24 January 2012 EDR: The US economic cycle and debt reduction

At its worst, the situation created record, unsustainable levels of debt to income, debt to assets and debt service to income.

Combined with the rising oil prices in 2008, the bursting of the real estate bubble caused a financial crisis and the most severe recession since the 1930s. Considering the importance of consumer spending for the US economy (72%), the reduced debt burden on American household spending will be crucial for growth in 2012.

However debt had not been restricted to households over the past decade. Until 2008, companies had also used debt and fi nancial leverage consistently in their financing strategy. It became necessary to reduce this burden by building up cash fl ows and limiting investment expenses.

Finally, governments relied on budget defi cits to respond to the recession. The democrat administration’s 2008 stimulus package (787 billion dollars), combined with lower tax revenues due to the slowdown, created annual defi cits which in turn led to a strong rise in public debt

REDUCING DEBT AND CURRENT FINANCIAL HEALTH

At the height of the credit cycle in 2008, mortgage debt had grown by 70.9% since early 2003 and the volume of personal loans had risen by 28.8%. In 2007, total debt amounted to 130% of a household’s income, a record high. The fi rst consequence of the housing downturn was the fragmentation of the sector’s funding. The entire securitisation chain (mortgagebacked debt instruments) which had been fed by mortgage debt was immediately impacted by defaults from borrowers and deteriorating fi nancing conditions. This break up was instrumental in causing the 2007-2009 crisis, and forcing the Fed to take unprecedented measures to ensure liquidity following the collapse of Lehman Brothers.
As the main players in mortgage securitisation, specialist federal agencies had to be put under conservatorship. Facing fast growing losses, retail banks reacted with a restrictive policy, and despite lower interest rates, access to credit became very diffi cult. Transaction volumes and prices dropped sharply: 32% on average for the latter, based upon the S&P/Case-Shiller index calculated from the peak on July 2006 to 2011. Affected by the fi nancial crisis of late 2008 and early 2009 and by the diminished value of their assets, households became very cautious and chose to increase their savings rate. The job market and income levels began a slow recovery at the end of the recession. Aware of their past mistakes, households began to reduce their debts. But although debt levels are lower today (redemptions and defaults have contributed to this), amounts remain high. The housing market is still mediocre and many home-owners are facing a mortgage debt that is higher than the value of their property. In September 2011, 22% of households found themselves in this situation of negative equity. Weighing down on confi dence and on consumer spending, negative equity also hinders any kind of geographical mobility – with salaried home-owners unable to sell their property and move on without facing a deterring loss.

While the total amount of household debt has only dropped slightly since 2008 (around 5% at $13.2 trillion), the monthly burden as a percentage of monthly income has fallen signifi cantly.
The most recent available fi gures, calculated by the Fed in September, show perfectly reasonable levels, close to those of 1995 (see chart). Households have benefi ted from lower interest rates and have renegotiated the terms of their mortgage loans. Monthly repayments have a direct impact on a family’s budget and lower monthly liabilities can leave room for new spending.
After a fi rst step in debt reduction (the debt to disposable incombe ratio fell back to 110%), work is still needed to return to levels in line with the historical average (75% for the 1975-2000 period).
However in a context of stable, low nominal interest rates and with reduced monthly repayments, the incentive to reduce debt is now limited.
High net wealth in relation to income, an improvement (albeit slight) on the job market, and higher wages are key factors in sustaining consumer spending. On the positive side, car sales figures have shown an upward trend, however fi gures have been quite disappointing for the services sector. All told, despite factors of instability – political disagreement over the debt ceiling, sovereign debt crisis in Europe – and lower consumer confi dence levels recorded at those times, consumer spending has remained more stable than expected.

In conclusion, the trend towards reducing debt is unlikely to accelerate. The savings rate has fallen again (3.5%), which is unsurprising considering the context: low interest and a recent improvement in consumer confi dence. In other words, consumer spending will continue to grow but at a moderate pace. News on the employment front could accelerate the trend – and fi gures have started to improve at a faster rhythm. But much will depend on the disposition of companies.
A recovery on the real estate market would also contribute to improving households’ fi nancial conditions. Property is often the main asset for a household, and fl uctuations in the value of a home can have a strong impact on consumer confi dence. Furthermore, the residential building sector also stands to gain from a recovery, which would in turn contribute to boosting growth and the job market. While prices are down over one year, markets are showing early signs of an improvement – in Washington for instance, where the housing stock is already falling.
Excluding sales of repossessed homes, prices have actually risen slightly over the last 12 months. But the market is far from reaching an equilibrium: with defaults still so high, supply will remain stronger than demand and will weigh down on housing prices. In California, 45% of all property transactions result from fi nancial diffi culties.

But it is important to consider the trend in demand too. Higher rents have made buying more attractive, particularly with longterm interest rates at a low – around 4% for a 30-year loan.
With prices becoming more stable, this increased profi tability attracts investors to property which can rival other, lower potential investments. As an illustration, 38% of all transactions are now carried out by cash buyers, whereas this fi gure has rarely exceeded 10% in normal times. After a fi ve-year correction, housing needs have not disappeared but demand is clearly lower than its potential at a time when property has never been so attainable (low cost of borrowing and low buying prices). Access to credit is a key problem. Although it is easier now, it remains tight and unemployment is weighing on the confi dence of potential buyers. While a slow recovery can be seen in both transactions and apartment construction, 2012 will probably not be a year of significant change, but one of further stabilisation.

