Good News for Consumers, Bad News for Banks

Consumer credit declined in the second quarter, according to the Federal Reserve's monthly G.19 consumer credit report.

Two types of debt make up consumer credit: revolving -- which is mainly credit card debt -- and nonrevolving, which are non-real-estate-backed term loans, like auto loans.

Here's how growth for both segments looked over the past few years:

1.9%

1.4%

1.6%

7.8%

4.4%

5.6%

5%

3.6%

4.1%

3.8%

4.9%

4.5%

4.1%

6.4%

5.6%

And over the past few quarters:

(8.2%)

(3.5%)

(5.2%)

(8.9%)

(0.4%)

(3.6%)

(6.5%)

(1.2%)

(3.2%)

3.2%

(0.6%)

0.8%

3.5%

4.2%

3.9%

These tables tell an obvious story: Consumer credit surged from 2004 to 2008. It made a lot of people artificially rich. Now that bubble is quickly deflating -- in some cases, faster than it inflated.

What's it all mean?
A few things. One, it's great news for the American consumer. After years of binging on cheap credit, sanity has prevailed. Realizing how precarious their financial situations might be, consumers are rushing to rebuild personal balance sheets, which usually means paying down debt. That's a great sign.

Now, in the short run, this isn't easy. As I showed back in June, household-debt-to-disposable-income ratios more than doubled from 1974 to 2008. Getting back down to historical averages could mean diverting several trillion dollars from consumer spending. That retrenchment alone is enough to send the economy into turmoil. And it has.

Long term, however, deleveraging is what we need. Look what happened to overleveraged idiots Lehman Brothers and Bear Stearns: One slight blip, and they were KO'd. While on a different scale, the effect debt can have on overleveraged consumers is comparable. One quick bout of unemployment, and it's game over.

And if necessity is the key motivator, realizing you're one paycheck away from insolvency will change your financial behavior real quick.

So yes, we should wholeheartedly embrace the retrenchment in consumer credit. It brings stability. It's what real recovery looks like.

So who's it bad for?
For one, the credit card processors. Visa (NYSE:V) and MasterCard (NYSE:MA) share a virtual duopoly in the processing industry. Since they don't issue credit, two metrics underline their health: the number of transactions consumers put on plastic, and the dollar amount of those purchases.

A long-term shift from paper to plastic has fueled both companies in recent years. But the now-obvious shift away from credit and consumer spending is taking a bite. Over the past two quarters, Visa saw payment volume decline. While debit volume is still growing, it isn't enough to curb to decline in credit.

If the shift away from consumer credit endures, the growth Visa and MasterCard enjoyed in recent years comes under attack. Easy as that.

This also isn't encouraging, not surprisingly, for banks. Banks made ungodly amounts of money off consumer loans in recent years. If you wanted credit, banks didn't feel it was their job to tell you otherwise. Years ago, for example, Washington Mutual instituted a company slogan called "The Power of Yes." This effectively meant, "Hey, if you're breathing, we'll give you money!" And it worked, so long as real estate prices kept going up.

But those days weren't sustainable. And they're gone. With this comes a deleveraging process that can vaporize profitability banks enjoyed in the past.

You can see this deleveraging in the decrease in the amount of credit card loans some banks hold:

This reduction is important to note because conventional wisdom tells us banks can earn their way out of this mess by making lots of profitable loans while interest spreads are huge. This is mostly true. However, a shrinking loan book implies just the opposite; rather than making new loans on a net basis, banks and consumers are simultaneously deleveraging.

Which brings up another point: We've heard a zillion times that the economy is a mess because "banks aren't lending." While the financial system is indeed providing less credit than in the past, how much of this is the result of less credit demanded by consumers? Do banks not want to lend, or do consumers not want to borrow? It's an important distinction to make, and one that might change how some interpret banks' recent behavior.

Any thoughts on this matter? Feel free to share 'em in the comment section below.