USA Banking Series

2007 Year End Review - State of US Household Debt

Subject:   The Leveraging of American Households

              & America's Over-fascination with Real Estate lending

A friend of mine once said, "you don't need to be all that smart, so long as you know a good thing when you see it."  In 2003, the first time I saw Ned Davis's research on US household debt relative to GDP, I was quite surprise by how much a simple graphs can be in capturing the essence complicated concepts.  Anyway, with that in mind, I have replicated and updated his quality research thorough Q4 2007 using data set from FRED.  

• Conceptually, this ratio is the sum total of all money borrowed by households and compares it to the size of the economy. 
• Household debt began its explosive rise even before Alan Greenspan (Federal Reserve Chairmen) essentially dropped short-tern interest rates to zero "post 911"
• Household debt actually began to explode from the rubble of the "internet bubble / tech wreck" the year earlier - 2000. 
• Anyway, when "tech" was "wrecking" in 2000, Household Debt in the USA was 69% of the annual amount of goods and service produce that year.
• Seven year later, through Q4 of 2007, Household Debt in the USA was 96% of the annual amount of goods and service produce that year.

Discussion

Chart speaks for itself and in may opinion is shocking.

If you log into the federal reserve data system (and I do), there is lots of charts and such.  However, you will not find this chart anywhere..  What you will find is stuff like "Household debt service relative to disposable income"  things like that.  Very classic "banker way" of looking at things - can they afford to pay back the loan.  However, no consideration is given to overall debt levels or to the idea that these days the level of debt service can quickly change because adjustable rate loans are now the loan instrument of choice by most banks.  . 

What I find offensive is not that they have come to different conclusions regarding what is the appropriate level of debt.  Intelligent people often review the same data and come to different conclusion.  What bothers me is that the omission of such graphs and analysis is so glaring that it is as if they don't even want to have to defend their opinion.

What is the an appropriate level of debt for individual as a whole?  Good question - difficult answer.. 

Anyway,  time will tell.  At this point in time, it is just all "blah blah blah" as my friend Justin is so apt in noting. 

Most people seem to understand that in the early 90s the "securitization market" for real estate assets changed in a big way.  The problems in the sub-prime market and alt-A market in all the rage.  I had a unique position in the 90s to see this first hand as one of my clients was the biggest sub-prime mortgage origination in the country and in fact could almost be said the he, Lehman, and Greenwich Capital were the visionaries of this market.    Anyway, securitizations are a modern phenomenon.  Commercial Banking on the other hand has been around for a long time.

• If you look at plain commercial banking real estate lending over the last 60 years you see and interesting trends.
• Historically, Bankers see real estate as more secure than assets that are capable of moving or being stolen.
• However, as collaterally, the are subject to the harshness of the market place.
• However, the level of lending increases, so does the liquidity of the collateral.
• Which then makes it more attractive for lending.
• Point is that over time, the market becomes depended on lending to support the prices as the cash buyers have long since left.

I see this long tem trend problematic for a number of reasons: 

• Market Value Now Entirely Dependant of Financing.  In a distant past, real estate valuation was heavily influenced by the availability of cash buyers.  Now it is entirely dependent on the availability of financing.  This is a problem since the early 1980s the US banking system has doubled the amount relative to the size of the economy.  This was possible because as the debt levels increase, the interest charged keep decreasing.  Hence, in order to fuel a credit expansion necessary to support asset prices,  real loan rate would have drop even more.  While conceptually the could decline, they can't go lower than zero.  Unfortunately, the medium term out look is for rising rate.  .     
• Long Term Assets Funded With Short Financing.  Ever since the Financial Institution Reform act (FIRREA) of the late 1980's, Banks are reluctant to make long term loans.  Hence, Banks now make long term loans at variable rates tied to short term rates.  Now, the fed finds it forced to lower or maintain low short term rates in order to support real estate.   Low rate result in the fall of the value of the dollar in currency markets and potentially contribute to global commodity prices spiral up.  The the Feral Reserve faced with the choice of two terrible outcomes. Raise rate to support the dollar and stabilize commodity prices at the expense of collapsing real estate values - or visa versa.  This is a new dynamic in the market which has only arisen since FIRREA.   

More text and charts to be added later......