Wednesday, August 23, 2017

No looming debt crisis

Perhaps it's the relaxation induced by 12 days on my favorite Maui beach. But try as I might—and I'm spending a few hours each day keeping abreast of economic, financial and political developments—I can't get concerned. The world seems to doing OK, the U.S. economy is still growing at a moderate pace (roughly 2% or so), financial markets display few signs of distress, and there is no shortage of analysts predicting bursting bubbles and general economic and financial mayhem.

President Trump is center stage, distracting the left and the MSM with his absurdities and his tweets, while slowly dismantling burdensome regulations, restoring the rule of law, rebuilding the military, and protecting American interests. We're still saddled with a mess of a healthcare system and an absurdly bloated and burdensome tax code, but even small victories in healthcare and tax reform could unleash significant upside economic potential. Big, stupid government has been a headwind to progress for many years, but the good news is that government is getting slightly less burdensome these days and there is hope that this can continue.

The charts in this post reinforce in part the message of an earlier post, No boom, no bust, by focusing on the absence of evidence of a looming credit crisis. If there's a problem in the credit sphere, it looks to be limited to student loans, and although it's hard dismiss this problem—which has created a huge burden for students and taxpayers—it's nice to know that student loans are no longer growing at breakneck speed.

Student loans grew at a frenzied 68% annual rate in the two years following Obama's 2009 decision to federalize the program and liberalize their issuance (virtually all student loans now come from the federal government). Since then they have grown 360% and now total over $1 trillion. This is problematic: according to the NY Fed, student loan default rates at the end of 2016 were 11.2%, up sharply from the 6.7% rate which prevailed in FY 2007. The good news is that student loans grew at a mere 4% annualized rate in the three months ending June '17. The problem is acute, but improving on the margin.

Whether we will avoid massive defaults and dislocations remains to be seen, but I wouldn't rule out a scenario in which taxpayers pick up the tab for hundreds of billions of defaulted and/or forgiven loans. Handing out mortgage loans willy-nilly is what led to the housing crisis, and it's likely we will see some kind of student-loan crisis in coming years. Fortunately, student loans are still a relatively small share of total credit: 28% of consumer credit, 11% of total home mortgages, and about 7% of total household liabilities. Unlike the housing crisis, in which trillions of flaky mortgages were used as collateral for trillions of financially-engineered securities which in turn were held by investors all over the world, the U.S. government is the one with the most exposure to loss—and these days, $1 trillion isn't a whole lot of money. A bursting of the student loan bubble is very unlikely to precipitate another global financial crisis.

With the exception of student loans, consumer credit has barely increased since 2007. Virtually all of the growth in consumer credit in the past 10 years has been in the student loan category.

C&I Loans, a good proxy for bank lending to small and medium-sized businesses, have grown a mere 2.4% in the past year, after years of double-digit growth. But the slowdown in bank lending to this sector is not necessarily problematic.

Relative to GDP, C&I Loans stopped growing a year or so ago, and are now beginning to decline. The fact that C&I Loans relative to GDP have rarely been higher than they were last year suggests that the slowdown in C&I Loan growth has more to do with a corporate sector that is satisfied with its current debt load than it does with a reluctance of banks to continue lending.

It's very important to understand that the current Fed "tightening" is fundamentally different from previous tightening episodes, thanks to QE. Before QE, the Fed raised rates by reducing the supply of bank reserves; this created a shortage of liquidity and resulted in higher interest rates. Reduced liquidity and higher borrowing costs eventually brought the economy to its knees by squeezing nearly everyone. This time around, the Fed is increasing short-term rates directly while keeping bank reserves relatively unchanged, and rates are still very low in both nominal and real terms. Bank reserves are still abundant (excess reserves today are about $2 trillion, whereas they were a mere $9 billion at the end of 2007), and thus it is not surprising that there is no sign of a shortage of liquidity in the banking system. Swap spreads are quite normal and credit spreads in general are relatively low. Nobody is getting squeezed by the Fed.

The delinquency rate on C&I Loans, as of June '17, was only 1.4%. Very few borrowers are getting squeezed these days. From an historical perspective, it's hard to see that banks are exposed to a collapse in business credit.

The delinquency rate on all bank loans and leases has rarely been lower than it is today. Bank credit totals almost $13 trillion these days, and in the past year this measure of credit has grown by about 4%. That's down from 7-8% annual growth a few years ago, but it's not by any means scary.

Household leverage has declined significantly since its 2008 peak. Household balance sheets are in pretty good condition these days. Compare today's leverage with the high levels that preceded the 2008 financial crisis.

