Onward and Upward

  It's been a long time coming, but the U.S. economy finally showed signs of life this year.
  Granted, economic growth in 2004 didn't set any records. But gross domestic product is expected to increase by between 4% and 4.3% by year-end.
  Further, productivity is increasing, credit quality is slowly improving, and inflation remains in check. People also are paying back credit card debt at record high levels.
  Still, there are worrisome signs. The job market remains weak, oil prices are hovering at record levels, interest rates are edging higher, and consumer debt loads are increasing.
  What's more, the tax cuts and the mortgage refinancing boom that fueled consumer spending over the past few years are coming to an end. "The flow of money into consumers' hands is pretty much at an end," says Wayne Best, senior vice president of strategic and economic analysis for Visa USA.
  And, as it has been since Sept. 11, 2001, there's always the specter of another terrorist attack on U.S. soil, an event that could put the brakes on economic growth.
  "The war on terrorism brings up unknowns regarding the amount of deficit spending that will really be required" to wage the fight, says Stuart A. Feldstein, president of Hackettstown, N.J.-based SMR Research Corp.
  And a terrorist incident in the U.S. during 2005 could prove to be a major setback for the card industry, Feldstein says. "When we had the attack at the World Trade Center and the Pentagon on Sept. 11, 2001, there was an immediate impact on spending due to reduced travel. To say that it could happen again is to state the obvious," he says.
  Despite all this, many economists are optimistic about 2005. Most expect GDP to increase from between 3.5% to 3.75% next year.
  "Generally, we think (economic growth) is going to slow down but still be pretty good," says David Wyss, chief economist at Standard & Poor's. "We're hoping that employment growth picks up, which has been the one missing ingredient."
  Indeed, the unemployment rate continues to be an area of concern. The number of Americans filing new claims for unemployment rose by 15,000 in early October to a seasonally adjusted level of 352,000. The September unemployment rate held at 5.4%.
  Typically, the number of jobs will increase to pre-recession levels within two or three years after the start of the recession, says Allen C. Grommet, senior economist with Cambridge Consumer Credit Index. Grommet spoke at Thomson Media's 13th Annual Credit Card Collections Conference in late October. "We're not anywhere close," he says. "This makes this recovery quite a bit different."
  Sharp increases in productivity over the past few years are partly responsible for high unemployment rates, economists say. In the 1970s, productivity increased by 1% to 1-1/2% per year, Grommet says. "Now, for the last couple of years, we've been seeing it increase from between 3-1/2% and 4-1/2% per year," he says. "What this means is employers are getting more and more work out of the same number of employees."
  Another factor weighing on job growth is "extra caution by CEOs who aren't willing to take the risk of hiring people," another unusual feature of this recovery, Grommet says.
  Unemployment is expected to decline, reaching about 5.1% by the end of 2005, says Keith Leggett, senior economist for the American Bankers Association. "What you're going to see is that basically the employment picture is going to improve because total demand ... is just going to continue to rise and that's going to cause the unemployment rate to drop." Support for that stance came in early November, when the U.S. Department of Labor reported a gain of 337,000 non-farm jobs in October, by far the best job growth since April.
  Consumer spending thus far has been the driving force behind the recovery, Grommet says. "Over the last year-and-a-half, consumers have been expecting that businesses will step in and take the baton to help this recovery grow at a faster rate," he says. "Instead, consumers have had to carry the weight on their backs."
  But that may not last, Grommet says. Personal consumption expenditures were "very positive for a period of time until we got into this year," he says. "It's become much more erratic ... and we're not quite sure why."
  In addition, for most of the past year, spending has been increasing at a faster rate than income, Grommet says.
  At the same time, personal savings rates are "quite low," Grommet says. Savings rates were in the 6% to 10% range in the late 1970s and early 1980s before dropping down to the 2% to 3% range. "Over the last 1-1/2 years, we've seen it dropping down to 1%," he says. "Obviously, the only way that consumers can continue to carry this economy on their back with these low savings rates is to use more and more credit."
  On the positive side, despite higher oil prices, inflation has remained in check thus far, economists say. "Inflation is at a historically low level" between 2% to 3%, Grommet says, adding that the core rate moved below 2% and "and is still there." Economists say they expect inflation to continue in that range during 2005.
