Americans Are Deleveraging, But Not Because They Want To

As comparisons between US and European debt to GDP levels and the finger-pointing of who is deleveraging more continues, McKinsey notes (in their quarterly Debt and Deleveraging article) that there may be a light at the end of the tunnel for the US as private-sector deleveraging has been rapid since 2008. However, reading on a little, we find that the light at the end of the tunnel may well be the front of the oncoming train of financial distress as some two-thirds of the 4% ($584bn) in US household debt deleveraging is from defaults on home-loans (and other consumer debt)! Of course, with homebuilder stock prices surging (notably rather dramatically relative to lumber or ABS/CMBS), consensus has once again agreed that the bottom in housing is in. McKinsey's initial forecast that the pent-up foreclosures and implicit deleveraging will bring us back to trend by 2013 seems like a pipe-dream and we tend to agree with their more conservative perspective that reversion in household debt will not be to trend but to pre-credit-bubble levels, implying a 22% further reduction (or a couple more trillion dollars of defaults).

The United States: A light at the end of the tunnel

From 1990 to 2008, US private-sector debt rose from 148 percent of GDP to 234 percent (Exhibit 5). Household debt rose by more than half, peaking at 98 percent of GDP in 2008. Debt of nonfinancial corporations rose to 79 percent of GDP, while debt of financial institutions reached 57 percent of GDP.

Since the end of 2008, all categories of US private-sector debt have fallen as a percent of GDP. The reduction by financial institutions has been most striking. By mid-2011 the ratio of financial-sector debt relative to GDP had fallen below where it stood in 2000. In dollar terms, it declined from $8 trillion to $6.1 trillion. Nearly $1 trillion of this decline can be attributed to the collapse of Lehman Brothers, JP Morgan Chase’s purchase of Bear Stearns, and the Bank of America-Merrill Lynch merger. Since 2008, banks also have been funding themselves with more deposits and less debt.

Among US households, debt has fallen by 4 percent in absolute terms, or $584 billion. Some two-thirds of that reduction is from defaults on home loans and other consumer debt. An estimated $254 billion of troubled mortgages remain in the foreclosure pipeline, suggesting the potential for several more percentage points of household debt reduction as these loans are discharged. A majority of defaults reflect financial distress: overextended homeowners who lost jobs or faced medical emergencies and found that they could not afford to keep up with payments. Low-income households are affected most by defaults—in areas with high foreclosure rates, the average annual household income is around $35,000, compared with $55,000 in areas with low foreclosure rates.

Up to 35 percent of US mortgage defaults, it is estimated, are the result of strategic decisions by borrowers to walk away from homes that have negative equity, or those in which the mortgage exceeds the value of the property. This option is more available in the United States than in other countries, because in 11 of the 50 states—including hard-hit Arizona and California—mortgages are nonrecourse loans. This means that lenders cannot pursue other assets or income of borrowers who default. Even in recourse states, US banks historically have rarely pursued nonhousing assets of borrowers who default.

We estimate that US households could face roughly two more years of deleveraging. As noted above, there is no accepted definition of the safe level of household debt, which might serve as a target for deleveraging. One possible goal is for the ratio of household debt relative to disposable income to return to its historic trend. Between 1952 and 2000, this ratio rose steadily—by about 1.5 percent annually—reflecting growing access to mortgages, consumer credit, student loans, and other forms of credit in the United States. After 2000, growth in household borrowing accelerated, and by 2008, growth in the ratio of household debt to income had climbed more than 30 percentage points above the trend line. By the second quarter of 2011, this ratio had fallen by 15 percentage points. At the current rate of deleveraging, it could return to trend by mid-2013 (Exhibit 7).

In the wake of a highly destructive financial crisis, it is reasonable to ask whether a continuous upward trend in household borrowing is sustainable. A more conservative goal for US household deleveraging, then, might be to aim for a return to the ratio of debt relative to income of 2000, before the credit bubble. This would require a reduction of 22 percentage points from the ratio of mid-2011.

Another comparison is with Swedish households in the 1990s, which reduced household debt relative to income by 41 percentage points. By this measure, US households are a bit more than one-third of the way through deleveraging.