- What is the one thing necessary for credit expansion?
- Should we expect credit growth?
- Are investors being adequately compensated for credit risk?
Stocks have enjoyed historic complacency and now, several indicators suggest a market closer to a high than a low. Complacency is not just relegated to stocks. In some respects, the absence of risk aversion in some credit markets is more astounding. One of my economic laws says,
The Great Credit Expansion
Without confidence there is no credit. Lenders will not lend unless they have confidence in the return of principal. The interest rate and the loan term are directly proportional to the lender's perceived risk. Responsible borrowers will not borrow unless they have confidence that a future stream of cash will cover their interest payments. The period from 1982 until 2007 represented the greatest credit expansion in the history of the world. Credit not only expanded but morphed into new forms. The result of this confidence increase was decreasing interest rates. Then confidence encountered a large speed bump.
The financial crisis of 2008 eroded public confidence. By definition, this reduction in confidence meant that outstanding credit experienced a contraction. Figure I illustrates what happened to consumer credit. The blue line depicts total consumer credit of the revolving and non-revolving variety. Think of revolving credit (red line) as credit cards and non-revolving credit (green line) as student or automobile loans. All three lines began their advance after 1982 and began to rise more rapidly after 1992. Then 2008 happened and total consumer credit fell for 2 years. Since consumers purchase many things on credit, the economic impact during those two years is understandable.
After 2010, total consumer credit expanded and eventually surpassed the high of 2008. If you examine Figure I closely, note how revolving credit has not exceeded its previous high and is currently about $150 billion lower. Non-revolving credit, on the other hand, surpassed its 2008 level late in 2010 and has maintained its upward slope since. The consumer placed a clamp on credit card balances and allowed the non-revolving component to go higher. Why? The answer lies with the massive increase in student loan debt. Since the official end of the recession in 2009, student loan debt grew by $500 billion. To put this amount in context, there are only 26 countries on earth that have a higher annual GDP than $500 billion. Student loans contributed more than 70% of the increase in non-revolving debt.
While the financial crisis gave consumers a reason to pause, there is certainly no absence of confidence in non-revolving credit. Irrespective of your opinion on the growth of student debt (a subject for another article), it is undeniable that the rate of accumulation is something to take note of. The creditor's concern for student loans is delinquency. Recent grads are experiencing higher delinquency rates and even people in their 50s remain saddled with student debt. The full weight of the repayment of $500 billion in new student debt is yet to be realized. In the near future, students and parents will carefully consider the cost of higher education. That consideration will be a confidence buster.
We also know that a large segment of the population is in a collections process. A story in the Huffington Post suggests 1 in 3 are being chased by debt collectors. This condition exists despite what I discussed earlier regarding lower credit card balances. Slow income growth makes it harder for many to escape crushing debt burdens. It will take time or default to extinguish debt -- neither of those options inspires much confidence.
Real Estate Credit
Consumers dampened their appetite for real estate credit but other forces intervened. Figure II (log scale) illustrates the significant contraction in mortgage debt (blue line). This contraction occurred despite a truly massive Federal Reserve intervention through the purchase of $1.7 trillion in mortgage backed securities (MBS) [red line]. Cash purchases increased during the real estate loan contraction. This type of purchasing lies outside of my economic law confidence model since no credit is involved. However, these cash transactions, by their nature, eliminate the need for credit, which is deflationary. A lack of confidence has deflationary consequences.
While consumer confidence waned for real estate, the Fed wizards conjured up $1.7 trillion worth of confidence. How long will the Fed hang on to this MBS stash? Will the market want to purchase MBS at the price the Fed ultimately seeks? That chapter in the tale of our credit markets is not yet written, though it when it is, it will be impactful.
Confidence extends beyond the U.S. borders. Let's take Ecuador as an example. Moody's assigns a credit rating of Caa1 (2 rungs from the bottom) to the South American country. This rating implies poor credit quality and a high credit risk. The President of Ecuador denounced creditors as "true monsters" and called the nation's debt "immoral" and "illegitimate" during its 2008 default. Sounds like a welcoming environment for investors, no? In June, bond buyers, ponied up $2 billion for Ecuadorian debt. While $2 billion does not seem like much, consider that Ecuador is a $90 billion economy. That would be equivalent to a $374 billion debt offer for the U.S. While some may argue that perhaps the coupon rate was favorable, you should always consider the return of principal as well as the return on principal, particularly for a country that defaulted just 6 years ago. On the other hand, Ecuador's debt as a percentage of GDP is 25%. File that figure away for a moment.
Argentina suffered through a default in 2001 on $100 billion of debt. A restructuring ensued but not all bondholders wanted to play. The U.S. courts ruled that Argentina could not exclude the holdouts. Argentina thought otherwise. On July 30th, Standard & Poor's declared that Argentina defaulted on its debt. The country has undertaken several devaluations of the peso. Its credit rating prior to the default declaration was the same as Ecuador's (Caa1). Argentina's debt to GDP ratio is 53%- another figure to remember.
