It is estimated that one in three Americans will experience some level of financial distress in their lifetime.
One thing that researchers agree on is that financial distress is persistent. For example, even a decade after experiencing a period of severe delinquency, borrowers are at roughly twice the risk of being severely delinquent as the unconditional person.
Recently, the Federal Reserve Bank of Kansas City published a paper on Financial Distress in America. In today’s post, we will summarize the key points of that paper.
The KC Fed’s analysis focused on individuals with a complete credit history between 1999Q1-2017Q4. They restricted their attention to the cohorts that entered 1999Q1 between the ages of 25-55. Thus, the oldest individuals in the sample would have been 73, while the youngest were 43.
The study looked at distress from three perspectives: extent, persistence, and duration.
EXTENT OF FINANCIAL DISTRESS
Let’s define financial distress by examining the figure below.
The left panel shows the fraction of individuals in delinquency. We see that financial distress, while relevant for consumers of all ages, is not widespread. The line begins a little over 14% for young adults and eventually falls below 10% for those 55 and older.
The right panel follows a similar pattern in looking at the “intensity” of debt across age groups. The youngest groups have the largest fraction of debt in delinquency (e.g., a little over 13% at age 25). The proportion drops substantially to around 6% by age 55.
PERSISTENCE OF FINANCIAL DISTRESS
The study then moves on to assess the persistence of financial distress. It compares the unconditional probability of falling into delinquency with the conditional probability. In this case, it is “conditioned” on the time elapsed since an individual first moved into financial distress.
Figure 2 below illustrates the degree to which financial distress is persistent across all age groups:
Conditional on being in financial distress today, the likelihood of being distressed in the short term is significant. As you can see, within two years (red line), the probability of financial distress is nearly five times that of the unconditional rate (black line) over the entire life cycle of the study (18 years). Of course, time does heal as you can see by looking at the green line. It shows us that the probability of being in financial distress after 10 years is only slightly higher than that of the unconditional rate. Still, regardless of age, financial distress today is predictive of the same over time.
The study also looked at the persistence of financial distress another way. Instead of defining distress to be a situation in which an individual has severely delinquent debt, the authors looked at the proportion of consumers who have depleted (i.e. maxed out) their available credit.
As you can see, the dynamics are similar. Limited borrowing capacity remains a prevalent issue for a small, but far from negligible, group of borrowers throughout the life cycle. As with delinquency, credit availability is another sign of financial distress.
DURATION OF FINANCIAL DISTRESS
The study also showed that time does not necessarily mitigate the persistence of financial distress.
Figure 4 shows that financial distress is not highly fleeting, but instead persistent over long periods. The figure displays the distribution of time spent (as a proportion of the 18 years in the sample) in financial distress for those who have been delinquent at any time during the sample window. We see that, while financial distress is fleeting for some (roughly 25%), it is a routine state of affairs for the remaining 75%. In fact, nearly 20% of consumers who experience financial distress spend at least half their lives in it.
Another interesting way to gauge time in relation to financial distress is by looking at “spells” of distress over a lifetime. A spell is defined as any discrete period during which an individual experiences some form of financial distress (e.g., credit card delinquency)
Figure 5 above shows how, for those who have experienced financial distress at least once, the number of spells they experience is often substantial, with roughly 10% of the sample experiencing four or more spells over their lifetime.
CONSUMER IMPATIENCE AND FINANCIAL DISTRESS
There are obviously myriad and complex explanations for both the extent, persistence and duration of financial distress in America. But one simple and generalized explanation that caught our attention is the notion of “impatience.”
Of all consumers who experience financial distress at some point, there is a small subset that, for any number of reasons, needs or wants to consume beyond their limitations. These are consumers who, for example, will have to pay steeper premiums for credit. This higher credit rate results in higher balances which may ultimately increase the likelihood of another round of defaults. It is, in effect, a vicious cycle that explains why about one-tenth of those who experience financial distress account for a disproportionate amount of out financial distress.
If you’d like to read the detailed analysis, here is a LINK to the Kansas City Fed’s report.