UPDATED: February 20, 2023

Lenders are showing an increasing willingness to take risk, especially over the last two years. One measure of risk tolerance that economists typically track in corporate bond markets is the credit spread–the difference between interest rates for risky debt versus safe debt. But for the household sector, it is much more informative to track the quantity of credit extended.

The Federal Reserve Consumer Credit Statistical Release has shown strong growth in consumer debt (excluding mortgages). But this doesn’t necessarily mean that lenders are taking on more risk. They could be extending more credit to people who have managed to get a high credit score and are unlikely to default.

But the microeconomic evidence suggests that the opposite is true: much of the growth in auto and credit card debt is among individuals most prone to default. We can see this using zip code level data.

We split up zip codes in the United States into four groups based on their 2009 default rate. The groups each contain 25% of the population. The highest default rate zip codes tend to be those with the lowest credit scores. Lending in these areas is almost by definition more risky. The lowest default rate zip codes are the safest. We then track the growth in auto debt and credit card debt originations in the riskiest and safest zip codes.

Here is the chart for auto debt:

Risk Tolerance of Lenders Increasing Growth in Auto Debt Originations

Auto debt originations have increased by almost 70% from 2010 to 2013 in the riskiest zip codes. They have increased by only 30% in the safest zip codes. The difference is especially pronounced in 2012 and 2013. Lenders are extending much more credit in the riskiest areas.

We see the exact same pattern in credit card originations:

Risk Tolerance of Lenders Increasing Growth in Credit Card Originations

Credit card originations increased strongly in 2011. But after 2011, they more or less leveled out for zip codes with a low default rate in 2009. Instead, they continued to grow strongly in 2012 and 2013 in the riskiest zip codes.

This evidence is consistent with the view that lenders are taking on more risk in search for yield and earnings. Some, such as the Federal Reserve Governor Jeremy Stein, have openly worried about easy monetary policy lowering the risk premium too far.

Should we worry about this credit expansion? Some would say this is a sign of a healthy credit market, returning to normalcy. Others would say that another unsustainable credit boom is in the works.

In our view, the critical question is: do the income prospects of individuals in riskier areas of the country warrant an increase in borrowing? Will they be able to pay back the debt when it comes due? During the subprime mortgage boom, our research shows that the answer to this question was clearly no. But what about now?

Unfortunately, we do not have up-to-date data on the income of the riskiest borrowers. But we doubt that their income prospects have improved significantly–we haven’t seen the kind of strong job and wage growth that we would need to make sure that the riskiest borrowers have adequate income going forward. We hope we are proven wrong.