Good News: Household Debt Restructuring Continues

by: John M. Mason

According to data just released by the Federal Reserve Bank of New York, American households reduced their total debt outstanding in the third quarter by $74 billion. Since the summer of 2006 the reduction in household debt has been greater than $2 trillion, bringing the total amount of consumer debt outstanding down to $11.3 trillion.

Thus the process of household deleveraging continues. This is a necessary condition for a solid economic recovery to take place.

Although the Federal Reserve is working very hard to get commercial banks to lend out more money, households, burned by the excessive debt loads that were carried into the Great Recession, are restructuring their balance sheets to feel more financially sound. The credit inflation created by the federal government over the past fifty years resulted in a massive increase in household debt as people continually leveraged up the largest asset that they owned. Mortgage debt, the largest amount of consumer debt outstanding, rose steadily throughout this time period.

Households have paid dearly for their highly leveraged position as many homes went into foreclosure during the Great Recession. Foreclosures still represent a major reason for the decline in mortgage balances outstanding. Of course, other households are paying down more mortgage debt than the new mortgage debt being created at this time, further contributing to the reduction in total mortgage debt outstanding.

I believe that this is vitally important to economic recovery. There are still a substantial number of homes in the United States that have mortgages that are greater than the economic value of the house. If the United States continues to experience very mediocre economic growth or drops back into another recession, foreclosures will accelerate once again as more people lose their homes.

This situation works against the efforts of the Fed to stimulate the economy and the housing market through quantitative easing. Many people in the household sector are hanging on hoping to sufficiently reduce debt by paying it down rather than increase it.

This is how an economy normally restructures. People seriously impacted by a severe recession attempt to get their finances under control. This is a psychological "must" for people hurt in the financial collapse. These people cannot and will not be rushed into re-leveraging their homes. This works against a rapid recovery in the housing sector- and in the economy as a whole- but it helps people control their pain in getting their lives back on track and regaining confidence.

The situation in the housing market is being helped as home prices continue to increase. The increases are not great at this time, but the recovery in home prices has been relatively steady.

The Case-Shiller home price index, also just released, has risen by 3.6%, year-over-year. The Federal Housing Finance Agency, using a different approach, released data that indicated that home prices rose by 4.0%. This is not the first month showing a year-over-year increase for both indices indicating, hopefully, a rebound in the value of private homes.

Rising home prices are, of course, very important for households because homes are, for most families, the largest asset they will purchase in their lifetimes and they represent, potentially, the greatest part of a household's wealth. And higher household wealth results in more consumption.

Home prices, according to both indices, are still about 29% below what they were in 2006, but, hopefully, a trough has been achieved and home values are on the rise again. There are several reasons for this rise including a decline in the backlog of re-possessed homes and the speed of foreclosures. The important thing is that prices are heading up.

If one moves beyond the mortgage field, one finds that other forms of consumer debt rose in the third quarter. Household debt, not including mortgages, increased by 2.3% in the quarter. This increase was led by a rise of 4.6% in student loans, an increase of almost $1 trillion. The trend line of this type of loans remains relatively steady at an almost 45 degree angle. There seems to be no stopping of this lending, recession or no. This is good news but it will remain good news only if the job market for new college graduates starts to improve more strongly. Delinquencies are still running quite high in student loans.

The balances on credit cards remained almost constant in the third quarter indicating that consumer retail shopping was still moribund. Credit card balances have been declining for more than three years and this may be a sign that some bottoming out is taking place. Again, households have been working hard to reduce these balances because they represent a major portion of their debt load.

Revolving home-equity loan balances declined in the third quarter of 2012 continuing a trend begun in late 2008.

Many analysts are starting to believe that households are feeling more confident about the economy, their employment situation, and their debt position, and may be starting to translate this feeling into more spending. This is good news, but I still don't believe that we should get too excited about these numbers at this stage. If history is any indication we still have further household de-leveraging to go through. What we want is to move into a good, solid economic recovery. To do this we need household balance sheets to be in a relatively strong position. We are getting there… but we are not there yet.

This is why the Federal Reserve's latest effort at quantitative easing is somewhat disconcerting. The Federal Reserve wants spending to pick up and it wants spending to pick up RIGHT NOW! The Fed is just acting upon what modern economics has taught us to think. If economic growth is too low and unemployment is too high, just step on the gas and everything will be all OK.

Also, remember that almost all macroeconomic models do not take into account debt, let alone household debt. In these models, monetary policy, by lowering interest rates, or, increasing the monetary base, can cause economic growth to rise, can cause unemployment to decline... and things will turn out fine.

But, this means that households should immediately start re-leveraging their balance sheets and get back out there spending. It does not account for the fact that people may not be psychologically ready to once again take on more and more debt and spend, spend, spend.

The real world does is more complicated. After a serious financial downturn, people want to reduce their debt loads. They want to have more control of their futures. According to the Fed data, these households have been reducing the level of their debt since the summer of 2006. I believe that they still have a ways to go. And, this is good because it will create the foundation for a more sustainable economic growth in the future.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.