Many times over the last six years, I made the argument that lower debt service burdens are the key to a sustained economic recovery. Bankers and the federal reserve want to see an expansion of credit for completely self-serving reasons. They point to times in the past when an expansion of credit fueled economic growth as evidence of its necessity for a vibrant economy. Perhaps it’s partially true. An expansion of asset-backed debt is good for the economy, but most credit expansions involve the populace taking on huge amounts of signatory debt, and expansions of signatory debt invariably lead to personal Ponzi schemes, HELOC abuse, and a contraction of credit when debtors have to pay the bills.
A sustained economic recovery requires disposable income. An expansion of signatory debt creates an artificial and short-lived economic stimulus as people and borrow and spend. This leads to less disposable income and an inevitable reduction in economic activity when the bills come due — which is what we have been experiencing over the last five years. Eventually, people either pay down these debts, refinance at lower interest rates (if rates keep falling), or discharge these debts through foreclosure or bankruptcy. One of the signs I have been waiting for to signal the end of our economic malaise is an overall reduction of consumer’s debt burdens. Apparently, we have reached the point where American’s have enough disposable income to fuel a sustained economic recovery. 2013 may be a good year.
Thu Dec 27, 2012 3:57pm EST — By Lucia Mutikani
Dec 27 (Reuters) – A measure of the burden of U.S. household debt tumbled in the third quarter to its lowest level in 29 years, which should help free up money for consumer spending and support the economy.
The household debt service ratio — an estimate of the share of debt payments to disposable personal income — fell to 10.61 percent from 10.72 percent in the second quarter, the Federal Reserve said on Thursday.
It was the lowest level since the fourth quarter of 1983.
The period from 1983 to 1999 was a great period of sustained economic growth. It was prefaced by a reduction in debt burdens triggered by declining interest rates very similar to the conditions we have today. Of course, that was sustained by a 30 year period of falling interest rates — something we probably don’t have to look forward to.
“Consumers have more money in their pockets to spend, which should be positive for the economic recovery going forward,” said Gennadiy Goldberg, an economist at TD Securities in New York.
U.S. households built up a massive debt load as the housing bubble expanded and efforts to pay down those debts have been a restraint on spending and the economy’s recovery.
Hyman Minsky predicted this 50 years ago. His writings on the economic and credit cycles were prescient:
“Minsky claimed that in prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As a result of such speculative borrowing bubbles, banks and lenders tighten credit availability, even to companies that can afford loans, and the economy subsequently contracts.
This slow movement of the financial system from stability to fragility, followed by crisis, is something for which Minsky is best known, and the phrase “Minsky moment” refers to this aspect of Minsky’s academic work.”
The debt service ratio, which takes into account outstanding mortgage and consumer debt, peaked in the third quarter of 2007, shortly before the economy tipped into recession.
The Fed has sought to help consumers dig out by keeping interest rates near record lows. It has held overnight rates near zero since December 2008 and has bought around $2.4 trillion in bonds to further lower borrowing costs.
Lowering interest rates can only do so much. Now that we are at the bottom of the interest rate cycle, the only tool available to the federal reserve is inflation. For the next 30 years, the federal reserve will deal with the dilemma of inflation. If they raise rates, economic activity will decline, and the economy will tip into recession. If they don’t raise rates, inflation will rise, and people will see a decline in their standard of living. The 60s and 70s saw this play out with numerous recessions and bouts of inflation capped off by a collapse in the value of the dollar, a severe double-dip recession, and the need to raise interest rates to near 20% to restore value to the currency and curb inflation.
Even though households are now in better shape, analysts caution that consumer spending could stall if Congress fails to prevent higher taxes from taking hold next year.
An even broader measure of financial obligations that includes automobile lease payments and the cost of renting a home also fell in the third quarter, dropping to 15.74 percent of disposable income — the lowest level since the first quarter of 1984.
That drop reflected an easier burden for homeowners as mortgage debt payments dropped to 8.90 percent of disposable income in the third quarter, the lowest in 11 years.
The reduction in the cost of ownership of residential real estate has been dramatic. A decline in prices couple with a decline in interest rates have reduced the cost of ownership to late 1980s levels.
Both the overall homeowners measure and separate mortgage gauge peaked in the third quarter of 2007.
“You have a lot of people refinancing their mortgages at lower rates,” Goldberg said.
In contrast, the relative cost of rent rose to its highest level since the first quarter of 2010.
The weak housing market has led Americans away from home ownership and toward renting, pushing up rents. At the same time, a modest economic recovery has encouraged some people who had moved in with family and friends to seek their own lodgings, further strengthening the rental market.
While a lightening of household debt burden puts the recovery on firmer ground, it also highlights a hesitance to take on new debt, which could be an obstacle to spending.
“We all (would) like to see better growth in credit, banks being more willing to make more loans to consumers, demand for loans rising,” said Omair Sharif, an economist at RBS in Stamford, Connecticut.
“That would push the ratio higher, but that’s not necessarily a such a bad thing, especially if rates are so low and you are able to service that debt.”
Those last statements reveal the bias of lenders and the disastrous mindset that leads to the creation of more Ponzi schemes. The economy would be much better off without an increase in debt. Further reductions in debt service would further boost the economy as workers would have even more disposable income to purchase goods and services.
Lenders want to create more debt because that’s how they make money, but that’s not the best thing for the economy. Frugality and prudence is.
