Is the Consumer Overextended? Ask the Fed

 |  Includes: DIA, QQQ, SPY
by: Tom Armistead

Many pundits have opined that the American consumer is on the ropes, so far in debt that he will be unable to contribute to the economic recovery. Because consumer spending has recently been about 70% of GDP, this has led many to declare that the recovery cannot proceed until a lengthy de-leveraging process has been completed. Factual information is available to assist in quantifying this concern: here is a link to the Federal Reserve's Household Debt Service and Financial Obligations Ratios. After downloading and studying this information, a plausible case can be made for the possibility that this process can be completed in a one or two year time frame, after which a strong and sustainable economic recovery would be possible.

The household debt service ratio - DSR - is an estimate of the ratio of debt payments to disposable personal income. Debt payments consist of the estimated required payments on outstanding mortgage and consumer debt. The Fed provides information going back to 1980, so it gives us a look at a number of troughs/recessions which preceded strong recoveries.

Click to enlarge

How much debt is too much? - The average ratio from 1980 to the present is 12.06%, with a max of 13.90% in 3Q 2007 and a min of 10.60% in 1Q 1983. My impression, after eyeballing the data, is that a DSR of less than 11% is optimal as a prelude to a strong economic growth spurt. Consumers are not over-extended and can safely handle more debt and drive the economy. This condition was present in the early 80's and again in the early 90's, when strong recoveries resulted. In the early 2000's and subsequent, DSR was not meaningfully reduced, which may be attributed to the extremely lenient monetary policies in place at the time. Very possibly this de-leveraging was not avoided but only deferred, and is taking place now.

DSR as of 2Q 2009, the last data point available, stood at 13.11%, and has been declining since the high of 13.90 % in 3Q 2007. Is it possible for DSR to be brought down as far as 11%, and if so, how long would that take? How about 12%, a little below average?

Making it better - to improve the ratio, either disposable personal income must increase or debt service must decrease, or some combination of the two. DSR was low in the early 80's because interest rates had been pushed so high nobody borrowed if they could help it. Also, the horrible inflation at the time had one benefit in that it allowed the repayment of debt with depreciated dollars. So that laid the groundwork for a strong recovery, in the economy and in the stock market. However, if we were to hold debt service steady and rely on increases of disposable personal income, 3% a year would require 6 years to get DSR down to 11%.

Debt service can be reduced by paying off debt, by restructuring it, or by writing it off. Banks have been taking huge write-offs on mortgages and credit cards, but more will be required before this is over. There has been some restructuring of mortgages, and some refinancing at more favorable terms. It is unlikely that banks can or will write-off or restructure enough debt to drop the DSR as far as would be desirable. Consumers are reducing debt, but if your credit cards are maxed out it takes a long time to dig out of that hole, particularly when every late payment generates another fee and another rate increase.

Actually increasing disposable personal income by increasing employment, rather than by igniting inflation, would be the ideal solution, but appears unlikely in the near future.

Projecting from the current rate of progress – during the first 2 quarters of 2009, DSR was reduced by .45 %, or .23% per quarter. At that clip, to get from 13.11% to 11% would require roughly 2 years, assuming things go on pretty much the same as they have been for the first half of the year. To get down to an average DSR of 12.06% would be about a year, maybe somewhat more. The third quarter information will not be available for another month or so, but it will be very interesting to see if the trend of reductions continues.

Investment implications – if consumer spending power requires another year (or two) of de-leveraging/recuperaton, it is unrealistic for investors to look for a strong economic recovery until that process is complete. The Fed's data linked above provides an objective way to monitor developments. Possibly easy money policies will again paper over the DSR situation, leading to a premature and unsustainable recovery. Or the process of de-levering, once started, may be self-sustaining, setting the stage for a better recovery.

Thoughts on public policy – enlightened public policy would attempt to bring DSR down to levels that have been associated with stable growth in the past and keep it there. That would imply diligent prudential regulation of the banking industry to ensure that they do not lend under terms that impose excessive debt service obligations on borrowers. Alan Greenspan would have done well to consider DSR before continuing his easy money policy beyond its proper duration.

Disclosure: No positions mentioned, the author is net long stocks