For those who aren’t familiar with the narrative on deleveraging – the process of households paying down debts – as being crucial to our weak economy and high unemployment, they should check out Paul Krugman’s column today. He points out:
What we’ve been dealing with ever since is a painful process of “deleveraging”: highly indebted Americans not only can’t spend the way they used to, they’re having to pay down the debts they ran up in the bubble years. This would be fine if someone else were taking up the slack. But what’s actually happening is that some people are spending much less while nobody is spending more — and this translates into a depressed economy and high unemployment.
What the government should be doing in this situation is spending more while the private sector is spending less, supporting employment while those debts are paid down…It’s true that we’re making progress on deleveraging. Household debt is down to 118 percent of income, and a strong recovery would bring that number down further. But we’re still at least several years from the point at which households will be in good enough shape that the economy no longer needs government support.
The Federal Reserve just released the latest quarterly Fed Flow of Funds last week, and consumers continue to delever:
Back when this crisis first started, people understood that this was going to be an ugly, ugly process. There were two ways of helping this process along. The first was modifying defects in the bankruptcy code to help with writing down mortgage debt, often referred to as lien-stripping or the cramdown bill. The second was a period of short sustained inflation, which was being recommended from all kinds of ideological places including Greg Mankiw and Kenneth Rogoff (Rogoff: “I’m advocating 6 percent inflation for at least a couple of years”).
That our current situation is the exact opposite of this happening would be an understatement. The cramdown bill failed and we’ve got a period of moral panic and hysteria around strategic defaulters, those evil-doers that nobody can actually quantify as actually existing. We also have Sarah Palin and the conservative base teaming up with the Hard Money Right to scream “Fire! Fire!” on Noah’s ark. They are going to try and make 2011 a year of seige against the Federal Reserve, stoking fears that we’ll have an inflation crisis any day now when we are actually disinflating.
The result is exactly what you’d expect: our consumer de-leveraging is mostly taking place through defaults on loans, the most painful, externality-prone, and drawn-out mechanism we have for resolving bad debts. That savings rate reflects less our ability to pay off our debts and more our inability with an unemployment crisis and the collectors kicking in the door.
Evidence
I need to compile my own evidence of this for future work, so I will summarize other’s work while I learn the data. To start:
1) Mark Whitehouse, Wall Street Journal, September 18th, 2010, Defaults Account for Most of Pared Down Debt:
The sharp decline in U.S. household debt over the past couple years has conjured up images of people across the country tightening their belts in order to pay down their mortgages and credit-card balances. A closer look, though, suggests a different picture: Some are defaulting, while the rest aren’t making much of a dent in their debts at all.
There are two ways, though, that the debts can decline: Pay them or default. The total value of home-mortgage debt and consumer credit outstanding has fallen by about $610 billion, to $12.6 trillion, according to the Federal Reserve. Of that $610 billion, “banks and other lenders charged off a total of about $588 billion in mortgage and consumer loans.
2) CoreLogic (h/t Alphaville’s Cardiff Garcia):
CoreLogic reports that 10.8 million, or 22.5 percent, of all residential properties with mortgages were in negative equity at the end of the third quarter of 2010, down from 11.0 million and 23 percent in the second quarter. This is due primarily to foreclosures of severely negative equity properties rather than an increase in home values.
3) Karen Dynan, Brookings Institute, Household Deleveraging and the Economic Recovery:
But, a considerable share of the deleveraging can be accounted for by high rates of defaults on consumer loans and mortgages. While defaulting typically has other consequences that are undesirable, it is a way in which some of the most distressed households have been able to shed their debt.
Although credit supply conditions have been thawing, it seems very likely that we will see significant further deleveraging, particularly in the form of additional defaults on mortgage debt.
What to make of this? First off, I’m terrified at the idea that national wealth is roughly at the level to pay for the servicing of debt but not necessarily pay off any actual debt. Our household sector is at the point where we can make the minimum payment on our metaphoric credit card without paying any of it down, and the only other choice is to not pay it at all.
Second, remember that your first mortgage payment is almost all interest, and your last mortgage payment is almost all principal. With that in mind, in a disinflation environment you could see eight years and above to pay to get a mortgage from an LTV of 130 to one at 100. Refinancing resets this problem. The mortgage structure isn’t set up to pay off principal quickly.
Third, foreclosures are mini-neutron bombs on property values and neighborhoods. The cynical implication that we are going to get out of this balance-sheet recession by destroying neighborhood after neighborhood in abandoned housing and wrecked communities when there are sensible alternatives in our bankruptcy code and monetary policy is immoral.
