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Household Leveraging and Deleveraging Karen Dynan Brookings Institution May 20, 2010 2 Household Leveraging and Deleveraging Ratio of Debt to Disposable Personal Income 1.4 1.2 Q4 1 .8 .6 1960 1965 1970 1975 1980 Source: U.S. Flow of Funds Accounts 1985 1990 1995 2000 2005 2010 3 Big Questions • About the past: What explains the pre-crisis uptrend in debt? Were these factors a good or bad thing for households and the economy? • About the present: How is the deleveraging occurring? Is the deleveraging a good or bad thing for households and the economy? • About the future: How much more deleveraging should we expect? 4 Why Did Household Debt Rise? “The most important factors behind the rise in debt and the associated decline in saving out of current income have probably been the combination of increasing house prices and financial innovation.” Dynan and Kohn, The Rise in U.S. Household Indebtedness: Causes and Consequences (2007) 5 Home Prices and Rising Debt Composition of the Aggregate D/Y Home Mortgage Debt and House Prices 1.4 1.4 20 20 Home Mortgage Debt Q4 1.2 1.2 .8 .6 Home Mortgage Debt .4 10 4-Qtr Percent Change Ratio 1 10 1 .8 0 0 House Prices .6 .4 .2 -10 -10 -20 -20 .2 Other Debt 0 0 1980 1985 1990 Source: U.S. Flow of Funds Accounts 1995 2000 2005 2010 1980 1985 1990 1995 2000 Source: U.S. Flow of Funds Accounts and First American CoreLogic Debt data through 2009q4. House price data through Feb. 2010 2005 2010 6 Financial Innovation and Rising Debt • “Democratization” of credit explains only a small part of the rise. • Rather, the key factors were easier access and lower cost of credit for those who already had access to debt markets. • Note that quantifying the role of FI difficult: » FI broad and has occurred gradually. » FI has interacted with other factors. 7 Evolution of Median Household Debt by Demographic Group Consistent with the incremental and thorough-going nature of financial innovation, increases in borrowing have been gradual and widespread. 8 Consequences of Greater Credit Availability “Developments in lending practices and loans markets that have enhanced the ability of households and firms to borrow … should be added to the list of likely contributors to the mid-1980s stabilization.” Dynan, Elmendorf, and Sichel, Can Financial Innovation Help to Explain the Reduced Volatility of Economic Activity? (2006) 9 Greater Access to Credit Probably Explains Reduced Sensitivity of Consumption to Income Declines after Mid-1980s 10 BUT, downsides to greater access to credit have become painfully clear … 11 Share of Income Committed to Debt Service Has Risen • From Dynan (Journal of Economic Perspectives, 2009): » Median DSR rose from .05 in 1983 to .13 in 2007. » Percent of households with DSR > 0.40 rose from 4% in 1983 to 11% in 2007. • Households with higher DSRs more likely to have trouble making payments. 12 Greater Leverage Has Increased Exposure to House Price Shocks Change in Wealth Implied by a 20% Decline in House Prices (as a Fraction of Income) 1983 1995 2007 All Households -.30 -.33 -.49 Households in Lowest 1/3 of Income Distn -.46 -.57 -.77 Source: Dynan (2009) based on the Survey of Consumer Finances. 13 Lessons about Household Leverage • Useful for getting around income constraints … » To smooth consumption. » To pursue higher returns via investment. • But exposes households to more risk if things do not turn out as expected. • FURTHER, financial crisis has taught us that it can hurt a much broader group than those who borrow if risk-taking is correlated across households. 14 Household Deleveraging 15 Both Mortgage and Consumer Debt Are Shrinking 1,000 0 500 -500 Billions of Dollars 1,500 Household Debt Growth q1 q2 q3 q4 q1 q2 q3 q4 2005 2006 q1 q2 q3 q4 q1 q2 q3 q4 2007 2008 Home Mortgage Debt q1 q2 q3 q4 q1 2009 2010 Consumer Credit Debt Source: U.S. Flow of Funds Accounts and Fed G.19 data release. 2010q1 consumer credit is estimated 16 How is deleveraging occurring? 