wage growth, as a means of making this focus more explicit still.

More specifically, some borrowers may need help with loan restructuring. Some highly stressed mortgagors are unable to access today’s lower rate deals because they lack equity in their home or because they have previously self-certified their income and therefore fall foul of today’s tighter lending criteria. Others are put off by arrangement fees or early repayment charges. And the incentive for banks to offer such deals may be limited given the revenue implications of switching customers to lower cost products. Encouraging borrowers and lenders alike to recognise the long-term gains associated with such actions, while at the same time ensuring that a healthy regard for responsible lending doesn’t get in the way of a flexible approach to easing the burden of those who are already over-stretched may need government coordination and – if the risk is considered sufficiently significant – some financial support.

Ultimately, the risk of a future repayments crisis hangs on how economic conditions evolve. But if we want to avoid letting the debt overhang take the heat out of the recovery, there is a pressing need to take advantage of the current window of opportunity to establish a suite of options that meet the needs of today’s problem debtors and tomorrow’s.