Consulting firm McKinsey issued an interesting and well-done report comparing the debt loads of different countries entitled “Working out of Debt”. The good news for the U.S. in the report is that we have made better progress than other countries. The bad news is that we still have a lot of debt that still needs to be repaid.
McKinsey describes the U.S. debt situation as follows:
Household debt outstanding has fallen by $584 billion (4 percent) from the end of 2008 through the second quarter of 2011 in the United States. Defaults account for about 70 and 80 percent of the decrease in mortgage debt and consumer credit, respectively. A majority of the defaults reflect financial distress: overextended homeowners who lost jobs during the recession or faced medical emergencies found that they could not afford to keep up with debt payments. It is estimated that up to 35 percent of the defaults resulted from strategic decisions by households to walk away from their homes, since they owed far more than their properties were worth. This option is more available in the United States than in other countries, because in 11 of the 50 states—including hard-hit Arizona and California—mortgages are nonrecourse loans, so lenders cannot pursue the other assets or income of borrowers who default. Even in recourse states, US banks historically have rarely pursued borrowers.”
By extrapolating a trend line, McKinsey claims that the U.S. deleveraging process is about half over and that there will be another year of two of U.S. consumer deleveraging. According to McKinsey:
Historical precedent suggests that US households could be up to halfway through the deleveraging process, with one to two years of further debt reduction ahead. We base this estimate partly on the long-term trend line for the ratio of household debt to disposable income. Americans have constantly increased their debt levels over the past 60 years, reflecting the development of mortgage markets, consumer credit, student loans, and other forms of credit. But after 2000, the ratio of household debt to income soared, exceeding the trend line by about 30 percentage points at the peak (Exhibit 1). As of the second quarter of 2011, this ratio had fallen by 11 percent from the peak; at the current rate of deleveraging, it would return to trend by mid-2013. Faster growth of disposable income would, of course, speed this process.”
McKinsey’s description of what happened so far is accurate, but the one to two year forecast is not. The deleveraging will take longer because:
- Much of the deleveraging to date occurred because of defaults and debt forgiveness. This will not continue at the same pace. The worst credit extensions naturally are addressed first.
- History tells us that deleveraging is like a pendulum, and will not likely stop at the long-term trend line. Those who were threatened by the recession will likely keep paying off debt even after the long-term trend line is reached. This is the stuff that creates business cycles.
Regardless of when the U.S. deleveraging process occurs, McKinsey provides the following prognosis.
Nonetheless, after US consumers finish deleveraging, they probably won’t be as powerful an engine of global growth as they were before the crisis. That’s because home equity loans and cash-out refinancing, which from 2003 to 2007 let US consumers extract $2.2 trillion of equity from their homes—an amount more than twice the size of the US fiscal-stimulus package—will not be available. The refinancing era is over: housing prices have declined, the equity in residential real estate has fallen severely, and lending standards are tighter. Excluding the impact of home equity extraction, real consumption growth in the pre-crisis years would have been around 2 percent per annum—similar to the annualized rate in the third quarter of 2011.”
Unfortunately, much of the private debt has been replaced by public debt. The overall workout timetable will not be complete until public debt is also brought into line with what has been historically reasonable. This will take even longer, particularly since so little progress is being made or is even acknowledged as being necessary.