Household financial burdens (monthly payments as a % of disposable income) have rarely been lower than they are today.

OK, it's time to get back to the beach and relax.

UPDATE: The Mortgage Bankers Association today released the Q2/17 mortgage foreclosure data. Foreclosures fell to a mere 1.29% of outstanding mortgages. Only 4.24% of mortgages were delinquent. Both of these numbers are very low. Homeowners are not being "squeezed" by mortgage rates, which have been very low for most of the past 5 years.


Thinking Hard said...

Scott – Thanks for the update. I am currently following senior loan officer surveys ( for small-med-large market firms and I am showing easing of lending conditions to these businesses across the board for the last two quarters. This typically precedes an uptick in C&I lending with an approximate two quarter lag, therefore I remain optimistic on the C&I front in regards to corporate defaults. Student loans are a different beast, and I really don’t see any way out of the current dilemma except allowing bankruptcy reform for the student loans. The current delinquency rate and default rates indicate a need for bankruptcy reform away from the 2005 BAPCPA reform. The other alternative is much scarier to me – major political change resulting in a far left candidate ala Bernie Sanders gaining power on the back of the millennial generation due to the increase in student loans and the overall default rate.

I recently ran some numbers for a number of Universities in the SEC and came out with the following facts: In 1992 it would have taken a student between 2000-2500 hours of working a minimum wage position to cover tuition and living expenses. That number in 2017 is between 5000-6000 hours of minimum wage work to cover the exact same expenses. I hear a lot of arguments about how the younger generation signed on the dotted line and they must meet their obligation, but look at the facts regarding wages and tuition….it just does not add up. The younger generation will solve this politically if the current political landscape does not offer a verified way out of debt servitude into many millennial’s age 50 or above.

Scott Grannis said...

Thank you for contributing! One great irony of student loans is that easy access to loans was one of the factors boosting the cost of higher education. The government lent hundreds of billions to students so they could afford to get a higher degree, and all that money made it easier for colleges to raise their costs. So, like most government efforts to solve problems, it backfired, and in this case terribly. We're going to have to get the government out of the business of making student loans if we are to begin to solve this problem.

Grechster said...

Scott: Thank you for the updated charts, and commentary. And thank you to Thinking Hard for the thoughtful commentary.

minnesota nice said...

I believe that student loans are "exempt" from bankruptcy - and that the government will recoup the debt by withholding social security. Perhaps this could be a solution. The loan would be forgiven in exchange for agreeing to receive a lower social security benefit - which many younger people aren't counting on anyway.

Unknown said...

“I cannot help but raise a dissenting voice to statements that we are living in a fool’s paradise, and that prosperity in this country must necessarily diminish and recede in the near future.”

- E. H. H. Simmons, President, New York Stock Exchange, January 12, 1928

Benjamin Cole said...

Seems to me there should be a mechanism for eliminating student debt in exchange for two years military service or the like.

BTW, I do have one complaint about this post:

"rebuilding the military, and protecting American interests."

Egads, the Bush II and Obama Administrations spent about $16 trillion on DoD, VA, DHS, and black budget. Both presidents spent much more (in real dollars) than Ronald Reagan on national defense, and Reagan faced a serious military adversary, in the form of the Soviet Union.

If after spending $16 trillion, we have to "rebuild" the military?…I would suggest a complete makeover of a defense sector with strict emphasis on spartan living.

The deposed Bannon may have been a nut, but I think he was right to question evidently permanent US involvement in Syria, Iraq, Afghanistan. We make enemies, and gain no victories, and next year will be the same. Beyond that, we are propping up the No.1 Narco-State on the planet in Afghanistan. The US Army is the muscle for opium-kings. Gadzooks!

Trump offered some real hope for many voters, with his pledges to control illegal immigration, cut middle-class taxes, seek better trade deals, and get out of military quagmires.

They say Trump is the nut, and the establishment GOP the sensible ones.

Really? I dislike Trump's statement that can be seen as racist, and I never like to judge a book by its cover, whether that is color, sex, height, physical attractiveness etc.

That said, I think Trump and the GOP could have created a dominant and pro-business p[arty in the US, but the GOP insists on clinging to endless foreign wars, globalism and tax cuts for the rich.

Shane said...

Thank you Benjamin for the lucid comment. People like Scott who clearly have a political bent only see one side of the story. They are quick to find fault in any party that is not their own and cannot find fault in their party. This blinds them to truths, some of which you outlined.