This will continue; foreclosures are expected to be at record highs for at least the next two years, and consumers have a lot of debt left to work off. What else am I missing? What are some other negative (or positive!) aspects of a default-driven de-leveraging process?
Rortybomb 
Hi Mike,
Deleveraging by default forces properties on to an already soft market, keeping prices low. Who has cash right now? Who has everything right now? The superwealthy are the only ones in the position to buy land. Corps are sitting on tons of cash. Govt is not, and may offer sweetheart deals to take over land. Upshot: several roads lead from this point to the rich getting even richer at the expense of the rest of us.
Also, when you consider the mortgage structure, don’t forget that a high percentage of mortgages were financed or refinanced in the last decade. Thus, the mortgage industry is no longer laddered as it used to be.
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Don’t all of these roads converge to the painfully obvious, paying down unsecured debt at LOW INTEREST RATES will bring an almost instant relief to consumers who can both pay down debt while still having some money left over for local purchases.
Credit card debt paydown incentive programs would help everybody, even the banks, by stabilizing their customer base which translates into a more steady cash flow on existing debt.
What Krugman is trying to do is feed Barack Obama’s Munchausen’s disease complex by saying the government, through taxation, must save the day.
I think as time goes on, the four point economic plan (link below) is the answer that everybody is afraid to validate because the billionaires rule, and it MODESTLY affects their bottom line, but not through taxation, but through residual income created by interest rate dividends.
Our billionaires need to get off the residual income/ interest rate dividend dole if the economy is to be fixed.
http://wallstreetchange.blogspot.com/2010/11/2010-after-election-4-point-economic.html
For those who say the billionaires don’t rely on interest rate dividends from the bank, I say PROVE IT. I think billionaires are addicted to that residual income stream and that is why banks have become too big to fail.
Small time investors are protected up to 250,000 dollars, but billionaires? They aren’t protected, so they are the people being protected in the too big to fail scheme, and in return, they should accept a LOW LOW interest rate in exchange for having their huge savings protected.
It appears that everybody has a favorite billionaire up their sleeve that they don’t want to piss off.
This is a great post.
I think the question of how bad is deleveraging-by-default can only be answered, Compared to what?
You are certainly right that compared with the alternatives of some years of 5-10% inflation, or a legal process to systematically renegotiate (or even just refinance) household debt, it’s bad. But compared to households continuing to make payments in full, it may be less bad. This is especially true of consumer debt, since defaults there don’t entail the disruptions of foreclosures. It seems to me that if you say the alternatives are a strong norm of repayment that leads households to further curtail consumption to continue making payments, vs. a weaker norm of repayment that leads to more defaults and a more rapid recovery of household consumption, it’s hard to prefer the former on either economic or moral/political grounds.
Especially since it’s pretty clear that a lack of liquidity is not the main constraint on most categories of real activity today, at least in part because of the level of public support for the financial system. So the debt-deflation dynamic that you saw in the 1930s wouldn’t apply today.
And at the end of the day, you’ve got to feel that more people saying, “Fuck it, I’m not paying” has to be a good thing, no?
Be careful with the data. A very common mistake is to apply the Fed’s charge-off rates, which are just for commercial banks, or FDIC charge-off rates, which apply only to insured institutions, to Flow of Funds loan amounts, which cover all lenders. But securitized trusts and finance companies might very well have quite different charge-off rates from banks.
The WSJ article you cite does not explain its calculations, but they do say that they combine FDIC and Fed data — a danger sign. An earlier WSJ article did give the calculation, and it was completely wrong, not only using an inappropriate charge-off rate but mixing seasonally adjusted and unadjusted data.
In my opinion, no one really knows whether pay-downs or defaults predominate. I’d love to hear if you think you discover some solid, quantitative evidence to the contrary.
http://www.clearonmoney.com/dw/doku.php?id=investment:commentary:2010:07:11-persistent_errors_in_reporting_on_consumer_credit
Thank you for this and the link. (I think it was your post I spent part of the afternoon trying to find to remember the weakness from the WSJ article.) I’m assuming that the FDIC charge off % was extrapolated, incorrectly, to the entire mortgage market. On the first approximation I would think that losses outside the regular banking system are better than in the securitization market, but I need to quantify that. What’s your take on the Brookings numbers? Usually Brookings is very good, hence me running with this. I’ll send an update when I know more.
That said, we are running 2 million foreclosures a year. That has to add up to something. Maybe there’s a way to approach it that way.
Dynan doesn’t explain “author’s calculations”, so I don’t know about the particular results in the graph above.
