The 7-Year Ditch: Why We're Sailing Toward a New Fiscal Crisis
According to FICO (FICO), negative financial information -- late payments, bankruptcies, foreclosures, collection accounts, etc -- will generally disappear from your credit report after seven years. You probably already knew this: Personal finance experts talk about it often when discussing credit scores, bankruptcy, or a host of other money issues.
But let's do the math.
In 2008, the worst financial crisis since the Great Depression hit this country. It led to a record number of foreclosure filings beginning -- nearly 3.1 million filings that year. And the trend continued, with millions of homes foreclosed each subsequent year.
Fast forward to 2015, when the first of the great recession foreclosures will start to vanish from credit reports. Credit scores improve as time elapses and your score can experience a big improvement when a major negative item drops off your report. According to Experian (EXPN) data provided to the New York Federal Reserve, the average credit score in the second quarter of 2014 reached 698, the highest level in the last 10 years. We can expect those averages to keep rising as the defaults, delinquencies and foreclosures of the Great Recession begin to be wiped from people's credit records.
In addition, housing prices have started improving. The Case-Shiller house price index has experienced double-digit increases over the last few years. And, bank losses have improved. For example, JPMorgan Chase (JPM) has reduced its loan loss reserves for mortgages by $1 billion over the last 12 months alone.
So, we are experiencing:
- Rapidly rising credit scores.
- Increasing property valuations.
- Improved bank balance sheets.
Fire Up Those Consumer Credit Engines
As memories of the Great Recession disappear from credit bureaus, so do the lessons learned. During the mortgage boom, we witnessed a banking sector abandoning common sense in favor of big data and complex products, with eventually disastrous consequences.
Remember the Home Equity Line of Credit? In the go-go days, you could even buy a Starbucks (SBUX) latte with a credit card that automatically took funds from your HELOC. Well, the credit cards aren't back, but HELOCs have returned in a major way. According to Experian Decision Analytics, HELOC originations are up 27 percent year-over-year, with $35.2 billion of new credit lines created in the last 3 months. And, guess which state led the nation? California. The products are starting to look eerily familiar. I saw an advertisement at Santander for a HELOC that was priced at prime -- 0.26 percent.
We've seen a lot of press about student loan debt surpassing credit card debt, but don't write off the boring credit card just yet. Bank card originations were up 26 percent year-over-year, with $85.3 billion of new credit card limits were issued to consumers in just three months. And you can't watch television or open your mailbox without seeing credit card companies trying to sign up new customers.
Even subprime mortgages are coming back. You can now get a mortgage today with a 550 FICO score.
What Does This Mean for You?
There is good news. So many people were talked into mortgages by unscrupulous brokers, to buy properties they couldn't afford, during the last mortgage boom. Banks just opened the floodgates and poured mortgage money on neighborhoods, inflating prices and making rational decisions difficult for even the most rational homebuyer.
For people who suffered the pain of losing their jobs, their homes and their credit ratings during the crisis, the 7-year cycle means healing is possible. This isn't a medieval country that throws people into debtors prison. Bankruptcy gives people the same rights that corporations have to hit the reset button. I know someone who has emerged from bankruptcy to set up a new business that is rapidly hiring new employees and helping to grow the economy. And I'm happy that credit scores improve over time, so that people can regain access to credit.
What Could Go Wrong?
But I am horrified by a system that can systematically forget lessons so quickly.
And I can't believe we still have a pro-cyclical banking system that requires banks to build reserves when times are bad, only to let them release their reserves when times are good.
%VIRTUAL-pullquote- I just hope that while banks will have a guaranteed case of amnesia, people will never forget the mistakes, lies and pain of the last recession.%The last mortgage crisis did not happen overnight. It was the product of years of "risk layering." Thirty years ago, you needed a 20 percent down payment, a verifiable and predictable stream of income, and good credit history to get a mortgage. Then, banks slowly relaxed credit. The minimum down payment was reduced by 5 percent. The income verification rules were tweaked. Each change, on its own, did not look too scary. But, by 2008, you could be self-employed, provide no income documentation and buy a home with no money down. Even worse, it would be a very complicated product that had a very low interest rate for five years, and then increased to a dramatically higher rate.
Today, banks say that they have learned their lessons. Banks say that they will only lend to people with good credit. But, those are just the same people they lent to before, seven years later. Lenders say we won't go back, but HELOC and sub-prime mortgages have already started to reappear.
To be clear, the products being made available today are still far less risky than the products being offered in 2006. But I'm concerned that we're slowly restarting that same risk layering process. And, if you fast-forward a few more years, to a day when all the worst financial memories from the Great Recession have been expunged from our records, a no-money down, no documentation, 550 FICO adjustable-rate mortgage may look appealing to some risk manager at some major bank.
So, while the credit bureaus will experience their scheduled bout of amnesia over the next few years, we as consumers can't forget the lessons from the last crisis. Most importantly:
- Don't trust your bank or broker to determine what you can afford. They will always give you more credit than you can afford to pay back.
- Don't borrow money to fund a life you can't afford. Banks will try to make it easy, and they are already starting to do that again with HELOCs. Self-discipline will become more important than ever.
Nick Clements is the co-founder of MagnifyMoney.com, a website that makes it easy to compare and save money on banking products. He spent nearly 15 years in consumer banking, and most recently he ran the largest credit card business in the United Kingdom.