U.S. Government Credit
This brings us to Uncle Sam. U.S. interest rates are of course historically low. The rates are reflective of the demand for U.S. debt, for which both domestic and foreign investors still have an appetite. Supporting the market in a massive way is the Federal Reserve. Despite this support, we should ask ourselves if interest rates reflect the proper risk premium for ownership. Allow me to engage in an exercise to determine this risk.
The spate of borrowing by the federal government since 2008 took our debt-to-GDP ratio from 63% to its current 102%. Don't think that 102% reflects the true debt condition. In the book, Comeback America, the former comptroller general of the U.S., David Walker, suggested an additional $60+ trillion in unfunded liabilities -- and that was in 2009. I have seen other estimates as high as $100+ trillion. Our funded debt is $17+ trillion and our unfunded debt is multiples of that. I think it is fair to conclude that our debt to GDP ratio is higher than 102%.
FICO - U.S. Government Style
A FICO score instills fear in the hearts and minds of anyone needing to borrow money. The three-digit number is the key not only to obtaining credit but it also determines the interest rate paid for that credit. What is a FICO score and what does it mean? FICO is the acronym for Fair Isaac Corporation, a Minneapolis-based company that first analyzed personal credit history and created a report on borrowing and repayment patterns. Fair Isaac distilled the score into a three-digit number ranging from 300 to 850. A higher score means a greater probability of a person qualifying for a lower interest rate.
The government competes for credit, albeit with advantages, in the credit market. How could we calculate the government's FICO score? Let's examine the factors in determining the score.
Payment History (35%)
The U.S. Government's (NYSE:USG) payment history is stellar. They have never missed a payment.
Score - Excellent
Amounts Owed (30%)
The current funded debt is over $17 trillion and the unfunded debt may be as high as $100 trillion. These are staggering amounts by any measure. The Amounts Owed component takes into account not just outstanding debt but also how much credit is possible. If the current debt ceiling is $17.2 trillion it means the outstanding debt is very close to this level, suggesting the ability to borrow is quite limited. Since government revenues are in the $3 trillion range, the ratio of debt to income is uncomfortably high.
Score - Poor
Length of Credit History (15%)
The nation is over 200 years old.
Score - Excellent
New Credit (10%)
The country's debt soared from $9 trillion in 2007 to its current $17+ trillion. This refers to funded debt. Unfunded liabilities increased commensurately.
Score - Poor
Types of Credit (10%)
The USG has many creditors investing in various bill, note, and bond denominations and terms.
Score - Fair
In summary, we have 50% weighting in the Excellent category, 40% in Poor and 10% in Fair. Our composite score in this exercise is in the 620-659 range and that is considered Fair.
While the above is an academic exercise, it illustrates how the Market might view the credit-worthiness of the USG. The suggested FICO score places the USG in a sub-prime category, meaning it would not qualify for the lowest rates of interest since it presents a higher risk profile. If a credit counselor were to advise the USG on improving their FICO score, they would suggest a reduction in the Amounts Owed and New Credit components.
Comparing Debt to GDP
Now recall what I asked you to commit to memory. Ecuador's debt-to-GDP ratio was 25% and Argentina's was 53%. The US percentage is at least 102%. Moody's rates the credit of the USG as Aaa or the highest quality and lowest risk. In order to reduce outstanding debt, there must be sufficient economic growth to generate revenue. The U.S. has proportionately a far greater burden compared to the two South American countries.
Here is the paradox with respect to USG credit. On the one hand, the FICO score is just Fair and the country's debt-to-GDP ratio is much higher than the lower rated Ecuador and Argentina. On the other hand, while interest rates have increased in the past year, they remain near historic lows. Should interest rates be higher on the basis of the calculated FICO score? If an individual borrower with a low FICO score merits a higher interest rate, why not the USG? Certainly the reader will look at the country's taxing power and stellar history and conclude that default risk is small. Others may suggest that massive Fed action depressed interest rates. Agreed. But should an investor accept such a low interest rate. Is there any reason for long-term rates to be so much lower than in 2007 from a credit risk perspective? Are investors saying that the USG is a better credit risk now?
The Market and Credit
The investment market retains a great deal of confidence in US debt despite empirical evidence to the contrary. The market ultimately sets this rate even if the Fed is a large part of the market. Individuals comprise a market and they are not always the cold, logical, rational investors that would make Mr. Spock proud (recall the dot com bubble).
On the consumer side, the credit market reacted as one would expect after the 2008 scare. The government and the Fed wizards mitigated the consumer's changed posture through massive intervention. Consumers have retrenched, somewhat. Investors remain sanguine when it comes to lower yields and government debt. Credit scares occur when a party cannot repay a loan or interest payment, meet a margin call, or some other similar event. That event is likely to occur first with "high yield" debt. Hopefully it will not progress beyond that point and spread to the government sector, since that would constitute the mother of all confidence busting events.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.