Dynan does mention FRBNY’s Consumer Credit Panel, which may provide the data you are looking for. In Nov FRBNY came out with a report, “Have Consumers Become More Frugal?”, which purported to show that in fact consumers were starting to really pay down debt, i.e. it wasn’t just charge-offs. They gave almost no details on their methodology or data, and when I wrote and asked for more, at that time, they said they weren’t ready to release any details.
But, sparked by your post, I just checked again, and now they do have a background paper out on their data. The basic idea is that they have a random sample of credit reports on about 5% of the population, and hence information on loan balances and defaults. Of course credit reports contain errors, and there are sometimes significant delays in reporting. They do not go into a very serious analysis of such errors, but, to the extent that credit reports are accurate, this may be a way to finally get at the question of defaults vs pay-downs.
The frugality report:
http://www.ny.frb.org/newsevents/news/regional_outreach/2010/an101108.html
And the background paper on the data:
http://www.ny.frb.org/research/staff_reports/sr479.html
Our household sector is at the point where we can make the minimum payment on our metaphoric credit card without paying any of it down, and the only other choice is to not pay it at all.
I’m just not sure that’s the case. I’m sure it is the case for a large number of households. But I have a suspicion that a lot of people who are otherwise fine are trying to rebuild their retirement accounts after the big meltdown. The interesting thing to do, I think, would be to compare debts owed versus income for the various quintiles.
The cynical implication that we are going to get out of this balance-sheet recession by destroying neighborhood after neighborhood in abandoned housing and wrecked communities when there are sensible alternatives in our bankruptcy code and monetary policy is immoral.
It is, but that seems to be the way we intend to do it. The upside is that a lot of people are going to be freed from owing very large debts that they’ll never pay off anyways. (And that’s why the banks are still on life support.)
What else am I missing? What are some other negative (or positive!) aspects of a default-driven de-leveraging process?
Well, the one negative that I can think of that you didn’t mention was the defaults costing banks. Also, I expect, there’s the continued fall in housing prices, which will intensify the default situation.
I don’t think there’s really anything positive about it. We’re going to do this the really really hard way. But that was apparent back in early 2009, at least to me.
max
[‘I’m gonna think about this some more.’]
Max, this is a tricky area. Is it wise to “build up” retirement income that is either non guaranteed, or may only net 2% a year guaranteed, while continuing to pay credit card interest rate debt at 10, 15, 20% or higher?
I agree that it is better to have liquidity for the present even if it means only paying the minimum on high interest rate credit cards, but to extrapolate that into the retirement years could end up being quite a waste of money if one is simply treading water paying the credit card minimum each month, unless the plan is to never actually pay off the credit card debt.
Which then contributes to the vicious economic cycle that this article is about.
Credit card debt is at least dischargeable. What are the demographics of cosigned non-dischargeable student loan debt? How many households are paying student loans because the former student cannot pay? This is another black hole with money going neither to the basket we’ll call credit card debt, to rebuilding 401ks, or to mortgages. Since total student loan debt is (I think I have seen) greater than credit card debt, this would seem to merit investigation. (And like mortgage debt, little principal is paid in the early years)
Sue, that is the catch-22. Credit card debt may be dischargeable, but somebody eventually feels the affect of someone else not paying down their debt. The key is to not suffocate the consumer with high interest rates.
I think I have a simple question. Does a bank see a difference between writing off one mortgage or renegotiating ten to have a 10% lower principal? For example, say I have 100 mortgages of $500,000, is it in my interest to just give up on 2 of them, writing off $1,000,000 of assets, or would I prefer to reduce the principal on 20 of them by 10%, also writing off $1,000,000? Ignoring second-order effects and negative externalities, does a bank see a difference?
My guess is that transaction costs drive the bank to prefer screwing over the two customers instead of helping 20. This is a pretty simple analysis, but I assume this is how banks see the problem on a loan-by-loan basis. If that’s the case, then we have another example of micro-rationality leading to macro-crap.
Interesting example, Zachary. My guess is the banks do not want to hire people to just monitor accounts and occasionally check in and say hi.
The irony is, that is a way to create jobs. Instead, the banks are still in a put up or shut up frame of mind, which allows them to hire the minimal amount of people who simply follow numbers and make decisions.
It presumably takes less people power to write two loans off than modify 20 loans, even though it is pretty obvious that helping 20 mortgages makes a ton more sense and actually helps the economies bottom line and keeps more customers solvent.
However, more customer service probably means less overall bonus money and I think it has become pretty obvious its all about the bonuses.
I have a few points:
1) The Fed is aware of this, especially as to mortgage write-offs. In a significant sense, the bailout of the banks has been a backdoor bailout of this charge-off process. Of if that offends your populist sensibilities, it has at least been designed to offset is.
