Tuesday, February 17, 2015

Household Debt - Walking the Knife Edge

Unsustainable household debt was one of the core issues (other than Wall Street and its imaginative use of supposedly AAA-rated securities that were derived from household debt) that touched off the 2008 financial crisis.  While the United States saw its household debt-to-disposable income ratio rise by 35 percentage points to 125 percent between 2007, the United Kingdom also saw an even worse household debt problem with the aforementioned ratio rising by 51 percentage points to 150 percent of income over the same timeframe.  While we might like to think that households learned their lessons the very hard way, a recent analysis by McKinsey Global Institute shows that household deleveraging has been quite limited since the end of the Great Recession.

Prior to 2008, household debt rose at an accelerated rate in almost all advanced economies as borrowers, the single factor that drove the economies to grow in most advanced nations.  Since the crisis began, household deleveraging has been fairly substantial in some nations, declining by 26 percentage points in the United States, 33 percentage points in Ireland (which also suffered from a massive housing bubble), 17 percentage points in the United Kingdom and 13 percentage points in Spain (another nation that suffered from the collapsing housing bubble) and 5 percentage points in Norway as shown on this graph:

You will note that both Germany and Japan do not appear on the graph.  In Germany, the amount of household debt has remained roughly stable while household debt has grown slightly, largely because there is a relatively low rate of home ownership (53 percent).  In Japan, the levels of both household debt and disposable income have declined since 2000 as a result of the slow-growth/no-growth economy, an aging population and dropping property values.

In many other nations, households continued to lever up as though the Great Recession never happened as shown on this graph:

Despite the crisis in its economy, Greece has seen its household debt-to-disposable income ratio rise by 30 percentage points and Canada has seen its ratio rise by 22 percentage points.  Denmark has the highest household debt-to-income ratio at a stunning 269 percent, however, Denmark has strict lending standards that limits borrowers to mortgages that are worth a maximum of 80 percent of the value of the property, contrasting sharply with mortgage lending practices in the United States during the housing bubble years.  

Household debt accrual in the developed economies of the world isn't the only problem. In developing economies, average debt-to-household income ratios have risen by an average of 13 percentage points since 2007 as shown on this bar graph:

The current household debt ratios for both Malaysia and Thailand are now similar to those in the United States and the United Kingdom.  China's household debt has quadrupled since 2007, rising by $2.8 trillion, however, this is still only 58 percent of disposable income or half of the current U.S. ratio.

What factor has caused such a substantial increase in household debt?  Rising mortgage debt is the main cause and, over time, rising real estate and land prices are the two factors that drive up household debt levels.  Mortgages account for 74 percent of household debt in advanced economies and 43 percent of household debt in developing nations.  Here is a graphic showing how the growth in mortgage debt has pushed the household debt-to-income ratio higher in the United States since 1945:

The steady increase in housing prices and accompanying debt can be attributed to:

1.) Rising home ownership rates: this is a relatively small contributor since home ownership rates change very slowly.

2.) Rising house prices: this is a significant contributor since rising house prices require larger mortgages.  When house values rise, banks are willing to lend more against collateral that appears to be gaining in value which cycles through to create even more housing demand which drives prices even higher.  Between 2000 and 2007, housing prices rose by 55 percent in the United States, 78 percent in Denmark, 98 percent in the United Kingdom, 108 percent in Ireland and 138 percent in Spain.  Here is a graphic that shows the correlation between changes in housing prices and changes in household debt-to-income ratios:

Let's now look at which nations have household debt levels that make them vulnerable.  Among the nations sampled, households in the Netherlands, Canada, South Korea, Sweden, Australia, Malaysia and Thailand appear to be the most at risk not only because their household debt-to-income ratios are high but because their debt ratios have continued to grow significantly since 2007.  Here is a comparison of household debt levels across the nations in the study, highlighting the danger zones in red:

While the United States gets a pass because of its deleveraging (sometimes involuntary) during and after the Great Recession, recent data from the Federal Reserve shows that total consumer revolving and non-revolving credit has risen to a record high of $3.312 trillion, up 5.4 percent on a year-over-year basis as shown here:

Even though total mortgage debt in the United States has not yet reached its pre-Great Recession levels, the never-ending borrowing by American consumers could prove to be problematic.

The root cause of increased household leveraging is the protracted period of near-zero interest rates which have lulled households around the world into mortgages and consumer debt that they will likely not be able to afford as interest rates rise or the economy slows and job losses occur.  Households, particularly in some nations, are walking a debt knife edge, one wrong move and the end result could be extremely painful.

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