Saturday, March 20, 2010

Household deleveraging is a very healthy indicator

The Fed's latest data on households' debt service burdens (as of Dec. '09) came out just the other day, and the news continues to be good. Households are reducing their debt burdens, which are best measured as shown in the chart by comparing total debt service payments to total disponsible income. Indeed, by this measure, household financial burdens are no higher today than they were in the mid-1980s. (Measures that compare household outstanding debt to income are flawed, because they compare the stock of debt to the flow of income; it only makes sense to compare the flow of debt service to the flow of income: to compare monthly debt payments to monthly income.)

By reducing their debt servicing burdens, households are expressing a strong desire to increase their holdings of money. (Reducing one's debt is equivalent to increasing one's holdings of money, just as increasing one's debt is equivalent to reducing, or shorting, one's exposure to money.) This is the phenomenon that the Fed has been fighting for the past year or so. The increase in money demand on the part of households and businesses has been so huge that the Fed has had to take extraordinary measures to increase money supply, via a massive expansion ($1.25 trillion) of bank reserves.

As an objective observer of the goings-on in the economy, I can't find anything in this data or in this chart that paints a worrisome picture for the economy. If the financial crisis of 2008 was brought on by excessive borrowing, we have surely corrected the underlying problem by now.

As a contrarian, I would note that with the deleveraging trend so patently obvious, and with the Fed so blatantly accommodative, it is probably not a bad idea to swim upstream and increase one's leverage these days. Which is equivalent to saying that holding cash is such a mainstream strategy—and so minimally remunerative—that it is embarrassing. See my posts over the last year on this same subject here.


alstry said...


Has anyone ever calculated what percentage of household spending comes directly or indirectly from government payments?

Basically, isn't government now borrowing $2 trillion dollars simply to pay workers and generate hundreds of billions of tax receipts simply a fraud and any talk of recovery simply fantasy?

Benjamin Cole said...

Looks like we are on slow mend.

I like the reference to yourself as "an objective observer."

Oh, to see others as they see us.

Interesting advice to leverage up-who is lending?

Let us hope the next Long-Term Capital Management computer whiz-kid team does not take that advice!!!

John said...

Scott may correct me here if I am misinterpreting his suggestion but I assume he is referring to borrowing perhaps on a securities margin account to purchase stocks or bonds with favorable prospects. This obviously involves some risk but his point that the investing public is so risk averse now and the cost of money so low relative to past levels that it may make sense for some investors.

I happen to be in agreement if this is his point. We are apparantly still early in the economic recovery and fears are still high. As fear abates along with the recovery asset prices should rise along with confidence. It takes a little faith and confidence but for those that can endure the volitility the rewards might just well be there.

Scott Grannis said...

John: I am indeed recommending the use of leverage. Many ways to do this, of course. Buy stocks on margin. Buy homes with a mortgage. Use futures or forwards instead of buying outright. said...

We have "deleveraged" as we have paid down several mortgages since the 2007 peak depicted in your chart. In addition, most of the loans are adjustable and 3.25 percent interest rate or less. Cash flow is up. Liquid net worth exceeds high of 2007 Q3 Q4 by March 2010, with total net worth hitting a new high several 1-2 quarters ago, due to principal reduction.

Cash 'returns' are no different now than was the 'return' of 2007 when I was earning 5% plus in money markets, with inflation running 4-5% and paying taxes at the 28 plus percent bracket. It is no sin to have some percentage of the portfolio in cash. Cash balances are necessary to take of advantage of opportunities. Ask Warren Buffett.

I will not be increasing my leverage in the near future, however.

Scott Grannis said...

sgt: It was not my intention to say that holding cash is a sin. If you are holding cash in anticipation of buying something, that makes a lot of sense, since opportunities are likely to crop up at times like these. The improvement in your personal finances is quite similar to what the economy as a whole is experiencing, and it's good to hear.

Leverage only makes sense for those who want to take some extra risk, and is not for everyone. Sometimes it is more advantageous than others, and I'm guessing that now is one of those times.

UFormula said...


I think you are underestimating how much deleveraging will happen. While we are back to levels that prevailed in the 80s, those were the highest levels at the time, before we embarked on a very large credit binge.

I believe in mean reverting and thus we should see debt/income percentage well below the current levels.

It's taken 2-3 yrs to get back to where we are today. I see another 2-3 yrs of deleveraging. This will cause profit growth to be much slower than what the market is anticipating.

I guess we'll find out come Q3/Q4.

Scott Grannis said...

Rodrigo: I have two important points to make in response. One, the Federal Reserve is trying very hard to discourage people from deleveraging. They would be very happy to have inflation rise, rather than seeing any sign of deflation. The Fed is the most powerful institution on earth, and they are unique in that they can always get what they want.

Two, even if deleveraging continues as you suggest, that is no reason to expect the economy to be weak of profit growth to slow. Economic growth is not built on leverage, it is built on productivity. Leverage may contributed to growth, but only to the extent it makes markets more efficient, and that is not always the case.

rg32 said...

Dear Scott, I really appreciate your comments on this subject. I completed a refi on my home in Jan 09 with the intent of taking out cash to pay off my small office building (the original idea was to lower my overall interest rate by about 2%). I ended up unable to take out enough to pay off the office, so I just took out 183k and invested it in late January 2009. That 183k is now 292k. I have been thinking that with another 10% increase in the markets, I would liquidate that account, and add another 100k, which would put me in position to have my office paid off in six months (instead of 12 years). I was thinking that I was moving in a contrarian fashion on both transactions, but you have me thinking that I am being too early on the payoff. Thoughts??

Scott Grannis said...

rg32: I can't really answer your question, because the degree of risk you assume is a highly personal matter. I can only say that to me the odds favor the use of leverage. I would also note that since the interest on mortgage debt is deductible, the government is effectively subsidizing (reducing) your interest expense. A wise friend once told me that you can never refuse to accept a government subsidy. Sometimes it doesn't pay to pay down your debts, especially if you believe that the assets you are financing can appreciate by more than your after tax cost of debt.