Household Debt and Delinquency Levels and Their Impact on GDP Growth

The recent Quarterly Report on Household Debt and Credit from the New York Fed shows an interesting change in the trend of household debt in the United States.

Here is a graphic showing the total household debt balance, including both housing and non-housing debt for the third quarter of 2013:

On September 30, 2013, total consumer indebtedness was $11.28 trillion.  This is up 1.1 percent on a quarter-over-quarter basis, however, it is still 11 percent below the peak consumer debt level of $12.67 trillion in the third quarter of 2008.  That said, this is the largest increase in consumer debt seen since the first quarter of 2008 when the Great Recession was just an infant.  It is also important to note that the housing market was severely over-valued at the beginning of 2008, putting significant upward pressure on the dollar value of housing loans, a situation that does not exist in most real estate markets today.  This renders a comparison between the current total consumer indebtedness level and that seen in 2008 rather difficult. 

Here is a breakdown of the increases by type of debt:

Mortgage debt: increased by 0.7 percent to $8.43 trillion

Non-housing debt increased by 2.7 percent to $2.85 trillion

Of non-housing debt, auto loan balances increased by $31 billion, student loans increased by $33 billion and credit card balances increased by $4 billion.  Auto loans increased to $97.4 billion, the highest level since the third quarter of 2007.

Here is a bar graph showing the total debt balance and a breakdown of its composition:

Now, let's look at the delinquency status of household debt in the United States.  Here is a bar graph showing the percentage of loans broken down the degree of delinquency:

It is interesting to note that while the percentage of loans that are more than 30 days delinquent has dropped from its peak of 11.9 percent in the first quarter of 2010, at 7.4 percent, it is still nearly double the 3.5 to 5 percent range experienced prior to the Great Recession.   Of the total outstanding household debt, $831 billion is considered delinquent with $600 billion considered seriously delinquent (at least 90 days late).  Here is a graph showing the new delinquent balances by the type of loan:

For the first time since the end of 2012, the total balance of new delinquent loans grew, hitting nearly $200 billion.  You will also note that the total delinquent loan balance is still well above the pre-Great Recession level of between $135 billion and $150 billion.

Despite the improvement in the economy, about 355,000 consumers had a bankruptcy notation added to their credit reports, roughly the same number as the year before.  Here is a graph showing the number of consumers with new foreclosures (in blue) and new bankruptcies (in red):

I find it interesting that the number of new bankruptcies has not dropped significantly since the middle of 2011 and that it is still quite elevated compared to levels seen from early 2006 to mid-2007.

The Federal Reserve has been using its "printing presses" to get the economy running on all cylinders.  Consumer spending is key to economic growth in America.  As shown on this graph from FRED, personal consumption expenditures make up nearly 69 percent of GDP, a multi-decade high:

With interest rates sitting at all-time lows and household deleveraging well underway, consumers are now showing signs that they are willing to take on increasing levels of debt to increase their expenditures which have risen from a low of just over $9.8 trillion in late 2008 to their current level of $10.52 trillion as shown on this graph:

What I find interesting is that, as shown on this graph, personal consumption expenditures are outgrowing inflation by over 2 percentage points:

What concerns me is the still elevated level of household debt delinquencies.  With household debt levels now on the rise and the threat of interest rate increases looming, only time will tell whether tapering will put upward pressure on already high delinquency rates, forcing consumers to reduce their debt levels.  With nearly 70 percent of GDP stemming from consumer expenditures, any reduction in consumer spending for any reason will put further downward pressure on what is already anemic economic growth.

Quantitative Easing Part 3 - The Losers

In Part 1 of this series on the impact of central bank actions on the economy, I looked at the total size of the interference in the free market by the world's four major central banks; the Federal Reserve, the ECB, the Bank of England and the Bank of Japan.  In Part 2, I looked at the three sectors of the economy that had a net positive benefit with the current ultra-low interest rate environment; central governments, non-financial corporations and banks.  In part three of this series I will be looking at two sectors of the economy that experienced a net negative impact from the current no-interest environment:

1.) Insurance and Pensions

2.) Households

As a reminder, here is a graphic from the McKinsey report on redistribution that shows the winners and losers in our new interest rate reality:

Let's now take a more detailed look at the net QE losers thanks, in no small part, to Mr. Bernanke.

1.) Insurance and Pensions:

Let's start by looking at the impact of QE on the insurance sector.  Life insurance companies around the world offer two types of savings products; variable-rate and guaranteed-rate policies.  In much of Europe, guaranteed-rate policies are used by households as a savings vehicle for both general purposes and retirement with more than 80 percent of European life insurance premiums being written for plans of this type compared to only 45 percent in the United States.  In the case of variable-rate policies, when interest rates drop, households bear to brunt of the drop in income since the amount of income received is linked directly to the change in the value of the investments chosen.  The authors of the study included the risk of lower interest rates on variable-rate policies in their analysis of households.  In the case of guaranteed-rate or fixed-rate policies, the insurance company offers a policyholder a fixed or minimum rate of return on the money that they have invested.  In this case, the risk of lower interest rates is borne by the insurance company.  As interest rates dropped, the income that insurance companies are receiving from their portfolios dropped in tandem, a situation that has become worse as the current low interest rate environment has lengthened.  As insurance companies have seen their portfolios mature over the past five years, their old inventory of high-yielding bonds has been replaced with an inventory of low-yielding bonds.  This means that there is great risk that the minimum return guaranteed to policyholders may, in fact, be higher than the rate of return on the insurance company's assets.  In fact, the current German 10 year bund which is yielding 1.54 percent is higher than the 1.75 percent minimum rate of return being guaranteed to policyholders.  Looking at Japan's experience with a prolonged period of ultra-low interest rates as shown here:

...we can see that the longer that interest rates remain low, the greater the chance that insurance companies could be forced to drastically change their product offerings or be forced out of business.  In the case of Japan, insurance company pre-tax profits have dropped by 70 percent over the past decade and a half due to low interest rates.

Now let's take a brief look at the impact of QE on pension plans, particularly defined-benefit plans.  These pension plans tend to invest in long-term assets to cover their future liabilities (the payments to pension plan members).  As interest rates have dropped, there has been a decrease in the discount rate used by pension plans to measure the present value of future plan liabilities.  The present value of liabilities has risen by 43 percent between 2007 and 2012 with low interest rates/low discount rate being responsible for 83 percent of that increase or a total funding gap of $817 billion.  United States public sector plans have seen their funding gap increase by $450 billion over the same time period.  Part of the shortfall in the funding of U.S. public sector pension plans can also be attributed to low interest rates; because these plans hold much of their assets in government bonds, low interest rates have seen their interest income drop by $19 billion between 2007 and 2012.  Europe has also seen an increase in defined-benefit pension plan liabilities, rising by 31 percent between 2007 and 2012 with a majority of this due to a decrease in the discount rate related to low interest rates.  Unlike the U.S., total European pension plan assets have grown, however, the 23 percent growth rate is still insufficient to prevent the funding gap from widening.

2.) Households:

Households across the United States and Europe tend to be net savers with assets outweighing liabilities.  Assets include all forms of savings including bank accounts and CDs/GICs, mutual funds, life insurance policies, annuities and retirement plans.  Liabilities include both consumer and mortgage debt.  The current ultra-low interest rate environment has reduced household income from assets by a greater amount than they have reduced debt service payments.  Here is a chart showing the reduction in net interest income for households in the United States, the United Kingdom and Europe:

Here is a graphic showing the changes in annual household interest expenses and income in the United States for the period from 2007 to 2012:

On the chart, you will notice that the net losses in the United States are far higher than in either the United Kingdom or Europe.  This can largely be attributed to the mortgage side of the equation; since interest payments on variable rate mortgage debt have declined with the drop in interest rates, mortgagees in Europe, where 70 percent of mortgages are variable, have resulted a smaller drop in net household interest income compared to the United States where only 20 percent of mortgages are variable.

Looking at the last number in the chart above gives us a sense of how households feel that they are faring in the current interest rate environment.  Interest income losses attributable to both insurance and pension plans is largely invisible to households compared to losses attributable to lower returns on savings.  When this aspect is considered, American households still have lost a great deal more in net interest income than their counterparts in both the U.K. and Europe.

One interesting note is that the loss of interest income has impacted various age groups far differently.  Looking at the United States, we find that younger households, where the head of household is under the age of 45, tend to be net debtors and, as a result, benefit positively from low interest rates.  Older households are generally net holders of interest earning assets and have lost interest income as shown on this graphic:

The oldest Americans, aged 75 and older, have seen their total income contract by $2700 or 6 percent due to lower interest rates compared to the youngest Americans, aged 35 and under, who have seen their total income increase by $1500 or 2.8 percent due to lower interest rates.

When all factors are considered, it is interesting to see that governments have, by a wide margin, been the biggest beneficiaries of our current ultra-low interest rate environment.  Central bank policies have allowed governments to continue to ramp up debt levels as though there were no tomorrow.  The biggest losers have been households, particularly older households where interest income used to provide a steady source of income.  Such is no longer the case.  On the upside, however, the experimental policies of Mr. Bernanke et al have allowed some households in some nations (i.e. Canada) to go on accumulating consumer debt at a record pace as shown here:

From this research, we can clearly seen that both governments, non-financial corporations, the banking sector and some households in some nations are setting themselves up for a major problem with even a small increase in interest rates.  On the upside, at least pension plan managers and life insurers will find solace in a more normal interest rate environment, something that will benefit those of us who live on Main Street.

Quantitative Easing Part 2 - The Winners

In Part 1 of this series on the impact of central bank actions on the economy, I looked at the total size of the interference in the free market by the world's four major central banks; the Federal Reserve, the ECB, the Bank of England and the Bank of Japan.  As a reminder, here is a graph that shows what happened to the balance sheets of these four banks as their desperation to keep the world's economy from crashing continues:

Now, in Parts 2 and 3 of this series, we will look at how this prolonged experiment with near-zero interest rates (ZIRP) has had on these sectors of the economy:

1.) Central governments

2.) Non-financial corporations

3.) Banks

4.) Insurance and pensions

5.) Households

Obviously, the impact of low interest rates has positively benefitted some sectors of the economy where debt levels are high and growing and has had a strong negative impact on some sectors of the economy that rely on higher interest rates for income.  Here's a quote from the McKinsey report:

"The ultra-low interest rate policies of major central banks have had distributional effects through the impact on interest income and expenses of different sectors of the economy. These distribution effects are most likely unintended consequences of central bank policies."  (my bold)

Here is a graphic that shows which sectors have been winners and which have been losers under the new central bank reality:

Let's look at the three sectors that have been unintentional winners of the QE experiment.