2) You MUST look at the charts Barry Ritholtz published on the big picture a few days ago about the ratio of debt issued by the federal government versus all others, and how it flipped in 2008. The credit markets had a heart attack, and I totally agree there is not the slightest risk of inflation right now, nor has their been since 2008. M2 and monetary velocity are too low. Now, wait and see what happens when all of these corporations start spending their corporate cash piles in a year or two, and if banks start lending again, look for significant inflation in, I would say, late 2012 or early 2013. My guess is the Fed will not raise the discount rate much before then, unless it raises it in early 2012, well before the general election.
3) It is actually not true that the bankruptcy process cannot be used to reduce loan debt. In fact, SECOND mortgage, typically home equity loans, can often be stripped if in fact the property is underwater, to the full extent that the property is underwater. So if a $400K first and $100K second are on a property now worth $300, I’m pretty sure the $100K second can be stripped right off. But you’d want to talk to a bankruptcy person.
4) I’m not sure there is a better way. Really what we are seeing are just a ton of contract breaches. What would be better is if banks and borrowers cooperated to keep people renting in the homes they formerly “owned” — though that ownership word has little meaning when they never had much equity in the first place. If borrowers were given a low rental rate for two years or so, that would protect communities, banks would get a return, even if it were less than the old mortgage payment, and banks would have the opportunity to sell the property later on, when the market in particularly distressed areas might be improved. Unfortunately we have not seen this, for too many reasons to name.
Cheers.
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When it comes to repayment of debt, americans can: tighten the belt and pay it down, tread water with the miinimum payments or throw in the towel and default.
Place your bets
I got all my money on default. Bankruptcies are at elevated elevels and will continue to be so for years.
jumpin jalopies, or, the fourth option, tighten the belt and pay down credit card debt that actually has the interest rate reduced.
The difference between a 24% interest rate and a 2.9 percent interest rate is profound on just a month to month basis.
Thanks for the article, it’s something I’ve wondered about and never quantified. Like much of Europe, the US is kicking the can down the road instead of fixing it’s problems. You can’t get wealthy by spending via debt (but you sure feel wealthy for a while).
China is spending it’s cash surplus (by increasing debt) to help stimulate their economy to 10% GDP growth. They are continuing the cycle.
Steve, it appears its the banksters, who control the government, who are intent on having debt kicked down the road.
As long as the banksters keep getting their huge bonuses every year, why would they want anything to change? Ironically, the worse the economy gets, the better they do when one compares their bonuses to everyone else.
The problem is that this is liquidation. In a liquidation, prices adjust too quickly, putting more and more debtors underwater with an alligator on their back, creating a snowball effect. Defaults beget more and more defaults. When the smoke clears, the economy is a smoking ruin.
This is the nightmare scenario, and it is developing apace in the US, UK, and EZ. Don’t take my word for it. Read the smart people blogging about banking, credit and the housing bubble.
Rising defaults could result in an unprecedented global depression if things gets out of hand. Some Minskians like Steve Keen and Michael Hudson are putting the likelihood of this pretty high, and worse, increasing.
All it will take is some shock to push things over the edge from disinflation into deflation. Once deflation takes hold, it has a tendency to spiral as people hoard money and anticipate lower prices in the future. Debtors holding too much debt and creditors that have extended credit imprudently get whacked, and the whole economy suffers from declining demand and increasing glut. Not a pretty prospect, and a whole lot of people don’t get this yet.
I want to underscore Inkerton’s #4. The idea that letting people stay in the properties and pay rent would be a decent solution. Foreclosure, in which property is involuntarily transferred from debtor to creditor in satisfaction of a debt, does not necessarily require eviction of the debtor. In the early days, when property values started to implode and unemployment explode, I thought that a government supported program of residential sale/leasebacks could avert the collateral damage to neighborhoods and lives and to the moral compact that links debtor and creditor.
People might have had a shot at managing down the card balances had they not been overwhelmed by the mortgage payment.
It is so obvious that a foreclosure is a losing proposition: the foreclosing lender never ends up with the property if there is any value left in it, else the owner would find a way to save the residual “net equity.”
The moment has probably passed when it might have been possible to securitize pools of residential sale leasebacks to investors willing to bet on a housing recovery 10-15 years out. Not because the investment thesis is a bad one, particularly with the sweetener of some government subsidy or other, but because there has been too much water over the dam and under the bridge–too much unfairness and injustice–selective mods, bait and switch, defective loan docs, robot signers and that kind of thing.
The fact that readily available statistics do not distinguish voluntary from involuntary deleveraging is in itself telling.
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