Households and the Debt Problem

The Federal Reserve released new data on the financial condition of the household sector of the United States. Like other sectors of the economy, the financial condition of this sector has deteriorated over the past year.

The value of household assets dropped about 15% falling from $77.3 trillion to around $65.7 trillion. Most of the decline came from the fall in housing values and in their stock market portfolios.

In terms of household holdings of stocks, the value of the stocks households owned, mutual funds that were held and funds in retirement plans, the loss was $8.5 trillion. That is, the value of stock holdings fell from $20.6 trillion to $12.1 trillion.

Although mortgage credit fell during the year, total household liabilities stayed roughly the same at about $14.2 trillion. This means that debt as a percentage of assets rose from around 18% to 22% during the year (or net worth as a percentage of assets dropped from 82% to 78%).

Mortgage credit at the end of 2008 was $10.5 trillion so that other household liabilities totaled around $3.7 trillion, with consumer credit making up $2.6 trillion of this latter number. Mortgage credit fell during the year, but not because the household sector was trying to get out of mortgage debt. The primary reason for the decline was foreclosures and the reduction in the willingness of financial institutions to lend.

What this means is that households took on increased leverage during the year, not because they wanted to in order to grow their balance sheets, but because of the decrease in the value of their assets and because of the need to borrow due to lower incomes. The increased leverage was a result of the collapse of the mortgage market, in particular, and the economy, in general. The increased leverage just happened—it was not planned.

In order to protect themselves in the face of these changes, households moved assets into cash and cash equivalent accounts. Banks deposits held by households were at about $7.7 trillion at year end.

This is important information for understanding the state of the economy and the contribution the household sector might make toward turning the economy around. The household sector was in free fall in 2008 and was reacting to events, not leading them.

Households took three major shocks last year: first was the decline in housing prices; the second was the rise in unemployment; and the third was the fall in the stock market. Not only was their cash flow significantly hurt, but the value of their assets fell precipitously. They borrowed in an effort to hold on and they became more liquid so as to be prepared for that “rainy day.”

The year 2009 does not look any better than 2008. Housing prices continue to plummet. The stock market has dropped since the first of the year. And, unemployment has ratcheted up. That is, one can assume that the direction observed in the balance sheets of American household in 2008 will continue to be followed this year. Even if the stock market were to stabilize or rise through the rest of the year consumer spending, I believe, will continue to be weak. Even if housing prices stabilize. Even with the implementation of the Obama stimulus plan.

According to the best information we have there are three further shocks looming on the horizon. The first two have to do with the mortgage market: over the next 18 a large amount of Alt-A and Options mortgages are supposed to re-price. Given the weakness in employment that is expected to continue and the lower household incomes, this event could be devastating. And, on top of that credit card delinquencies are rising and these are expected to grow given the financial condition of the household sector.

Consumers will continue to withdraw from the marketplace as they add debt where they can in order to maintain at least a part of their former living standards. Also, consumers will continue to try and become more liquid so that they can be prepared should they need to need cash to tide them over a rough time. Any improvement in the stock market will be met with households selling more stock so as to move the funds into more liquid assets, the rise in the market making it easier for them to get rid of stocks—even at a loss.

And where are the funds going to go that come to households from the Obama recovery plan? My guess is that a good portion of them will go into liquid assets, or into paying down debt. Households are scared right now. They are going to use whatever they have as conservatively as possible. This even goes for those that have some security in their employment condition.

The data that are coming out confirm the strength of the problem that the policy makers face. The United States has a tremendous debt overhang. This debt problem is going to have to be worked off. Economists talk about “the paradox of thrift”, the problem that consumers are not spending at this time and probably will not spend much in the near future, even though if everyone opened up their pocketbooks and spent, everyone would be better off.

This situation is like a “Prisoner’s Dilemma” game. If everyone else increases their spending reducing their savings and, willingly, increasing their debt and I don’t follow their lead, then I will be a lot better off that all these other people. But, if everyone else believes as I do and doesn’t reduce their savings and doesn’t increase their debt, then I end up losing big to everyone else. So, as in the “Prisoner’s Dilemma” everyone defaults to the decision to save more where they can and to pay off their debt. The consequence of this will be that consumer spending will remain weak and much effort will be extended, where possible, to work themselves out of debt.

The overall problem is that there is too much debt outstanding. The policy makers are focusing upon stimulating the economy by increasing spending. If the debt overhang is truly too great, then the stimulus package will only have a small multiplier effect on the economy as households try and get their balance sheets back in some kind of order.

Such behavior will not have much affect on the economy, and it will also not have much affect on the stock market. Government policy makers must direct more attention to resolving this debt problem. It seems to me that this is what the financial markets are trying to tell them. As Citigroup and Bank of America claim they are showing some signs of profitability. As General Electric survives a reduction in its credit rating, meaning that GE Capital has more of a chance to re-structure itself. As General Motors indicates that it has reduced costs sufficiently to rescind the request for another $2 billion from the government in March. And, as other financial institutions seek to repay to TARP money they had received last fall, the stock market rebounds.

It is the debt problem that is the big concern of the financial markets. In my opinion, as long as the government policy makers put their primary focus on stimulating spending, the financial markets—and the economy—will continue to flounder. When they refocus on the more crucial problem they will find that the financial markets will be more supportive of what they are doing.