08 February 2010

Where Does The New Thrift Come From?

Spending is out. Thrift is in.

After a long period in which economists bemoans rising consumer debt levels and near zero or negative consumer savings (a measure that includes payments of principal on loans), consumers are saving again and consumer debt levels are rapidly declining.

Cash In Mortgages

The biggest ticket consumer debt for most families is their mortgage. People are still refinancing mortgages. But, now rather than trying to get cash out of a mortgage to gain access to home equity, people after often putting cash in when the refinance to reduce their long term mortgage interest:

In Freddie Mac's latest quarterly survey of refinancings, 33% of homeowners put cash into the deal to lower their mortgage balances, the highest percentage ever. By contrast, only 27% of refinancers took cash out -- the lowest percentage on record. . . . there has been a steady rise since the fourth quarter of 2007, when cash-ins hit 9%, up from just 5% of all refis earlier that year. By early 2009, they accounted for 13% of refinancings, then grew to 18% in the third quarter. After that, cash-ins jumped to 33% in the final three months of 2009.

From the L.A. Times via Calculated Risk.

The shift isn't as driven by morality and sentiment as it seems. For example, one reason to put "cash in" a mortgage is that you must in order to refinance. Interest rates are low, so many people with adjustable rate or high interest mortgages wanted to refinance with fixed rate low interest mortgages.

But, you can only refinance if you have enough equity in your home to justify a loan (usually, at least five percent). If your home's appraised value has fallen to the point where you have little or no home equity, the only way you can do this is by paying off some of your existing mortgage. Investment prices have recovered much more quickly than real estate prices, so many people are able put money into homes whose values remain low.

The trend of people walking away from your upside down or low equity homes has also made headlines.

But, walking away from a mortgage doesn't work if you intend to keep living in your home, which will probably recover much of its lost value before you sell it, or if you want to be able to finance a new home with a mortgage loan, which a foreclosure on your credit record makes very difficult except in the now non-existent subprime mortgage market.

Walking away from a mortgage is also costly if you have a "recourse mortgage" (as do most people outside of a handful of states, most notably California). A "recourse mortgage" allows a mortgage lender to sue you if the value of your foreclosed upon house is less than the amount of the mortgage plus default interest rates and late fees plus attorneys' fees and costs associated with the foreclosure. If you have investment assets, the recourse mortgage debt incurred by walking away from the home will be larger than the cost of paying down your existing mortgage to the point where you have equity.

Other Factors In Behind Thrift

Wealth Effects Generally

Some of the change is driven by how "savings" is measured. The period of declining savings and increased consumer debt were accompanied by rising asset values. Home prices were soaring as were stock prices.

An unofficial but economically important way to think about savings is as unspent increases in wealth. Families were seeing their net worths increase despite a lack of additional savings. They didn't spend all of those increases, but they took out home equity loans and ran up unsecured credit, to access some of their new paper wealth. This left them with savings rates that seemed adequate. Remaining investments and home equity were viewed as sufficient to handle emergencies.

When asset prices fell in the housing bubble collapse and the financial crisis that followed making financial asset wealth disappear, many families found themselves with little or negative home equity, and with credit card debts that were no longer backed up by investments. So, now they are cutting back on consumption in order to pay down debts that have reached excessive levels for their current wealth.

If one views holding onto assets that decline in value as a form of spending, then savings rates now are probably considerably lower now than they were when the official savings rate was zero or negative.

Weak Job Markets As Savings Incentives

Why do those families feel the need to trim their debts and beef up their savings?

High unemployment is a factor there. The more insecure your job, and the more time it would likely take you to find a new job, the more likely it is that you will need to rely on emergency funds or incur new consumer debt. So, in times of weak employment, more people prepare by freeing up credit lines and putting money in the bank.

Changing Credit Card Terms and Underwriting Standards

Asset values swings didn't, of course, have any impact on the savings of roughly one-third of Americans who don't own homes and don't have any substantial market priced investment assets. In their case, increased "savings" are simply a product of increased minimum payments on credit cards, which mean that credit card borrowers must now make payments that cover not only interest but a meaningful amount of principal.

Also, credit card companies have been trimming unused credit lines, limiting the ability of people with credit cards to borrow. Banks have also made it harder to get loans for cars, homes, and other purposes, even though interest rates are low, which standing alone would encourage more borrowing. So, consumer debt has fallen, in part, because people who would spend more if they borrow to support that spending have been unable to spend more. People with bad credit, in particular, are facing a credit crunch.

Also, since a grossly disproportionate share of those saving the most (and of the total dollar value of credit card debt) involve people who own homes and/or have investments, the impact of low wealth people on savings rates is modest.

Debt Elimination

Another reason that we are seeing declining consumer debt levels is that a lot of debt is being written off.

When people do walk away from mortgages in non-recourse states like California, the unsatisfied balance of their mortgages is written off by banks, disappearing from the balance sheets of the consumers who once lived in the foreclosed homes.

Those who do not walk away from their mortgages are often "short sellers," selling their homes for less than the value of the outstanding mortgage. Banks sometimes are willing to forgive the unpaid balance on the loan or compromise it, because an ordinary sale of a home by a realtor followed by a prompt pay off of the proceeds of the sale to the bank is usually a better deal for the bank than going through the foreclosure process. In a foreclosure, the bank gets paid many months later and incurs attorneys' fees and collection costs, yet the proceeds that can be earned from selling the house are usually lower because there is pressure to sell (banks are not known for getting top dollar when they sell houses they have foreclosed upon) and because the physical condition of a house usually declines during the foreclosure process when home owners have no incentive to maintain the home.

Also, of course, bankruptcies are returning the levels not seen since before the 2005 bankruptcy reform legislation was imminent, discharging debts in the process. Someone who has lost their upside down home in a recourse mortgage state and has no investments has little incentive not to go bankrupt, particular if they have an income below the state's median income allowing them to do a Chapter 7 bankruptcy (i.e. one with no payment plan). For members of the growing ranks of the unemployed, eliminating debt through bankruptcy also makes sense.

Lenders may also voluntarily accept partial payment of debts in satisfaction of the entire amount owed, also eliminating debt, because the debtor could go bankrupt and wipe out a larger share of the amount owed, even if the debtor doesn't actually go bankrupt. Both sides in a deal like this avoid bankruptcy litigation expenses making a greater share of a debtor's limited funds available to satisfy the debt itself.

And, even if consumer debt is not formally discharged or forgiven, a debt that is written off by a lender can look identical to a discharged debt on the books of the lender for statistical purposes, thus making national consumer debt levels look lower.

Bottom Line

Most of the new trend towards thrift in the United States has little or nothing to do with changing consumer morality. Indeed, it is to some extent a statistical fluke if viewed as a change in "savings rates" rather than a change in consumption rates.

Still, low consumption habits may persist long after the constraints that made them necessary abate. People who survived the Great Depression, for example, often made permanent changes in their spending and savings habits.

Also, the net effect of the trend towards increased thrift is that our economy is growing less leveraged and more robust. Families with less debt, by whatever means, are more able to handle bad economic times in the future. This is one reason that "double dip" recessions are uncommon.

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