Weekly Market Update
Jim Finnegan, CFA Investment Writer
Many things are different about the current economic recovery compared with past recoveries from recessions. One of the most important differences is the lack of any meaningful resurgence in consumer spending. Households continue to reduce their debt levels (in what economists call the deleveraging process), which can be good for our long-term economic outlook. But in the near term, deleveraging (along with increases in personal savings rates) means consumers cannot play the same role they have in past recoveries of driving strong economic growth by a surge in spending that satisfies their deferred consumption during the downturn. In this Weekly Market Update, we’ll take a look at how households and consumers are faring in their efforts to reduce debt.
Overall Debt Levels Are Declining
In August, the Federal Reserve Bank of New York released its Quarterly Report on Household Debt and Credit,1 which covered a time frame up through the end of the second quarter (June 30). As the chart below illustrates, overall consumer (or household) debt has declined by about $1.1 trillion between the second quarter of 2008 and the second quarter of this year. That covers all types of consumer borrowing, including home mortgages, home equity lines of credit, auto loans, other types of consumer durable term loans (appliances, recreational equipment such as boats, etc.), student loans, unpaid balances on credit cards, and other consumer borrowing.
This $1.1 trillion decline is the first downward shift in consumer indebtedness in at least a decade. Another way of measuring consumer indebtedness is to divide this number by the nominal (i.e., not inflation-adjusted) gross domestic product (GDP) for the same year. Since GDP measures the aggregate output of our economy in terms of both goods and services, this statistic normalizes consumer indebtedness by the size of our overall economy. As the percentage numbers beneath the bar chart illustrate, the absolute drop in consumer indebtedness has resulted in this ratio of debt to GDP also declining from about 96% (its peak in 2009) to 86% this year. (What’s also interesting to note is how this level of indebtedness is also approximately equal—currently—with our federal government’s total indebtedness, which this year will equal about 85-90% of GDP.)
Delinquency Rates Are Declining but Still Elevated
In the chart below, we plot the delinquency trends for household borrowing by the number of days payment is overdue. The data are on the basis of percent aggregate dollars of debt (for example, $12.5 billion for the second quarter of 2008, as the previous chart shows), not the percentage of households or consumers. The chart clearly illustrates how delinquency increased substantially as the Great Recession unfolded between December 2007 and June 2009. More interestingly, it also shows how loan delinquency began to rise well in advance of the official start of the recession. The percentage of all outstanding consumer loans which were current on payments began to erode as early as the first quarter of 2006.
The chart below also illustrates that we are far from fully recovered in terms of delinquency rates for consumer borrowing. As the dashed lines indicate, 7% of the value of all outstanding loans are seriously delinquent (greater than 90 days past due on payment) where this number had averaged only 2% prior to the Great Recession. Likewise, 10% of the value of all outstanding consumer loans is at least 30 days delinquent; this number had averaged 4% prior to the Great Recession. The difference between these pairs of numbers (7% minus 2%, and 10% minus 4%) suggests that—in a worst case scenario—an additional 5-6% of current loans outstanding (or $11.4 trillion) could be at risk of having to be written off, equaling approximately $610 billion.
Delinquency rates vary considerably by the type of loan and consumer borrowing. It’s understandable that an individual or family under financial duress would (first and foremost) attempt to keep payments on their home mortgage current so as not to risk losing their home. On the other hand, home mortgage payments are usually the largest monthly loan payments households make, meaning that keeping current during a time of economic stress is a major challenge. As the chart below illustrates, the highest rates of delinquency are currently for credit cards and student loans. (Like the previous chart, these data are also based on a percentage of the aggregate dollar value of each loan outstanding, not the percentage of households). Over the past three years, U.S. consumers have drastically cut back on the number of credit cards they carry. In total, this figure dropped approximately 115 million down to about 375 million—a large decline, but still a mind boggling number of credit cards outstanding.
Student loan delinquency rates are the second highest—partly because of limited job opportunities in the current economy for recent graduates—and continuing to trend upward. Delinquency rates on home mortgages have come down slightly (from nearly 9% to approximately 7%) over the past year. However, 7% is still well above the historical average of approximately 1%, something that will have to be addressed in order for the current housing crisis to truly be considered solved.
Student Loans Outstanding Continue to Grow
As noted in the previous section, the one area of consumer borrowing and indebtedness that is not declining is student loans. The chart below plots the 12-year trend in total loans outstanding for all categories of borrowing excluding primary home mortgages. The dashed circle highlights the common trend toward lower amounts outstanding for three important types of consumer loans: credit card borrowing, auto loans and home equity lines of credit. The category of “Other Loans” (appliances, recreational equipment such as boats, etc.) has also been on a slower decline trajectory. However, the aggregate amount of student loans outstanding has grown over this time frame from approximately $75 billion to $500 billion.
There is another aspect of student loan growth that is not captured in the chart below. As anyone who’s taken out a student loan knows, during the period you remain in school, the loan is classified as being in an “accrual phase.” Payments are not due and—for this reason—these loans are not counted in the $500 billion number shown for 2011. It’s only when the student graduates (or drops out of a program) that the loan is classified as performing (with monthly payments due) and counted as part of the total value of student loans outstanding. According to the Federal Reserve (the Fed), the amount of new loans that have been taken out and are still in the accrual phase (many by recent college graduates unable to find work and who decided to continue on in graduate studies of some kind) is now approximately $400 to 450 billion. This means the total level of student loan indebtedness is now actually close to $1 trillion.