17 Importance of Defaults Charge-offs of Consumer Loans 10 10 Q4 8 8 If charge-offs had not been unusually elevated … Credit Card Loans 6 6 4 4 2 Q4 Other Consumer Loans 2 0 0 2000 2002 2004 2006 2008 2010 Source: FFIEC Consolidated Reports of Condition and Income Consumer credit would have declined 2¾% in 2009 instead of declining 4½% (charge-offs explain 60% of decline). Charge-offs of Residential Mortgage Debt Q4 2.5 2 2.5 2 All Mortgages 1.5 1 1.5 1 .5 At Commercial Banks .5 0 0 2000q1 2002q3 2005q1 2007q3 Sources: Federal Reserve Board and Fed Economist Jim Kennedy 2010q1 Mortgage debt would have been flat in 2009 instead of declining 2% (charge-offs explain all of decline). 18 Evidence of Supply Constraints Net Percent of Banks Tightening Standards Banks Tightening Consumer Lending Standards 60 40 20 0 Banks Tightening Mortgage Lending Standards 100 100 75 75 60 Other Loans 40 Subprime 50 50 Nontraditional 20 25 Credit Cards Prime 25 All Q1 0 0 -20 Q1 -20 2000 2002 2004 Source: Fed Senior Loan Officer Survey 2006 2008 2010 2000 2002 2004 Source: Fed Senior Loan Officer Survey 2006 2008 2010 0 19 More Evidence of Supply Constraints • Loan officer survey: 2/3 reported loan standards for nonprime households unlikely to return to long-term averages “for foreseeable future.” • Private nonprime mortgage market still closed. • Lower credit card limits, higher LTVs on new car loans. • More austere regulatory environment (CARD act, new HOEPA regs, push for CFPA). 20 Demand for Loans Also Down • Not surprising in a downturn when demand for consumer goods and services falling. • 1/5 of senior loan officers (on net) reported that demand for consumer loans had fallen relative to 3 months earlier in May 2010 (well after consumption trough). • But, signal from other possible indicators of greater prudence among households fairly weak. 21 Disentangling Supply vs. Demand Selected Household Interest Rates 15 15 10 Used Cars 10 Rate 30 Yr Conventional Mortgages Feb Apr 5 Feb 5 New Cars 0 0 2000 2002 Looking at price is a traditional way to see if demand or supply effects are more important. 2004 2006 2008 2010 Sources: Freddie Mac Primary Mortgage Market Survey. Fed. Reserve Release G.20. Car loan rates are from subsidiaries of the three major U.S. auto manufacturers. But these measures tell us only part of story because there is nonprice rationing too. 22 Is the Deleveraging a Good Thing or Bad Thing for the Economy? • Short run: Inability / unwillingness to borrow is dampening the pace of recovery. • Longer run: Deleveraging puts households and the broader economy in a more solid and sustainable position. » Regardless of how it occurs. » Lower debt service payments have already made much more cash available for spending. 23 Aggregate DSR Has Fallen by 1.25 Percentage Points Household Debt Service Ratio 14 14 13 13 Q4 12 12 11 11 10 10 1980 1985 1990 Source: U.S. Federal Reserve. 1995 2000 2005 2010 24 Looking Ahead 25 High D/A Suggests Potential for Considerably More Deleveraging Aggregate Household Debt/Asset Ratio .22 .22 Q4 .2 Ratio .2 .18 .18 .16 .16 .14 .14 .12 .12 1980 1985 1990 Source: U.S. Flow of Funds Accounts. 1995 2000 2005 2010 26 Future Deleveraging Most Likely to Occur in the Mortgage Area • Mortgage charge-offs likely to remain high. » Foreclosures are on the rise again after having been forestalled by HAMP and other factors. • Even as lenders’ standards ease, new borrowing should be dampened by lack of home equity. » CoreLogic: Close to 30% of mortgage borrowers have little or no equity (50% or more in the hardest-hit states). 27 Scope for Further Deleveraging in the Consumer Credit Area Less Clear • Delinquency rates are very high, particularly for credit cards, and soft labor markets should keep them high => more charge-offs to come. • But borrowing is likely to pick up with consumer demand. • Q1 saw first increase in outstanding consumer credit since 2008:Q3 (up 0.4% but if charge-offs not elevated the increase would have been around 3%). 28 Conclusions • More deleveraging seems likely, especially in the mortgage area. • The deleveraging reflects a combination of households defaulting and borrowing less (different in some ways but gets them to the same place). • Big unanswered question: Who is deleveraging?