  "The biggest unknown is energy prices," Grommet says. "We have seen gasoline (prices) going up the last year at a significant rate."
  Oil prices are expected to fall below $40 a barrel in 2005, Grommet says. "If they don't, then inflation could very well be a (bigger problem) than anticipated."
  But inflation is not the only threat posed by higher oil prices. Households are spending an average of 5% of their after-tax income on energy, up from 4% in early 2002, Wyss says. "The money you're spending at the gas pump is money you don't have available to spend at the shopping center," he says.
  Measured Increases
  And if oil prices continue to climb, they could push the U.S. into another recession, Wyss says. He notes that oil was largely responsible for the 1974 and 1980-81 recessions and played a role in the 1991 recession. "The question is how high do oil prices have to go to cause a recession," he says.
  Wyss says fears of terrorism and supply disruptions added $15 to $20 to oil prices this year, but that prices should go down to about $35 per barrel over the next two years.
  Short-term interest rates also are expected to rise to about 3% by the end of next year, Leggett says. That means consumers would have higher debt-service costs and might be reluctant to take on more debt.
  The Federal Reserve-which has thus far this year raised short-term rates by 75 basis points-"is on a path to continue to have measured increases for the remainder of this year," says Keith Stock, president of MasterCard Advisors. "Those are still very low interest rates compared to what we've had in the past."
  The end of federal tax cuts also will have a dampening effect on consumer spending, economists say. "We're not going to get any more tax cuts," Wyss says. "We're looking at a $420 billion deficit. I don't see how they can cut taxes anymore. At best, we'll hold them where they are, and my guess is they go up."
  Adds Visa's Best: "The tax cuts have left the effective tax rate at its lowest level since World War II. As a result, we're pretty much out of balance. That suggests there's going to have to be some tax increases" in mid or late 2005, he says.
  On the plus side, credit quality improved in 2004, with a chargeoff rate of 6.2% on securitized pools of card receivables in September. That compares to a peak of 7.5% of receivables in May 2003, Wyss says.
  Card issuers also have benefited from a dip in bankruptcy filings in 2004, a trend they hope continues into 2005.
  "Overall, as an industry we agree bankruptcies have been reasonably good for us this year," says Bill Herberger, senior vice president of the customer support division of Chase Card Services. He cited statistics from Visa showing that bankruptcy filings were down 3.8% from the year-earlier period as of Aug. 31.
  Herberger also spoke at the Credit Card Collections Conference.
  'Muddle-Through Economy'
  But while 2004 "shaped up as a pretty good year overall," there are warning signs ahead, Herberger says. "We're deep in the middle of a muddle-through economy," he says. "There is no real clear direction."
  For example, payment rates hit 17.3% of receivables in September, up 5% from a year earlier, according to Standard & Poor's, and stock prices are improving. But consumers are coming under more stress in the form of increased health-care costs, energy prices, rising mortgage rates and property taxes.
  Health-care premiums paid by employees with family coverage rose nearly 13% last year, adding $300 to annual household costs, Herberger says.
  And rising mortgage rates could cost homeowners an additional $1,300 annually on a $200,000 house. Consumers also are facing higher property taxes.
  Combined, these additional expenses represent about 5% of pre-tax income for a household with annual income of $62,500, Herberger says. "That's a pretty substantial impact, given the average 2% increase in income," he says.
  "If these events come together, creating the perfect storm, you can bet we'll be competing a lot (harder) for every dollar we want to collect and we're not going to be competing with discretionary income," Herberger says. "We will be competing with survival expenses."
  A March survey by the Cambridge Consumer Credit Index found that 49% of those responding are planning to use more credit because they need it to cover their bills and maintain their lifestyle. That compares with 45% in March 2003. "That is a significant increase, and (another indicator) of how consumers are struggling more trying to meet their financial obligations," Grommet says.
  How Will the Poor Fare?
  Although U.S. consumers on average look "fine" financially as the economy recovers, low-income consumers with annual incomes of $25,000 or less are not faring quite so well, Grommet says.
  One disturbing trend is that low-income people are using "more and more credit," he says. That means card issuers are "going to have to exercise a little more discretion" in granting and managing subprime loans.
