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The Hierarchy of Payments

It's the end of the month and you have $1,000 of bills to pay. The problem is, your bank account balance is just $500. Which bills get paid?

Most consumers reach very similar answers. This pattern of behavior is called the "Hierarchy of Payments" and it refers to the fact that consumers will choose to maintain certain loans first and let others go delinquent if necessary. Intuitively, collectors know this pattern exists, but it has been difficult to quantify.

Figure 1

hierarchy
Timing of Macroeconomic Impacts

Mortgage, then Auto, then Cards

The payment hierarchy is driven by perception as much as practical reality. Consumers stop paying credit cards and most other unsecured products first. This may occur because the repercussions from delinquency on unsecured loans are unclear. The economy's most optimistic consumer is the one a few dollars short of their credit card bill. "I can catch up next month. Things will be better then."

When financial problems worsen, then the choices become more difficult. Consumers consistently choose to pay their mortgage long after they stop paying for their auto loan or credit cards. This may not represent an optimal decision on the consumer's part, since a home is more difficult for the lender to repossess than a car. The pattern, however, is clear, even if it is driven more by emotion than financial realities.

The payment pattern of mortgage-then-auto-then-cards is not universal. Differences in cultural attitudes and legal constraints can change the hierarchy. For example, in Thailand the conventional wisdom is that consumers stop paying their mortgage first, knowing that their home cannot be foreclosed for several years. Similarly, many regions and jurisdictions in the U.S. make home foreclosure an extended process, but Americans still tend to protect the home first. This may be explained by a cultural bias toward homeownership (an essential component of the American Dream) and the related emotional need for security in one's home.

Home equity loans and lines are one of the great unknowns in this hierarchy. Will consumers pay them as if they were a first mortgage or view them more like other lines of credit? Since home equity portfolios have experienced very little stress to date, the question is still open, however, it is known that home equity loans with low or no equity do experience higher rates of delinquency. This might indicate a different perception on the part of the consumer in our hierarchy (e.g., home equity loans with little equity are more like lines, whereas those with substantial equity are viewed more like second mortgages), or the increased delinquency associated with low/no equity loans may simply be an indicator of credit quality. The answer may not become apparent until these portfolios experience more loss events.

Measurement

The existence of a Hierarchy of Payments is conventional wisdom in the banking industry. Still, it has remained resistant to precise quantification. The difficulty is the classic problem of taking performance data and stripping off all the confounding effects so that the underlying structure is revealed. In addition, we need a process that can perform such cleaning the same way across multiple products to create consistent metrics for comparison.

The solution to this problem has already appeared in the pages of RMA Journal (September 2002 and September 2003). Nonlinear decomposition and similar approaches strip away the effects of credit quality, vintage maturation, and seasonality to reveal the impacts coming solely from the economic environment. Our analysis has shown that such a process permits the quantification of the timing and magnitude of macroeconomic shocks on each product type. Comparing these dynamics clearly shows the payment hierarchy in action through the last recession.

Our work has also confirms another bit of conventional wisdom around the Hierarchy of Payments: response to economic expansion may be different from the delays experienced going into recession. In other words, the consumer's response time is asymmetric. Consumers seem to hold out as long as possible before going delinquent on their mortgage, but they appear to respond quickly and resume payments once their finances have recovered and the cycle has turned.

The challenge here is that very few portfolios have data back to the recessions of the early 1990s. That leaves us with a single example from which to quantify the Hierarchy of Payments. The next recession may follow this pattern, but there are no guarantees.

Planning through the Hierarchy

Why do we care about this Hierarchy? First, this information can be useful in managing collections, but the greater value is in making strategic decisions about portfolio management. Macroeconomic indicators often lag the economy badly and it can take one or two quarters to reveal that a recession is already under way. However, the environmental impacts on a credit card portfolio can show the beginning of a turn in the economy months before it is reflected in the macroeconomic data.

Additionally, the manager of an auto or mortgage portfolio may get a better forecast of portfolio performance using the environmental impacts on credit card performance than trying to look directly at macroeconomic data. Some products can feel macroeconomic impacts up to a year after the impact on credit cards, which gives management significant and valuable lead time for changing originations strategies, product pricing, and collections.
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