This Recovery Is Different
At the outset of this Weekly Market Update, we noted that the lack of a strong resurgence in consumer spending is one unique feature of the current economic recovery relative to past recoveries from recessions. As the previous charts have illustrated, the primary reason for this has been the need by consumers to deleverage from high levels of all types of borrowing—including, but not limited to, home mortgages.
But the other side of this coin is that past recoveries have not simply lacked the current need to increase personal savings and reduce debt, they have been driven and fueled in part by consumers increasing their personal borrowing. The chart below illustrates the trend in cumulative change consumer debt over the eight quarters (i.e., two years) after a post-recession economic recovery began. Each line represents this trend in the change of consumer indebtedness for a particular recovery—those beginning in 1982, 1991, 2001, and (our current situation) 2009. As the chart illustrates (confirming the earlier analysis), overall consumer debt levels have declined modestly since the start of the current recovery. The drop (about 5%) from 2009 to 2011 is consistent with the first chart in this Weekly Market Update where overall consumer debt dropped from $12.2 trillion to $11.4 trillion between the second quarters of 2009 and 2011, also about a 5% decline.
In contrast, the other three recoveries shown were accompanied by substantial increases in cumulative consumer debt outstanding. Perhaps most notable is the much vaunted 1982 recovery, which has often been compared and contrasted to the current one. In that case, cumulative consumer debt rose by nearly 25%, which is highly stimulative to economic growth.
Consumer Psychology Is Also Playing a Role
In addition to less borrowing capacity to fuel the kind of surge in consumer spending we’ve seen with past recoveries, there are also psychological factors at work. One thing to keep in mind in reviewing the data, analysis, and charts in this Weekly Market Update is that—despite the large financial challenges consumers face—there is still a large proportion of households that are not overleveraged, are making their loan payments on time, and have secure jobs and strong credit scores.2 And yet, according to Fed-sponsored research, even many of these households are in the process of deleveraging by paying off loans early and avoiding any unnecessary new borrowing (and even at today’s very attractive rates).
The severity of the Great Recession has likely had an impact on the thinking and outlook of all Americans regardless of their personal financial circumstances. The Fed estimates that the market value of all residential real estate has declined by $6.6 trillion since its peak in mid-2006. That represents a large paper loss and psychological blow even for those who have no mortgage to pay or plans to sell. And home prices continue to decline in many markets. Unemployment remains extremely high by historical standards with most companies being very cautious about adding new workers.
Adding to these effects, the media headlines have been dominated by regular reports of sovereign debt problems in Europe. Here in the U.S., Standard & Poor’s recently issued a credit downgrade on our nation’s debt while Congress and the president argue about the best way to reduce our massive budget deficit and rapidly growing national debt in a way that does not adversely impact our weak (but positive) economic growth. Finally, 2011 represents the year when the leading edge of the Baby Boom (those born in 1946) reach the traditional retirement age of 65. Over the next 18 years, this generation of approximately 74 million Americans will cross that age threshold, and many are in the midst of a change in mindset from conspicuous consumption to concerted preparation (saving and reducing debt) for their “golden years.”
Back in the 1930s, the noted British economist John Maynard Keynes commented on a “Paradox of Thrift.” While we normally consider thrift a virtue, Keynes noted that—when it is widely practiced by everyone simultaneously—it can lead to low economic and income growth and elevated unemployment. Behavioral psychologists who study markets and economic behavior have long observed that individuals seek reassurance from following widespread movements and popular trends that are often reactions to major events such as financial shocks.
How long the psychological effects of this new frugality will last is open to debate. Many observers expect that continued progress in the consumer deleveraging (which can only go so far), along with gradual reductions in the unemployment rate and renewed demand for home buying will ultimately jumpstart a new wave of growth in consumer buying and borrowing. Certainly, at today’s very low interest rates, the incentive is present for consumers to renew borrowing, especially if we can achieve price stability in markets like residential housing.
On the other hand, a paper released a year ago by economists Carmen and Vincent Reinhart titled After the Fall3 suggests it might take longer. Their analysis studied 15 severe national or regional financial crises post-World War II and three major worldwide economic contractions to evaluate the recovery times in terms of spending behavior, aggregate supply growth (i.e., new business investment), real estate pricing, unemployment rates, and (ultimately) GDP growth. Two of the crises they analyzed were the Asian financial crisis of 1997 and the first global oil price shock of 1973. Not surprisingly, they conclude that the recovery time (in years) is proportional the depth of the crisis and the length of time (also in years) which preceded the crisis, especially if it involved the building up of a speculative financial bubble that burst. By this metric, it may yet be several more years before we have fully recovered from the financial crisis at the heart of the Great Recession.
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1The Quarterly Report on Household Debt and Credit is produced by the Research and Statistics Group, Microeconomic Studies at the Federal Reserve Bank of New York, one of the 12 regional Federal Reserve member banks.
2To wit, as of the second quarter of this year (based on data from American Core Logic, a provider of financial, property and consumer information), one-third of all homeowners had no primary mortgage on their homes and an additional 55% held a mortgage but had positive equity—meaning that the category of distressed homeowners who owe more on their mortgage than their current home value is only approximately 12% of all homeowners.
3 After the Fall by Carmen Reinhart (University of Maryland) and Vincent Reinhart (The American Enterprise Institute) was published in August 2010.
The opinions expressed are those of American Century Investments and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.
