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The Productivity Network - Speeches |
Remarks by Chairman Alan Greenspan
At the Federal Reserve System?s Fourth Annual Community Affairs Research Conference
Washington, DC
Consumer Finanace
April 8 , 2005
It is a pleasure to be here today as you conclude your discussions about our dynamic consumer finance market. Our nation's vibrant financial services industry is remarkable in many respects, with myriad providers offering consumers a broad range of transaction and credit options. The industry is central to the functioning of our robust consumer sector. Therefore, it is essential that policymakers, regulators, bankers, researchers, and consumer groups remain fully engaged in monitoring developments in the consumer finance market and continually seek to better understand the strengths and weaknesses of the financial services industry, including how well it serves lower-income and underserved consumers.
Evolution of the Consumer Finance Market
A brief look back at the evolution of the consumer finance market reveals that the financial services industry has long been competitive, innovative, and resilient. Especially in the past decade, technological advances have resulted in increased efficiency and scale within the financial services industry. Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. Such developments are representative of the market responses that have driven the financial services industry throughout the history of our country.
From colonial times through the early twentieth century, most people had quite limited access to credit, and even when credit was available, it was quite expensive. Only the affluent, such as prominent merchants or landowners, were able to obtain personal loans from commercial banks. Working-class people purchased goods with cash or through barter, since banks did not make consumer loans to the general public.
However, more-intense industrialization and urbanization during the late nineteenth and early twentieth centuries dramatically changed the market for small consumer loans. Urban wage earners used credit to help them purchase the vast array of durable goods being produced by the new industrial economy, such as automobiles, washing machines, and refrigerators. Naturally, this growth in demand fostered increased competition for consumer credit, and, most important, the development of new intermediaries to supply it. Early in the twentieth century, many new organizations that focused exclusively on the needs of consumers entered the field, and the structure of consumer finance began to change dramatically.
Semi-philanthropic groups, called remedial loan societies, were formed to combat the high-rate cash lenders. "Morris Plan" banks, which made loans based on savings plans by borrowers, and the first credit unions, accessible exclusively to consumers with a common place of employment, soon followed. By the 1930s, a wide array of lenders served consumers, including credit unions, small local savings banks, and a nationwide network of state-licensed consumer finance companies. Savings and loans were created, in large part, because commercial banks and other local lenders would not make home mortgage loans. Hundreds of sales finance companies were formed to help manufacturers and retailers provide credit to their customers. Although commercial banks continued to finance merchants, manufacturers, and farmers, they were forced to turn more to consumer lending during the Depression, when their primary business sharply contracted.
As these structural changes continued, market demand and growing competition among this wider variety of lenders spawned further innovation. As early as 1900, some hotels began offering credit cards to their regular customers. By 1914, gasoline companies and large retail department stores were also issuing credit cards to their most-valued patrons. These first cards were simply a convenient way for good customers to run a tab with a particular retail business concern, since balances had to be paid in full each month. Later versions, introduced by retail giants Sears Roebuck and Montgomery Ward, allowed customers to pay their bills in installments, with interest charged on unpaid outstanding balances. This shift to revolving credit, and another innovation--allowing one card to be used at multiple businesses--later generated increasing competition in the card industry. In the 1950s, commercial banks entered into the credit card business.
Home mortgage loans, as we know them today, are a fairly recent product born of the failures of the mortgage finance system during the Great Depression. Clearly, radical change was needed. One of the most significant responses to this need was creation of the Federal Housing Administration, which instituted a new type of mortgage loan--the long-term, fixed-rate, self-amortizing mortgage--which became the model that transformed conventional home mortgage lending. A whole industry--thrift institutions--grew up around this one product.
The development of a broad-based secondary market for mortgage loans also greatly expanded consumer access to credit. By reducing the risk of making long-term, fixed-rate loans and ensuring liquidity for mortgage lenders, the secondary market helped stimulate widespread competition in the mortgage business. The mortgage-backed security helped create a national and even an international market for mortgages, and market support for a wider variety of home mortgage loan products became commonplace. This led to securitization of a variety of other consumer loan products, such as auto and credit card loans.
The Current Banking Structure
Today's fiercely competitive market for consumer credit evolved into its present form slowly but persistently. Along the way, critical structural changes occurred, including entry of, and expansion through, new players.
Deregulation of U.S. banking markets has contributed to an approximately 50 percent decline in the number of banking and thrift organizations since the mid-1980s, when industry consolidation began. From 1995 to 2004, the ten largest U.S. banking and thrift organizations, ranked by the total assets of their depository subsidiaries, have increased their share of domestic banking and thrift assets from 29 percent to 48 percent.
However, according to most studies, this ongoing consolidation of the U.S. banking system has not reduced overall competitiveness for consumer financial services. When consolidation occurs, it is not uncommon for the merger to result in de novo entry to take advantage of any inefficiencies or transition difficulties of the newly consolidated enterprise. Over the past five years, for example, for every five bank mergers that have been approved, two de novo bank charters have been granted. Even in the face of consolidation, competition is fought on the battlefield of the local market, where most households obtain the majority of their banking services. And, it is noteworthy that our measures of local market competition have remained quite stable over the past fifteen years.
