18 August 2010

About Household Debt

Household debt is down 6.4% from its peak levels in 2008 to $11,700 billion.

Household Debt Is Lower Risk Than It Seems

Perhaps equally interesting, however, is its composition. Mortgage debt accounts for 74% of it. Another 6% is in the form of home equity loans. Another 6% is in the form of car loans. Student loans account for 4% of the total. Credit cards make up 6%. Other household debt accounts for 3%.

Thus, 86% of household debt is backed by assets that serve as collateral for the loan and has priority over all other debts in that collateral, and another 4% cannot be discharged in bankruptcy. Further, the residential mortgages and car loans that have been recently taken out aren't subject to being crammed down in bankruptcy.

Thus, only about 9% of all household debt owed by a family with a home worth more than the value of the loans on that property, and with a car worth more than the car loan on it, is subject to being discharged in bankruptcy.

Also, close to 90% of household debt is subject to pro-creditor exceptions in the bankruptcy law, rather than the general rules.

Default rates for debts of all kind are high right now. The collapse of the housing bubble in the financial crisis also left a lot of homeowners with little or no equity in their homes, so mortgages post extraordinary risks that they normally would not.

Still, a loan secured by a home or a car is almost never a total loss to a lender.

Debt and Institutions

It is also the case that household debt is overwhelmingly owed by households to large financial institutions like banks, credit unions, government lenders and finance companies. This may seem unexceptional, but it wasn't always the case.

Fifty years ago, it was common for the provision of goods and services to be tied directly to debts. A typical household owed money to a dozen different store keepers and service providers. But, the credit card has replaced a majority of household debt to retail good and service providers.

Non-financial businesses mostly operate on something close to a cash only basis, something that has not been true for most of the economic history of the United States. While households have more household debt than they have for most of U.S. history (except the last few years) by most measures, businesses that were once a massive shadow banking industry are now out of that business, providing them with a much more precise knowledge of their current assets than they had in the past. One of the reasons that businesses generally have been able to leverage more than they once did is that there balance sheets are more accurate because they aren't muddied by the uncertainties associated with large allowances for bad debt.

This also means that the deals that give rise to debts have been largely decoupled from the debts themselves. Credit card companies have much simpler stories to tell in court than merchants trying to collect their accounts did.

Household Debt and Social Class

The other point that this data suggests, and other economic data would confirm, is that household debt is overwhelmingly a middle class phenomena.

Renters who have never gone to college don't have any part of 84% of household debt, and realistically, tend to have less expensive cars if they have cars and lower credit limits on credit cards if they have them.

The mental image that comes to mind when economists report on a rise in household debt levels is often one of poor or working class people who are barely able to scape by, and a visit to a limited jurisdiction court where collection and eviction cases are brought, or a bankruptcy court, would easily leave you with that impression.

But, the economically important part of the household debt business is largely indifferent to the lives of the working class. Particularly in the wake of the demise of the subprime lending industry and the increasingly rigorous underwriting standards of default conscious banks, renters who didn't go to college live in something close to a cash economy.

Indeed, while it is clear that the last decade has been characterized by excessive levels of household debt for middle class homeowners, the working class is probably didn't and still doesn't have access to credit at interest rates that reflect the actual risk that they will not be able to repay their debts. The degree to which payday lenders and other businesses that offer financing or the equivalent for the poor have flourished at exorbitantly high interest rates prior to regulatory action suggests that there working class Americans have a huge unmet need for credit. And, the fact that the poor manage to largely pay these debts at huge interest rates (for goods and services that often cost more than comparable goods and services purchased by members of the middle class) with surprising low default levels suggest that default levels would be even lower if the interest rates weren't so great and the prices paid for goods and services were more reasonable.

But, because the dollar amounts of the credit needs of the poor and working class are modest compared to the credit needs of those who are better off, because transaction costs are higher relatively to the needed loan amounts, because default rates are somewhat higher, and because the collection process is much the same regardless of the size of the loan but brings bigger returns when loans are large, private lenders haven't been interested in lending to the poor and working class at reasonable interest rates.

Household Debt and Morality

The changing economic climate has also changed the moral dimension of debt collection actions. Increasingly, loans are designed so that collection actions are primarily necessary when the borrower suffers misfortune that is not entirely or even mostly the borrower's fault.

Cases where a lender isn't made whole by foreclosing on a house or repossessing a home, and as a result are suing the borrower, are cases where the lender and borrower have mutually made a mistake regarding what the assets financed were worth and have generally suffered an unexpected bout of deflation in that class of assets. When housing prices are stable, homeowners can usually sell their homes before losing them to foreclosure and make the lender whole. When car prices are stable, the value of a repossessed car is usually more than the amount owed on a loan. There is no need for lenders to bring collection lawsuits in court against debtors. When collection suits are brought, the economic event that caused asset prices to fall is as much to blame as anything that the borrower has failed to do.

Similarly, when student loans default, there is some sense that the problem may be the low quality education that was received, rather than being exclusively the result of moral fault on the part of the borrower.

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