Expanding debt didn’t help this borrower
As an example of how expanding debt creates a temporary economic boost, one need look no further than the personal finances of the bubble-era Ponzis. The former owner of today’s featured property borrowed and spent more than a million dollars between 2000 and 2005. He undoubtedly stimulated the economy during that time. However, once the Ponzi loans dried up, he no longer contributed to the economic health of the country and became a drain instead.
- This property was purchased on 3/3/2000 for $680,000. The former owner used a $544,000 first mortgage and a $136,000 down payment.
- On 5/16/2000 he obtained a stand-alone second for $68,000.
- On 11/4/2003 he refinanced with a $750,000 first mortgage.
- On 3/14/2004 he opened a $266,000 HELOC.
- On 12/2/2005 he refinanced with a $1,000,000 first mortgage.
- On 12/29/2005 he opened a $755,000 HELOC.
- Assuming he maxed out the HELOC, the total property debt was $1,755,000 and the total mortgage equity withdrawal was $1,211,000.
That was some serious economic stimulus!
He quit paying the mortgage in 2009 and was allowed to squat in luxury for two and a half years.
The wisdom of the ages
Matt138 recently posted a link in the comments to the writings of Frédéric Bastiat, a 19th century French economist. He has a great essay on Thrift and Luxury that speaks to today’s point on the economy.
Mondor and his brother Ariste, having divided their paternal inheritance, each have an income of fifty thousand francs a year. Mondor practices philanthropy in the fashionable way. He is a spendthrift. He replaces his furniture several times a year, changes his carriages every month; people talk about the ingenious devices to which he resorts to get rid of his money faster; in brief, he makes the high livers of Balzac and Alexander Dumas look pale by comparison.
What a chorus of praises always surround him! “Tell us about Mondor! Long live Mondor! He is the benefactor of the workingman. He is the good angel of the people! It is true that he wallows in luxury; he splashes pedestrians with mud; his own dignity and human dignity in general suffer somewhat from it. …. But what of it? If he does not make himself useful by his own labor, he does so by means of his wealth. He puts money into circulation. His courtyard is never empty of tradesmen who always leave satisfied. Don’t people say that coins are round so that they can roll?”
Ariste has adopted a quite different plan of life. If he is not an egoist, he is at least an individualist; for he is rational in his spending, seeks only moderate and reasonable enjoyments, thinks of the future of his children; in a word, he saves.
And now I want you to hear what the crowd says about him!
“What good is this mean rich man, this penny-pincher? Undoubtedly there is something impressive and touching in the simplicity of his life; furthermore, he is humane, benevolent, and generous. But he calculates. He does not run through his whole income. His house is not always shining with lights and swarming with people. What gratitude do the carpetmakers, the coachmakers, the horse dealers, and the confectioners owe to him?”
These judgments, disastrous to morality, are founded on the fact that there is one thing that strikes the eye: the spending of the prodigal brother; and another thing that escapes the eye: the equal or even greater spending of the economical brother. …
But how superior it appears, if our thinking, instead of confining itself to the passing hour, embraces a long period of time!
Ten years have gone by. What has become of Mondor and his fortune and his great popularity? It has all vanished. Mondor is ruined; far from pouring fifty thousands francs into the economy every year, he is probably a public charge. In any case he is no longer the joy of the shopkeepers; he is no longer considered a promoter of the arts and of industry; he is no longer any good to the workers, nor to his descendants, whom he leaves in distress.
At the end of the same ten years Ariste not only continues to put all of his income into circulation, but he contributes increasing income from year to year. He adds to the national capital, that is to say, the funds that provide wages; and since the demand for workers depends on the extent of these funds, he contributes to the progressive increase of remuneration of the working class. Should he die, he will leave children who will replace him in this work of progress and civilization.
Morally, the superiority of thrift over luxury is incontestable. It is consoling to think that, from the economic point of view, it has the same superiority for whoever, not stopping at the immediate effects of things, can push his investigations to their ultimate effects.
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Proprietary OC Housing News home purchase analysis
$949,900 …….. Asking Price
$680,000 ………. Purchase Price
3/3/2000 ………. Purchase Date
$269,900 ………. Gross Gain (Loss)
($75,992) ………… Commissions and Costs at 8%
$193,908 ………. Net Gain (Loss)
39.7% ………. Gross Percent Change
28.5% ………. Net Percent Change
2.6% ………… Annual Appreciation
Cost of Home Ownership
$949,900 …….. Asking Price
$189,980 ………… 20% Down Conventional
3.98% …………. Mortgage Interest Rate
30 ……………… Number of Years
$759,920 …….. Mortgage
$189,482 ………. Income Requirement
$3,619 ………… Monthly Mortgage Payment
$823 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$237 ………… Homeowners Insurance at 0.3%
$0 ………… Private Mortgage Insurance
$215 ………… Homeowners Association Fees
$4,895 ………. Monthly Cash Outlays
($836) ………. Tax Savings
($1,099) ………. Equity Hidden in Payment
$262 ………….. Lost Income to Down Payment
$139 ………….. Maintenance and Replacement Reserves
$3,361 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$10,999 ………… Furnishing and Move In at 1% + $1,500
$10,999 ………… Closing Costs at 1% + $1,500
$7,599 ………… Interest Points
$189,980 ………… Down Payment
$219,577 ………. Total Cash Costs
$51,500 ………. Emergency Cash Reserves
$271,077 ………. Total Savings Needed