Companies have managed to reduce their debt burden more than any other economic player. Caution was the rule in the wake of 2008-2009 and since the economic upturn, they have avoided using any leverage. As a result, today companies can boast an exceptional fi nancial situation, both in terms of cash fl ow and balance sheets. The US economy should emerge strengthened, as companies generate the jobs and wages that ultimately drive consumer spending.
Investment also depends on their health, as they can choose a strategy of growth rather than a fall-back, as they did in 2008. At the time, their fi nancial vulnerability together with soaring in
oil prices, was a direct cause of the recession, accelerating and amplifying the break up of the cycle.
However caution does put a break on growth: the main cost for companies is labour and this could affect the job market. Finally, this prudent stance is also impacting investment, which is generally lower than cash flow amounts and management costs (inventories, running costs).
Banks ended up at the heart of the crisis because of the fragile nature of their balance sheets, loaded with toxic debt – real estate in particular, in high risk, excessively leveraged fi nancing conditions. However help from the Fed has enabled most of the large institutions to get through the crisis. Now recapitalised and sound, having recovered a degree of their profi tability, American banks are now confronted with a regulatory challenge: the transition towards a more restrictive legal framework which will force them to reform their economic model.

Rising federal debt managed to compensate for the negative consequences of the private sector’ deleveraging. However public debt has now reached an amount equal to the country’s GDP – around 15 trillion dollars, a dangerous threshold which caused the country to be downgraded in August 2011. The maturity structure of the US Federal debt is very short, with a majority of the issues reaching maturity – and needing refi nancing – by 2015. Getting fi nancing on the short section of the yield curve is an advantage for cost reasons, but can also be problematic in the future when half the amount is held by non-residents.

Furthermore, multi-year projections show that a fundamental reform is necessary for the public Treasury to be able to face the inevitable increase in social and medical expenditure due to an
ageing population relatively smoothly.
While the current defi cit – around 96% of GDP – must be reduced, the prospect of upcoming presidential elections in November next year has already frozen any legislative debate into a confrontational deadlock.
The defi cit reduction plan passed in August calls for automatic cuts from 2013 onwards and concerns $13 trillion over ten years, covering social and military expenses. But whether the
next Congress will be red or blue will have more importance than this plan. For 2012, Congress was not able to go further than a compromise which maintains unemployment benefi ts for the first two months, and the suspension of a 2% tax on wages. Local authorities are also facing severe budget cuts, as they have to balance their annual accounts. Their revenue has been affected by lower property prices (both in the value and number of transactions) and fi nancial efforts and discipline are still required. They have shed over 700 000 jobs since 2009, an unprecedented cut in the history of the country.

Current expenditure, including labour costs, and social security benefi ts will continue to be impacted and this will affect growth. This strained state of affairs has given rise to questions over US local governments’ ability to meet their liabilities, which amount to a quarter of federal debt. During 2011, many feared multiple bankruptcies. In reality, while some collapses were spectacular (Jefferson County), their number was low and municipal bonds turned out to be the best bond investment in the United States in 2011. These will enable local governments to raise funds easily and at a relatively low cost. Thanks to the recovery, revenues are up and the situation should continue to improve gradually, giving States, counties and towns the fi nancial needs to boost expenditure in 2012, after the cuts of 2011.

DEBT AND MONETARY POLICY

The Federal Reserve helped to put an end to the crisis through severe monetary easing and by actively buying up bonds – sovereign and mortgage-backed. In this way, the central bank managed to contain any defl ationary risk. The growth in loans and in money supply demonstrates that the Fed has succeeded, except in the area of real estate – for now. The central bank now believes that putting some order into public fi nances must be the main priority for Congress, which controls the budget process.

IMPACT FROM THE EUROPEAN CRISIS?

US exports only account for 12% of GDP and the share destined towards Europe is only 17% (2% of GDP). Trade with Europe is exposed to the consequences of the recession but probably
accounts for less than the business carried out by US companies located in Europe. However these multinationals are also expanding in other areas of the world.

US companies have largely corrected any excesses made during the credit cycle of the past decade. Households have to sustain their efforts in a paradoxical situation where the Fed’s interest rate policy and low interest is a deterrent for increasing their savings. However households absolutely have to reduce their debt burden, as any hike in interest rates would put them in an uncomfortable situation, with a sharp rise in the cost of borrowing. Until then, a gradual reduction of debt can occur that would not put into jeopardy the early improvement in consumer spending, driven by a better job market, income and asset wealth. In the long term, the main problem lies with federal debt. In three years, the debt has risen from 40% to 100% of GDP – times four in eleven years. Any form of stabilisation will necessarily requie signifi cant cost cutting, and no doubt, a tax increase. The United States does have the benefi t of pro-active monetary policy and significant room for manoeuvre: unlike European countries, the country levies one of the smallest percentages on GDP across the OCDE. At 28%, the fi gure is low as social security is partly covered by the private sector. However arbitrage will not be easy and will require political courage.

The signifi cant improvement in household confi dence over the past few months is backed by the latest employment statistics. With a further 200 000 jobs created in December, a total of 2.6
million jobs have now seen the day since the low point of 2010. This positive trend will be crucial in boosting home buying fi gures, an area where stabilisation is key for the sustainable growth of the economy. Currently, real GDP growth stands at 1.5% between Q3 2010 and Q3 2011.

Disclaimer:

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