The Next Crisis

A furniture company offers 0% financing and no payments for a year. Consumers gladly take this free credit. Sales skyrocket. Buoyed by rising revenues, the company takes out a loan and opens a second store, expecting to pay its employees, its suppliers, and its bank with future revenues. Unfortunately, this isn’t the only financing the company’s current and potential customers are using. Rather than pay off their credit card bills every month, more and more people are leaving balances, and those balances are growing larger. People are taking out 72-month loans to finance their new cars. They’re just starting to make payments on the home appliances they bought 12 months ago with those other buy-now-pay-later deals. They’re tapping into home-equity lines of credit to go on vacation. As more and more of their disposable income is going to pay off their debts, new purchasing slows abruptly. Some people start defaulting on their cards altogether, turning past purchases into present bad debt. Sales slow dramatically at the furniture store, and it closes the second store, laying off workers. This has an impact not just on the retailer but also on its suppliers and its financers, some of whom don’t survive. Other companies that do business with those unfortunate suppliers and former employees find their operations affected as well. Scale up this scenario even a little bit, and it starts to be clear that the degree to which consumers have come to depend on easy, inexpensive credit is a far bigger threat to the economy than most people realize. Few companies are immune to the risks. Consumers are using record levels of debt to purchase goods and services, leaving the corporations selling to them greatly exposed, sometimes fatally. But thankfully, this corporation killer can be diagnosed, analyzed, and managed. Analysis of simple ratios can help you identify the warning signs of consumer leverage exposure (CLE) and take action to forestall much of the crippling impact it could have on your company. Managers who ignore the warning signs and leave their companies vulnerable will have only themselves to blame. What Is Consumer Leverage Exposure? Just as a finance manager would measure corporate leverage as a ratio of debt to income, we measure consumer leverage as the ratio of total household debt to total personal disposable income. Specifically, it’s a measure of how much money American consumers have tied up in credit card debt, mortgages, home-equity loans, auto loans, and education loans compared with their ability to pay off this debt. As the exhibit “Consumers’ Mounting Debt” shows, the ratio stands at 1.30, slightly off record highs of 1.33 in the first quarter of 2008. Learn about Consumer Leverage Exposure with our CLE toolkit (PDF download). This toolkit teaches you what CLE is and how to calculate it using a mythical company as an example. It also includes a CLE Calculator (XLS download) that lets you input your company’s financials to see your real CLE. Consumers’ Mounting Debt The ratio of consumers’ debt to their disposable income—the consumer leverage ratio—not only has been rising steadily since 1975, but has risen alarmingly since 2000. Source: Authors’ analysis of data from the U.S. Federal Reserve and Commerce Department. That’s a scary number: It would take consumers 1.3 years to pay down existing debt with their current after-tax income, provided they spent that income on absolutely nothing else. That means no purchases of clothes, food, coffee at Starbucks, or anything else for 16 months. Scarier still is the rise in that ratio over the past 35 years—and the especially rapid rise since 2000. Managers should be deeply troubled by these statistics because the profits and cash flows of nearly all U.S. companies are built directly or indirectly on consumer spending, which means they have significant exposure to the vagaries of consumer credit. The connection is not always obvious. How many loyal supermarket customers are quietly opting to pay for their food with their credit cards rather than their debit cards? How many consumers will tap their home-equity lines of credit to pay for their next vacation, new sectional sofa, or state-of-the-art steam dryer? How many consumers, realizing they’re headed for default anyway, are piling up the charges while they still can? How many companies are unaware of their indirect connection to these debt-laden consumers through their distributors, retailers, and financial institutions? Who’s Most at Risk? Three sources of consumer leverage exposure, and two structural risks, have already torpedoed the profits, if not the very existence, of many corporations in the past year. Companies that finance their customers’ purchases. Naturally, the more directly involved in issuing consumer credit a company is, the greater its exposure to consumer leverage. Companies that directly finance their consumers’ purchases can be left high and dry when consumers reach their credit limits and curtail their spending. This is a common theme for firms selling big-ticket consumer goods like cars, furniture, electronics, and appliances. In recessions, these companies face a triple whammy. First, product sales contract rapidly. At the same time, the often-significant interest revenue from financing those now-nonexistent new sales falls off as well. Finally, consumers defaulting on their payments of past purchases put revenue streams from those sales in jeopardy. Managers in these industries should be working flat out to reduce their companies’ dependence on such revenue streams. At the very least, they should be preparing for the drop in profits that this type of consumer leverage exposure inevitably creates in downturns like this one. Companies whose customers pay with credit cards. Studies show that consumers typically spend more with credit than they do with cash; thus even modest changes in consumer leverage can have a large impact on corporate revenues and earnings. This spending volatility alone should cause serious concern for managers worldwide. What’s more, larger default rates will likely translate into higher fees from the credit card companies as they try to cover their increased risk. What’s troublesome here is not just the number of people defaulting but the rising amounts they’re walking away from. Since many consumers have yet to tap the full potential of their current credit lines, there is considerable scope for the size of those debts to rise. As credit card companies place new limits on consumer credit and get ready to charge new fees both to consumers and to retailers