The Consequences of Debt Are All Around Us

Why isn’t the economy expanding at a faster pace?  Why aren’t consumers spending as robustly as they have in the past?  Why aren’t banks lending?

The answer has to do with either the debt still on the balance sheets of businesses, banks, and households, or the remains left by the debt that was created over the past fifty years.

We see the consequences of the half-century debt binge posted all over…on the Internet, in newspapers, and on radio and television.  Lots and lots of debt or the results of debt everywhere. 

Of course, the Greek debt situation is all over the papers this morning  In addition, the Socialists lost control of many local governmental bodies in Spain on Sunday, giving rise to fears that large amounts of unrecorded debt in many of these units will be discovered as a result of the change in government. (http://seekingalpha.com/article/271083-the-global-economy-debt-and-accounting-gimmicks)   

State and local governments in the United States are offering thanks that the media attention has shifted from them to the European entities.  But, the debt problems of state and local governments will not go away…so just wait!

The most important news this morning, to me, is the attention given to the banking systems of both Europe and the United States.

The headline in the Wall Street Journal proclaims, “Buyers Battle for Europe’s Bad Loans,” (http://professional.wsj.com/article/SB10001424052748704083904576335510788215984.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj) “The push by banks across Europe to clean up their balance sheets is causing a feeding frenzy among hedge funds and private-equity firms hungry for their troubled assets.”

“Banks from the U.K., Ireland, Germany, Austria, Greece, Italy, Portugal and Spain have been unloading tens of billions of dollars worth of assets…”

Marathon Asset Management LP, for example, is reported to have purchased bank assets “usually in batches of $25 million to $100 million, at discounts of as much as 50% of their face value.” 

“European banks are sitting on more than €1.3 trillion ($1.9 trillion) of loans that are considered ‘non-core’ to their businesses and are likely to be put up for sale over the next decade.”

“In the U.S., a similar process has been going on for years…Until recently, European regulators generally were content to let their banks work through their problems over time.” 

Europe’s sovereign-debt crisis put an end to that!

The point is that there is still a “ton” of debt “out there” that is being written down or is going to be written down and still has to be “worked out.” 

In other words, the economies of Europe and the United States are not fully out-of-the-woods.

The “working out” part of this statement is captured in the New York Times headline, “Banks Amass Glut of Homes, Chilling Sales” (http://www.nytimes.com/2011/05/23/business/economy/23glut.html?_r=1&hp). “The nation’s biggest banks and mortgage lenders have steadily amassed real estate empires, acquiring a glut of foreclosed homes that threatens to deepen the housing slump and create a further drag on the economic recovery.”

“All told, they own more than 872,000 homes as a result of the groundswell in foreclosures, almost twice as many as when the financial crisis began in 2007.” 

“The pileup could lead to $40 billion in additional losses for banks and other lenders as they sell houses at steep discounts over the next two years…”

And, this problem is extended to other areas of the real estate market like the commercial real estate sector. 

The good news…”the number of new foreclosures and recent borrowers falling behind on their payments by three months or longer is shrinking.”

Where is the focus of the banks?

The focus is more on attempting to minimize the amount of write down the banks must take and is not on generating new loans to build up revenue streams.  Right now, the balance of effort in banks seems to be on the side of keeping down charge-offs because of the larger impact on solvency, rather than just on earnings.  In fact, the recent increase in bank earnings has been largely due to a reduction in loan charges rather than an increase in revenues. 

If we are to get the focus of banks back on lending and on supporting economic growth we must get through this period of restructuring the balance sheets of commercial banks to remove the bad assets.

But, this presents a problem to the policy makers in Washington, D. C.  If commercial banks, and other economic bodies, must work through their debt problems before they can focus on increasing loans and increasing spending, efforts to stimulate the economy through further governmental credit inflation will have little impact on picking up economic growth.

This factor is not considered in most macro-economic models because the importance of debt on business decision-making will vary from time-to-time.  At lower levels of indebtedness, economic units may not feel that they have to restructure their balance sheets to reduce debt loads and further fiscal stimulus, more credit inflation, will bring about more rapid economic growth.

However, in periods when the burden of the debt loads become too heavy, people will need to re-adjust their behavior and reduce levels of financial leverage to more reasonable amounts.  At these times, further fiscal stimulus, more credit inflation, may have only a modest impact on economic growth.  In situations like these, fundamentalist preachers like Paul Krugman may cry all they like about the need for more and more governmental spending, but even that will not bring on “the Rapture.”

We are in a period when the excesses of the credit inflation of the past must be worked off before people can begin to fully focus again on the future.  The economy is highly bi-furcated, both in Europe and in the United States.  Those people and institutions that are not highly leveraged and have cash-on-hand, will prosper relative to those that are highly leveraged and are short on cash.  The last fifty years has seen a tremendous skewing of the income and wealth distribution in the United States toward the richer end of the spectrum.  My guess is that, given the current situation and the current economic policies, this trend will continue.  Maybe debt is not such a “good thing” after all.