Deregulation and consolidation have also cultivated the expansion of the financial services marketplace, as evidenced by the proliferation of many nonbank entities that provide the credit and transaction services that were once mainly the province of depository institutions.
The Impact of Technology on Financial Services Markets
As has every segment of our economy, the financial services sector has been dramatically transformed by technology. Technological advancements have significantly altered the delivery and processing of nearly every consumer financial transaction, from the most basic to the most complex. For example, information processing technology has enabled creditors to achieve significant efficiencies in collecting and assimilating the data necessary to evaluate risk and make corresponding decisions about credit pricing.
With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. The widespread adoption of these models has reduced the costs of evaluating the creditworthiness of borrowers, and in competitive markets cost reductions tend to be passed through to borrowers. Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending; indeed, today subprime mortgages account for roughly 10 percent of the number of all mortgages outstanding, up from just 1 or 2 percent in the early 1990s.
For some consumers, however, this reliance on technology has been disconcerting. Credit-scoring models are complex algorithms designed to predict risk. Consumer advocates have raised concerns about the transparency and completeness of the information fit to the algorithm, as well as the rigidity of the types of data used to render credit decisions. Consumer advocates contend that the lack of flexibility in the models can result in the exclusion of some consumers, such as those with little or no credit history, or misrepresentation of the risk that they pose.
To address these concerns, some firms have worked to customize credit-scoring systems to include new data and to revalue the weight of the variables employed. Also, new organizations have emerged, developing new systems for collecting alternative data, such as rent payments and other recurring payments that will enable creditors to evaluate creditworthiness of consumers who lack experience with credit.
Improved access to credit for consumers, and especially these more-recent developments, has had significant benefits. Unquestionably, innovation and deregulation have vastly expanded credit availability to virtually all income classes. Access to credit has enabled families to purchase homes, deal with emergencies, and obtain goods and services. Home ownership is at a record high, and the number of home mortgage loans to low- and moderate-income and minority families has risen rapidly over the past five years. Credit cards and installment loans are also available to the vast majority of households.
The more credit availability expands, however, the more important financial education becomes. In this increasingly competitive and complex financial services market, it is essential that consumers acquire the knowledge that will enable them to evaluate products and services from competing providers and determine which best meet their long- and short-term needs. Like all learning, financial education is a process that should begin at an early age and continue throughout life. This cumulative process builds the skills necessary for making critical financial decisions that affect one's ability to attain the assets, such as education, property, and savings, that improve economic well-being.
Conclusion
As we reflect on the evolution of consumer credit in the United States, we must conclude that innovation and structural change in the financial services industry have been critical in providing expanded access to credit for the vast majority of consumers, including those of limited means. Without these forces, it would have been impossible for lower-income consumers to have the degree of access to credit markets that they now have.
This fact underscores the importance of our roles as policymakers, researchers, bankers, and consumer advocates in fostering constructive innovation that is both responsive to market demand and beneficial to consumers.
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U.S. natural gas prices have historically displayed greater volatility than prices of crude oil, doubtless reflecting, in part, the less-advanced development of price-damping global trade in natural gas.
Over the past few years, notwithstanding markedly higher drilling activity, the U.S. natural gas industry has been unable to noticeably expand production, or to increase imports from Canada. Significant pressure on prices ensued. North America's limited capacity to import liquefied natural gas (LNG) has effectively restricted our access to the world's abundant gas supplies.
Because international trade in natural gas has been insufficient to equalize prices across markets, U.S. natural gas prices since late 2002 have been notably higher, on average, than prices abroad, thereby putting significant segments of the North American gas-using industry in a weakened competitive position. Indeed, ammonia and fertilizer plants in the United States have been particularly hard hit as the costs of domestic feedstocks have risen relative to those abroad.
The difficulties associated with inadequate domestic supplies will eventually be resolved as consumers and producers react to the signals provided by market prices. Indeed, the process is already under way. As a result of substantial cost reductions for liquefaction and transportation of LNG, significant global trade in natural gas is developing. This activity has accelerated sharply over the past few years as profitable arbitrage has emerged in natural gas prices across international markets.
At the liquefaction end of the process, new investments are in the works across the globe. In Qatar alone, five large-scale projects have begun construction or are at advanced stages of development. In January, Egypt exported its first LNG cargo. Enormous tankers to transport LNG are being constructed, even without being dedicated to specific long-term delivery contracts. The increasing availability of LNG around the world should lead to much greater flexibility and efficiency in the allocation of energy resources. According to tabulations of BP, worldwide imports of natural gas in 2003 were only 24 percent of world consumption, compared with 59 percent for oil. Clearly, the gas trade has significant margin to exercise its price-damping opportunities.
In the United States, import terminals in Georgia and in Maryland have reopened after having been mothballed for more than two decades. The added capacity led to a noticeable increase in LNG imports last year, but LNG imports still accounted for less than 3 percent of U.S. consumption.2 Additional import facilities, both onshore and offshore, are being developed. According to the Federal Energy Regulatory Commission, the number of approved and proposed new or expanded LNG import terminals in the United States stood at thirty-two as of last month with a capacity to import 15 trillion cubic feet annually, far in excess of any pending needs. Clearly, not all of these projects will come to fruition. Some will be abandoned for economic and business considerations, and others will fail because of local opposition, motivated by environmental, safety, and other concerns.
