THE JUNK FOOD INDUSTRY continues to face legal action over allegations that it stuffed hungry consumers with products that were bad for their health, despite its protests that it can't force anyone to overeat. Recent developments in the consumer credit sector have led some to wonder whether lenders might find themselves in a similar position in the near future.

Some of the commentary makes it sound as though consumer lenders have strapped their customers into high chairs and – without so much as tucking bibs under their wobbling chins – have force-fed them home equity loans, card loans, personal loans and auto loans until their finances were ready to burst.

But the real threat faced by consumer lenders is more prosaic: an economic shock could leave their customers unable to repay. Default risk is nothing new for lenders, of course, but the growth of the consumer credit industry raises new questions. The average borrower is carrying far more debt than ever before: does anyone have a clue how they're likely to behave under the extreme stress that's likely to result from an economic shock?

“No-one knows,” says Andrew Cunningham, senior vice-president in the European banking group with Moody’s Investors Service in London. “Most of the predictions I have seen seem to be based on guesswork or amateur psychology.”

During the late-1980s recession, the average consumer in the UK had a debt-to-income ratio of about 90%, he says. Ten years later, after a period of fairly slow growth, debt levels started to race up. The average debt-to-income ratio is now 125% – growth that has recently prompted a flurry of cautionary speeches from Bank of England officials warning that an economic shock could leave consumers struggling to service their debt. The picture is similar in the US, where the total amount of consumer debt outstanding has more than doubled in the last decade.

The growth in consumer credit has been accompanied – and, arguably, facilitated – by a proliferation of lenders and new products, heaping change upon change. But many bankers refuse to accept that they are walking into the unknown.

“There’s a lot of conversation in the industry at the moment about whether the increase in consumer debt is an issue or not,” says Gregg Meyers, senior vice-president of credit risk management with Wachovia Mortgage Corporation in Charlotte, North Carolina. “It’s my belief that if you bring the right information to bear, it is possible to understand and mitigate the risk.”

As historical data has become less useful, the need to understand credit risk has increasingly forced the biggest banks to try to understand their customers. Rather than treating all loans as equal, and then trying to manage a portfolio as though it was a homogenous mass, risk management has established a presence at the front end of the lending operation.

One concern for card lenders is the speed and ease with which consumers can now switch between providers, using free balance transfers to carry debt from one place to another and take repayment holidays. In theory, a firm could attract large numbers of these riskier customers and only find out when an economic downturn forced a rash of defaults.

But Meyers notes that the multiple enquiries made by “credit surfers,” as he calls them, will “eventually show up” on credit bureau reports. If the lender doesn’t want to take the risk, these customers can be weeded out.

By far the biggest component of consumer debt is mortgage lending. At the end of 2002, non-mortgage credit represented 17.6% of total consumer lending by the UK's ten biggest banks, says Moodys’ Cunningham. That figure's up from 14.7% at the end of 1997, but it's still just a small slice of the total market.

Mortgage loans are typically less risky than other forms of consumer loan, largely because they are secured against what has proved to be wonderfully reliable collateral in recent years – the borrower’s home. Unsurprisingly perhaps, many bankers consider the behaviour of mortgage borrowers to be a constant.

“In all of our studies, we’ve found that borrowers can still be relied upon to keep up repayments on their mortgage in preference over all other forms of debt,” says a consumer risk manager with a large regional bank in the US. “It’s the roof over your head, after all.”

But not all mortgages are created equal, of course. In its comment on the latest iteration of the proposed new Basel Accord, Bank One notes that second mortgages with a high loan-to-value can be almost as risky as an unsecured credit card loan to the same borrower.

Lenders should be all right as long as they stick to some fairly standard, common-sense rules, like ensuring that they borrowers have adequate loan collateral, says Urs Wolf, head of quantitative credit portfolio management with Credit Suisse Banking.

“In Switzerland, levels of indebtedness are very high," he says. "But if a bank has a sound property valuation and monitoring system, and a sound loan-to-value policy – not more than 90% - our experience was, and still is, very low losses in mortgage lending. And we’ve seen some stress.”

The great danger for lenders is a slide in house prices which would erode their collateral protection, notes Moodys’ Cunningham. “From a ratings point of view, what I want to know is – if a borrower can’t repay the bank, are there assets that the bank can take to make good their loss? If there was a widespread fall in house prices, that would be a worry.”

The acid test for lenders would come if unemployment or interest rates rose significantly, if housing values fell – or if the economy entered a deflationary spiral in which both wages and housing values fell. Wachovia’s Meyers says he is “very confident” that the bank’s loss forecasts, in a range of economic conditions, are accurate.

He concedes that debt-to-income ratios have increased, that the markets and products have changed – but he maintains that banks now have far more data than ever before, which they can use to get a handle on those changes. “You can feel confident if you spend a lot of time with the data.”

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