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The trouble with high household debt

Posted by admin on June 22, 2009 in Investment Information

Household debt is the amount of debt any household carries and typically comprises of mortgages and consumer debt. As an absolute figure, it does not mean much. However, household debt measured as a percentage of disposable (i.e. after tax) income gives a good perspective debt loads; the easiest figure to keep account of is 100%. If household debt is 100% of disposable income, it means debt is equal to 1 year’s worth of disposable income.

There appears to be two contradictory trends occurring in connection with  household debt that has potentially negative consequences for the consumer, investor and the economy as a whole. While financial obligation ratios (which is defined as mortgage debt + consumer debt + property tax + insurance + rental payments if a renter) has been relatively stable, household debt as a percentage of disposable income has risen dramatically and to unsustainable levels.

In Q4 1998, an average American household’s financial obligation ratio was 17.44% (i.e. it spent 17.44% of after-tax income on debt servicing). In Q4 2008, an average American household’s financial obligation ratio was 18.97% (household debt data courtesy of the American Federal Reserve Board). Thus, for the last 10 years, our average carrying cost of debt has remained relatively stable.

BUT, in 1989, household debt as percentage of disposable income was 84.6%; in 1999, it was 103% and it is now estimated at 170% in the U.S. (an equally eye popping 140% in Canada; 150% in Britain and a more tolerable 90% in Europe). In other words, an average American household carries 1.7 years of its annual disposable income in debt.

What do we make of this?

1. Rising household debt combined with stable debt servicing ratios can only occur if there continues to be cheap credit. As the Bank of Canada noted last week, this situation has arisen because credit growth has outpaced income growth. If income growth stalls (a real possibility) and credit growth slows (a real possibility), does the whole deck of cards come down and the W shaped recovery occur (a double recession)?
2. Rising household debt combined with falling household net worth means the ability of leverage will slow down. Household net worth fell 6.7% year over year in Q4 2008 according to the Bank of Canada. Assuming that most households were continuing to service their debt load by continuously leveraging appreciating assets, what happens if falling household net worth becomes more than a short term trend?
3. Assuming both of the above result in negative outcomes, what happens to the banks? Bank of Canada ran a stress test, assuming a 10% unemployment rate, and estimated that banks would lose 10% of their Tier 1 capital due to defaulting loans (in simplistic terms, tier 1 capital measures a bank’s financial health and is a ratio consisting of shareholder equity plus retained over its assets; a tier 1 capital ratio of 10% is considered healthy).

What are the consequences of all this data for the investor?

1. For investors of financial institution stocks. We are not out of the woods yet. If one of the following happens: (i) interest rates rise; (ii) unemployment continues to rise; (iii) it takes longer for the unemployed to return to employment (Stats Canada estimates it typically take 15-26 weeks to find another job based on historical data), the banks could be in for another shock as losses from bad loans mount.
2. Non-financial institutions are in decent shape especially if they are in business to business industries. In Q4 2008, the U.S. Federal Reserve estimated that non-financial industries had a debt to equity ratio of approximately 75% while Canadian non-financial industries had a debt to equity ratio of 50%; both respectable levels of corporate debt, especially given the fact that this ratio has been declining since the 1990′s. In other words, it appears the banks lost the plot but most other businesses cleaned up their balance sheets. Assuming it will take years for household debt to be controlled, it appears the industries in the best shape are those who sell to other businesses (railways, pipelines certain types of teleco and tech companies, engineering firms) and not to the over-leveraged consumer.
3. It may take a while for the economy and stock market to recover. If one assumes the consumer is entirely over-leveraged and approximately 70% of the American economy is based on consumer consumption, it could take a while for the consumer to retrench and this could mean a long recovery. I am also a big believer that people in China will not suddenly become American and spend like Americans circa 2005, no matter how much prodding,  so there is no white knight coming to rescue the global economy.

If you are a consumer wrestling with debt, remember these key ratios:

1. The size of your mortgage should NOT be more than 2 times your household’s income. Since the biggest rise in the absolute and relative percent of household debt in the last 20 years is attributable to an increase in mortgages, one should watch mortgage size carefully.
2. You should have sufficient financial assets (cash on hand, line of credit, emergency funds) to survive a 15-26 weeks of unemployment (assuming historical data holds true and depending on your industry).
3. The Federal Reserve found that if you are in the 90th percentile and above in income, less than 10% of your disposable income is used to service debt. In other words, if you want to be financially secure, control your debt.

Good luck.