The larger question, of course, is what will increased world trade in LNG and expanded U.S. import capacity do to currently uncompetitive natural gas prices in the United States? During the past couple of years, when U.S. prices of natural gas hovered around $6 million Btu, import prices of LNG in Europe have ranged between $2 and $4 per million Btu, and those in Japan and Korea have generally been between $3 and $5 per million Btu. Estimates of production and delivery costs of LNG to North America appear to hover around $3 per million Btu. In the short run, exporters to the United States are likely to receive our domestic price, currently above $7 per million Btu. But unless world gas markets tighten aggressively, competitive pressures will arbitrage the U.S. natural gas price down, possibly significantly, through increased imports.
In addition to increased supplies from abroad, North America still has numerous unexploited sources of gas production. Significant quantities of recoverable gas reserves are located in Alaska and the northern territories of Canada. Negotiations over the construction of pipelines connecting these northern supplies to existing delivery infrastructure are currently under way.
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To be sure, the dramatic changes in technology in recent years have made existing oil and natural gas reserves stretch further while keeping energy costs lower than they otherwise would have been. Seismic imaging and advanced drilling techniques are facilitating the discovery of promising new reservoirs and are enabling the continued development of mature fields. But because of inexorably rising demand, these improved technologies have been unable to prevent the underlying long-term prices of oil and natural gas in the United States from rising.
Conversion of the vast Athabasca oil sands reserves in Alberta to productive capacity has been slow. But at current market prices they have become competitive. Moreover, new technologies are facilitating U.S. production of so-called unconventional gas reserves, such as tight sands gas, shale gas, and coalbed methane. Production from unconventional sources has more than doubled since 1990 and currently accounts for roughly one-third of U.S. dry gas production. According to projections from the Energy Information Administration, the majority of the growth in the domestic supply of natural gas over the next twenty years will come from unconventional sources. In many respects, the unconventional is increasingly becoming the conventional.
In the more distant future, perhaps a generation or more, lies the potential to develop productive capacity from natural gas hydrates. Located in marine sediments and the Arctic, these ice-like structures store immense quantities of methane. Although the size of these potential resources is not well measured, mean estimates from the U.S. Geological Survey indicate that the United States alone may possess 200 quadrillion cubic feet of natural gas in the form of hydrates. To put this figure in perspective, the world's proved reserves of natural gas are on the order of 6 quadrillion cubic feet.
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In the decades ahead, natural gas and oil will compete in the United States with coal, nuclear power, and renewable sources of energy. As the manner in which energy is produced and consumed evolves, it is not unreasonable to expect that, in the long run, the prices per unit of energy from various sources would tend to converge. At present, long-term futures prices for natural gas are, on a Btu-equivalent basis, notably less expensive than those for crude oil.
Clearly, limited substitution possibilities across fuels have resulted in persistent cost differentials, but those very differentials inspire the technologies that, over time, reduce such limitations. A clear example is gas-to-liquids (GTL) technology, which converts natural gas to high-quality naphtha and to diesel fuel. Given the large-scale production facilities that are currently being contemplated (and some that have already begun construction), GTL is poised to become an increasingly important component of the world's energy supply. Current projections of production however remain modest. GTL promises to add a good measure of flexibility in the way natural gas resources are utilized. In addition, given the concerns over the long-term adequacy of liquid production capacity from conventional oil reserves, GTL may provide an attractive, competitively priced, option for making use of stranded gas, which, for lack of access to transportation infrastructure, cannot be brought to market.
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We are unable to judge with certainty how technological possibilities will play out in the future, but we can say with some assurance that developments in energy markets will remain central in determining the longer-run health of our nation's economy. The experience of the past fifty years--and indeed much longer than that--affirms that market forces play the key role in conserving scarce energy resources, directing those resources to their most highly valued uses. Adequate productive capacity, of course, is driven also by nonmarket and policy considerations.
To be sure, energy issues present policymakers and citizens with difficult decisions and tradeoffs to make outside the market process. But those concerns, one hopes, will be addressed in a manner that, to the greatest extent possible, does not distort or stifle the meaningful functioning of our markets. We must remember that the same price signals that are so critical for balancing energy supply and demand in the short run also signal profit opportunities for long-term supply expansion. Moreover, they stimulate the research and development that will unlock new approaches to energy production and use that we can now only scarcely envision.
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Footnotes
1. The energy intensity of the United States economy has been reduced by about half since the early 1970s in response to sharply higher prices. Much of the displacement was achieved by 1985. Progress in reducing energy intensity has continued since then, but at a lessened pace. This more-modest rate of decline in intensity should not be surprising, given the generally lower level of real oil prices that prevailed between 1985 and 2000. With real energy prices again on the rise, more rapid decreases in the intensity of use in the years ahead seem virtually inevitable. Return to text
2. U.S. natural gas consumption in 2004 amounted to 22.3 trillion cubic feet. Return to text
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