1.) Governments

Obviously, today's highly indebted governments have been big winners as interest rates have dropped.  While the implosion of the world's economy resulted in massive government intervention in the form of stimulus which pushed up debt and deficit levels and an accompanying drop in tax revenue, overall, governments have benefitted positively on a net basis because they have been able to finance their massive debts and deficits at far lower interest rates than would normally have been the case as shown on this chart:

Note that the interest saved is on the amount of debt in 2007.  In the case of the United States alone, the amount of debt has risen from $8.68 trillion on January 1, 2007 to $17.2 trillion today, an increase of $8.52 trillion.  On that extra $8.52 trillion in debt, the interest savings alone is $204.5 billion annually using the drop in interest rates noted in the chart above.

On top of the interest savings, governments have also benefitted from the bloated balance sheets of their central banks.  As I noted in Part 1, the four key central banks have seen their balance sheets expand by $4.7 trillion since 2007.  Any profit generated by these additional assets is remitted to their respective federal governments.  For the Federal Reserve alone, the authors estimate that around $145 billion of the $291 billion remitted to the U.S. Treasury between 2009 and 2012 came from the expansion of the Fed's balance sheets related to QE.

Taking lower debt service payments and increased interest earned on the bloated central bank balance sheets, the benefits to central governments since 2007 can be summarized as follows:

United States - $1.045 trillion or 7.8 percent of government debt

United Kingdom - $170 billion or 7.3 percent of government debt

Eurozone - $365 billion or 4.1 percent of government debt

This works out to 3.8 percent of GDP for the Eurozone, 6.7 percent of GDP for the United States and 7.0 percent of GDP for the United Kingdom.

2.) Non-financial corporations

Corporations have balance sheets that are heavily weighted toward debt rather than interest-earning assets.  For example, in the United States, non-financial corporations have $15 trillion in debt liabilities compared to only $6 trillion in assets that could earn interest.  This means that non-financial corporations experience a net positive benefit from ultra-low interest rates.  It is important to note, however, that all corporations have not benefitted from lower interest rates; since larger corporations tend to issue more debt in the world's capital markets and since they have greater access to commercial bank loans, they tend to benefit more from QE than smaller companies.

Here are the net positive interest benefits in 2012, for the years between 2007 and 2012 and how much the interest savings have added to net income for 2012 for the United States, the United Kingdom and the Eurozone:

It is quite interesting to see that the non-financial corporations have seen quite a substantial benefit from lower interest rates and that these savings have added between 3 and 5 percent to the bottom line in 2012 alone.

3.) Banks

The current environment of low interest rates has impacted the effective net interest margins (the difference between interest paid on deposits and debt and the interest received on loans and other assets) for banks, particularly in the United States.

United States banks have seen their effective net interest margin increase by 63 basis points between 2007 and 2012, from 2.5 percent to 3.13 percent (after peaking at nearly 3.5 percent in late 2009).  This reflects a very steep drop in the interest rates paid to savers as shown here:

The current rate on a one-month Certificate of Deposit is 0.16 percent; this is down from a high of 5.5 percent in August 2007.  In fact, despite the fact that depositors were getting nothing in return for their bank savings, the fear rippling through the economy between 2007 and the present caused bank deposits to do this:

That's deposit growth of 57 percent or $3.5 trillion as nervous Americans sought the appearance of "safety" for their meagre savings.

By way of comparison to the very steep drop of around 5 percentage points paid on deposits, the drop in the effective interest rate received on loans was only 1.8 percent.  These two factors in combination are what has improved the effective net interest margin for U.S. banks.

Here is a chart showing the overall impact of the current near-zero interest rate policy on the banking sectors in the United States, the United Kingdom and the Eurozone:

Obviously, the banks in the Eurozone and the United Kingdom saw much less benefit to the current low interest rate environment compared to those in the United States.  In the case of the Eurozone, the interest rate paid on deposits only dropped from 2.9 percent in 2007 to 2.0 percent in 2012.  On top of that, large European corporate borrowers put pressure on the banks to pass along the decline in interest rates.

Let's summarize.  Three key sectors of the economy have benefitted handsomely from lower interest rates, none more so than our overly indebted federal governments that go on accumulating debt like there will never be a day of reckoning.  What I find most concerning about this research by McKinsey is the fact that two key sectors of the economy, the government and business, have relied on the current historically unprecedented period of near-zero interest rates to keep debt growth in check.  Thanks to the world's major central banks, the economy is being painted into a corner from which there is no escape.  It makes one shudder to think of what will happen to the economy when interest rates return to normal levels as they surely will.