  Grommet also notes that while homeowners' debt obligations have remained "fairly constant" since 1986, renters' obligations have risen sharply, except for small decreases in recent months. "Most renters are low income," he says.
  The only way the financial profile of low-income consumers will improve is if the economy grows fast enough to help them, Grommet says, adding that most jobs added in an economic recovery tend to be lower-income positions.
  Higher income people, too, could run into trouble as interest rates increase. "The only way (they) can afford these higher rates is if their incomes increase," Grommet says.
  Indeed, "one of the critical questions for credit cards in 2005 is what will happen with credit quality," SMR's Feldstein says, adding that he expects the moderating trend of chargeoffs to continue into early 2005. However, he says he expects credit quality to start to deteriorate towards the end of next year, based on historical trends.
  In the past, bankruptcy filings hit a plateau or declined slightly before resuming their climb, Feldstein says. These plateaus typically occur about one year after a mortgage-refinancing boom, he says. "We had a big (refinancing) boom that started in 1992, continued in 1993, and then the bankruptcy rate leveled off in late 1993 and all of 1994," he says. Similarly, the 1998 mortgage-refinancing boom led to reduced bankruptcy rates in 1999 and 2000. "We're seeing that happen again," he says. "If the past is any indicator of the future," the plateau from the 2003 refinancing boom should end in late 2005.
  Several trends in the mortgage arena also could cause credit quality problems, Feldstein says. He notes that the $3.32 trillion in mortgage refinance loans originated in 2003 will begin to season next year, resulting in higher delinquencies and home foreclosures. "The seasoning problem is not new," he says. "It's just happening on a more massive scale than ever before."
  In addition, two loan products that enable less creditworthy individuals to get mortgages are becoming increasingly popular.
  One such loan-a so-called piggyback loan-allows consumers with a 10% or lower down payment to avoid paying private mortgage insurance. Most lenders require the insurance for loans with a loan-to-value percentage in excess of 80% to protect against losses if a borrower defaults on the loan. The insurance allows high-risk borrowers to buy a home with as little as a 3%-to-5% down payment.
  With a piggyback loan, a borrower takes out two loans-a first mortgage equal to 80% of the purchase price and a second loan for another 10% of the value. "In 2004 so far, piggyback loans accounted for more than 40% of all the dollars of home purchase loans, Feldstein says. "It's really grown to tremendous proportions."
  Many of the second loans are home-equity loans, which typically re-price higher as short-term interest rates rise, he says. And many of the first mortgages are adjustable rate mortgages.
  Another newcomer is the interest-only mortgage. "For the first time ever, you can get a mortgage loan where you don't have to pay the principal," Feldstein says. "That means you have a huge debt and you never are going to retire even a penny of it."
  If high-risk home borrowers begin to have problems making payments, their problems will carry over into the credit card market, Feldstein says. "If these people aren't going to pay on their mortgages, they're sure as hell not going to pay on their credit cards."
  In 2003, 25% of all residential loans funded were ARMs, according to survey data compiled by Thomson Media's National Mortgage News. In the first half of 2004, 45% of all residential loans funded were ARMs.
  With the end of tax cuts and the mortgage-refinancing binge, increases in consumers' disposable income in 2005 primarily will depend on increased salaries and wages, says Best. "The average increase in the United States is expected to be between 4% and 4.5% (in 2004). That's going to be climbing slightly in 2005," he says.
  But for disposable income to grow in 2005, "we have to continue to have more people going back to work," he says.
  There are signs that corporations are starting to contribute to the recovery. "We're starting to see capital spending pick up so that it's just not the consumer supporting the economy anymore," S&P's Wyss says. "The consumer is slowing down. We're already spending 99% of our income. How much more can we do?"
  The $400 billion-plus federal budget deficit is "something the public can't really get excited about," Wyss says. In the short term, it helped the economy by boosting spending. But in the long run, it's got to be brought under control. "We have a huge chunk of spending coming at us from the retirement of the Baby Boomers," he says. "If we don't do something for 2010, we'll be back in bad shape. You can reduce benefits, raise the retirement age, lower Social Security payments, pay less for health care, but the trend seems to go in the opposite direction."
  Nevertheless, economists expect the economy to move forward in 2005, albeit at a slower pace. And that would be good news for the card industry.