As the US entered its worst economic downturn since the Great Depression, consumer balance sheets were laden with debt. Household debt as a percentage of GDP, less than 49% in 1980, had risen to more than 96% by the end of 2007. The doubling of this debt ratio was supported by a secular decline in both savings and interest rates, a doubling of bank leverage ratios, which itself was supported by easy lending standards, the failure of regulators to remain abreast of financial innovation, the housing bubble, and outright fraud. As this house of cards began to crumble, the pain was first felt by the capital markets. When the commercial paper market dried up, the crisis engulfed the financial sector and lending markets all but ceased to function. As credit, the grease for capitalism’s gears, ground to a halt, corporations prepared for economic Armageddon and the unemployment rate doubled.
Yet despite stubbornly high unemployment, consumers have made significant headway in restructuring their balance sheets. Household debt as a percentage of GDP peaked at 98.33% in the 1st quarter of 2009, nearly two standard deviations above the its 30-year average, a level often associated with bubbles. By September 2010 it had declined to 91.08% (Chart 1). While that is a significant decline in just 18 months, it remains well above the norm. In fact, the average itself is skewed by the enormous growth in household debt during the first eight years of the 21st century. The median level is more than 350bps lower than the average over the last 30 years. While much of the decline is a function of increased consumer frugality, some too, is a function of record levels of foreclosures. While the reduction in household debt as a percentage of GDP is impressive, it remains extremely elevated.
However, debt service levels are much more reasonable due to historic monetary ease, decreased use of often high-cost revolving debt, and the reduction in total debt. Revolving debt as a percentage of total consumer credit, which peaked in the late 1990s, declined to the lowest level in 18 years in the 3rd quarter of 2010 (Chart 2). While revolving credit remains a significantly higher percentage of total consumer credit than it was 30 years ago, it is important to note that credit cards, which comprise a significant portion of revolving debt, did not truly begin to proliferate until the 1970s and revolving debt was not included in the Fed’s consumer credit data until 1968. Not only has revolving credit declined as a percentage of total consumer credit, but the absolute level has declined dramatically over the last two years. From its peak in August 2008, the volume of revolving consumer credit declined 17.21% through September 2010.
The Fed’s dramatic easing has resulted in historic lows in mortgage rates. Largely lost amid the foreclosure news is the fact that the vast majority of homeowners have significant equity in their homes. That fact, coupled with historically low interest rates, has resulted in a refinancing boom that has significantly lowered mortgage payments for many households. The financial obligations ratio (FOR), which utilizes a broader definition of debt payments than the debt service ratio (DSR), is an indicator of consumers’ ability to service their debt. It indicates the percentage of disposable income that must be allocated to debt repayment. Like the debt-to-GDP ratio, the financial obligations ratio peaked at nearly two standard deviations above the norm. However, unlike the debt-to-GDP ratio, it has declined below its average of the last 30 years and is at the lowest levels in a decade (Chart 3).
Not only have consumers reduced their debt, dramatically lowered their dependence on less stable, high cost, short-term financing, and significantly reduced their debt service as a percentage of disposable income, they have done so while rebuilding their savings. Savings as a percentage of disposable income bottomed at 1.2% in the 3rd quarter of 2005, nearly two standard deviations below the norm. While we do not typically define bubbles by movements below the mean, this may be considered a corollary to bubbles in debt and consumption. After bottoming, the savings rate crept higher until the crisis hit, at which point in began to rise rapidly, peaking at 7.2% in the 2nd quarter of 2009. While it has since declined, it remains slightly above its average of the last 30 years and at one of the highest levels in the last 15 years (Chart 4). However, the average has been significantly impacted by the dramatically low savings rates that prevailed from the mid-1990s through the middle of this decade. As such, while the increase in the savings rate over the last few years is significant, it likely needs to rise further, just as the absolute level of household debt-to-GDP needs to fall further.
The recent improvement in consumer balance sheets has been impressive. Consumers have reduced debt while rebuilding their savings. With the help of historically low interest rates, they have significantly lowered their debt service ratios, paid down debt, reduced the use of revolving credit, and refinanced mortgages. This, in turn, combined with rising capital markets and relatively flat housing prices has lifted household net worth. After bottoming in the 1st quarter of 2009, household net worth rebounded more than 12% over the next 18 months (Chart 5).
While it remains more than 16.50% below its peak, household balance sheets are on much firmer ground today than they were in 2007. Equity markets are more reasonably valued than they were at their peak in October 2007. Home prices in 2006 and 2007 reflected bubbles in the housing and credit markets. Today thy are far more reflective of long-term economic value. While equity prices could certainly suffer a significant correction after the dramatic rally in the 2nd half of 2010 and home values could well decline further, neither is in imminent danger of collapse as they were when household net worth peaked in 2007.
The speed at which household balance sheets have recovered has been impressive, but work remains to be done. Household debt-to-GDP remains above sustainable levels. While debt service appears sustainable, this is a function of both greater fiscal responsibility by consumers and enormous monetary largesse by the Fed. The latter will very likely give way to tighter monetary policy by late 2012 or 2013, requiring further vigilance by consumers if they are to maintain, or further, the progress they have made in strengthening their balance sheets.