to cover the costs of expected defaults and the new regulatory legislation, we can expect a significant decrease in consumer sales and corporate profits. If your company is exposed to this type of consumer leverage, you need to be bolstering your reserves now. Companies in the consumer credit industry itself. Many corporations generate healthy revenue from the creation, repackaging, and buying or selling of consumer credit. Finance companies, credit card issuers, banks, insurance companies, asset managers, and pension funds, to name just a few, are on the front lines when it comes to consumer leverage exposure. In recessionary times, when consumer leverage is high, these revenue streams can dry up very rapidly as overstretched consumers stop searching for new credit and banks restrict how much they’re willing to lend. Defaults by once-creditworthy consumers cause existing securitized products to lose value very quickly and slow the creation of new securitized products, hindering the transfer or diffusion of risk. What’s more, since credit cards, unlike mortgages or even car loans, are not backed by collateral, there’s little chance for those trafficking in credit card finance to recover any money if debtors enter bankruptcy. The housing crisis may be over, but the consumer credit crisis is coming: Managers in financial services, therefore, should be bracing for a record number of consumer bankruptcies and in record amounts. Companies that are highly leveraged. Your problems with consumer leverage are multiplied if your company relies heavily, as our furniture retailer did, on debt financing. Falling consumer creditworthiness quickly brings you closer to bankruptcy as your ability to repay your own loans is imperiled by consumer defaults and declining sales. Many firms that were involved in the leveraged-buyout boom of the early- and mid-2000s have an enormous amount of debt in their capital structures and are especially vulnerable to this risk since they are relying on consumer sales to make the interest payments on their debt. (Many technology companies, on the other hand, born of venture capital, are nearly debt-free, which makes their exposure to consumer leverage less toxic.) It’s this phenomenon of compounded leverage—that is, corporate leverage on top of consumer leverage—that we believe will bring down some of the world’s most pristine corporations. Companies in vulnerable industries. Using historical data, we’ve been able to assess which industries are most at risk for consumer leverage exposure. The table “Who’s Most at Risk?” ranks the top 10 S&P 500 industries from most to least at risk from changes in consumer leverage. Who’s Most at Risk? Some industries are more dependent on consumer credit than others. Here’s a list of the top 10 S&P 500 sectors ranked from most to least sensitive to shifts in consumer leverage. CLE Rank: Sector 1: Consumer Discretionary 2: Consumer Staples 3: Information Technology 4: Financial Services 5: Utilities 6: Health Care 7: Energy 8: Telecommunications 9: Industrials 10: Materials Where Should You Be Looking? Sensitivity to consumer leverage varies not only across industries but also within companies. The first step in managing your consumer leverage exposure, therefore, is to take a cold, hard look at exactly where in your company you are most sensitive to changes in consumers’ debt levels. Then you should take an equally careful look at your cost structure. You obviously have to start with revenues that come directly from consumers. So of course your marketing and sales functions should be examining what percentage of your business comes from consumers (as opposed to B2B sales), as well as the degree to which you finance your customers’ purchases. Marketing and sales should also be heavily focused on how changes in customer spending habits may affect your sales. And they should be tracking consumer loan default rates and trends in consumer credit score declines. Your accounting and finance people should be keeping a close eye on how long it takes to collect receivables and on trends in the proportion of purchases being made on credit rather than with cash. They should be adjusting their bad-debt loss reserves and consumer credit terms (if applicable). And, on a more structural level, they should be keeping a close eye on how leveraged the company itself is. Operations should be investigating how sensitive your suppliers and distributors are to rising debt levels among their own customers. Risk managers should be modeling the impact of different levels of consumer leverage on company income and earnings. They should also be running simulations to see what effect shifts in consumer leverage would have on your business model. And they should be investigating the default potential of your customer base. Your strategy team should be taking into account the level of consumer leverage exposure of your industry, products, and target customers. And it should be comparing your level of exposure with that of your competitors. Clearly, in recessionary times, outperforming your competitors in this area can lead to significant competitive advantage. On the cost side of the equation, you should be thinking about flexibility—that is, how much of your costs are fixed rather than variable. In the pursuit of growth and scale economies, many companies have loaded up on fixed costs, leaving themselves particularly vulnerable to a collapse in demand. Operating and profit margins are often much more sensitive than gross sales margins to consumer leverage changes. This means that many of the steps you’ll need to take to contain and manage your consumer leverage exposure will not be on the revenue side, in the sales and marketing function, but rather on the cost side, in the way you manage purchasing, supply, overhead expenses, and working capital. In a companion piece, “How Exposed Is Your Business to Consumer Leverage?,” we present a detailed “how-to” that will help you determine exactly where in your business you are most at risk from changes in consumer leverage and what you can do to reduce that risk. This tool will let you measure the level of your exposure to consumer credit, analyze how sensitive your company is to sudden changes in default rates, and determine what steps you can take to mitigate your risk. The idea of consumer leverage is hardly new. Nor is the notion that it can rapidly destroy corporations. But with this framework, managers will be able to quantify, assess, and approach this risk as never before.

The Next Crisis

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