Never have so many owed so much

American households are mired in debt, says David Wyss, chief economist of S&P in New York.
The American consumer continues to borrow more and more. With the US savings rate sinking into negative territory for the first time since the Depression, households took advantage of the low interest rates to buy houses, cars, and everything else. So far, consumers have ignored higher interest rates and record oil prices in their charge to buy.

When will they stop? It's difficult to believe that Americans can borrow any more, but we have learned not to underrate the willingness of consumers to borrowùor of banks to continue lending them the money. The housing sector, however, is showing signs of fatigue, as higher mortgage rates finally seem to be eating into sales and prices. Car sales may be slowingùwhich is no surprise, given the high cost of filling them up. However, consumers are still spending more than they are earning. We do expect consumers to slow down, and the savings rate to move back to positive next year. But only a slowdown, not a retrenchment, is expected.

Usage of credit cards and installment loans is likely to increase. Over recent years, Americans have refinanced their credit card debt into mortgages and home equity loans to take advantage of lower interest rates and tax deductibility. Debt consolidation was the No. 2 reason for taking out a home equity loan, according to the Mortgage Bankers Association, after home remodeling (education was third). With mortgage rates rising and home prices stabilizing, taking cash out of the house to pay credit card bills will become less possible.

The 2004 Federal Reserve Survey of Consumer Finances, just released this spring, provides us with an update on who owes the money. The changes since the previous 2001 survey are not major, but they show that the rise in indebtedness has been across the economic board, with all income levels borrowing more. The distribution of wealth may be becoming less equal, but the distribution of debt remains very egalitarian.

Nevertheless, we see few signs of distress among borrowers. Charge-off rates for credit cards, installment loans, and mortgages remain at or near historical lows. The passage of the new bankruptcy bill, which became effective Oct. 17, 2005, did cause a surge in bankruptcies, but the impact on losses was even more fleeting than expected. Loss rates are likely to remain low as long as the economy continues to perform well, in spite of higher interest rates.

Consumer Debt And Wealth

Household debt reached a record 131% of after-tax income in the first quarter of 2006. The average household has $106,447 of debt outstanding, up from $50,796 (92% of after-tax income) 10 years earlier. The increase is concentrated in mortgage debt (see chart 1). Nonmortgage debt has been relatively stable, at least as a percentage of income, rising to 23.2% from 21.1% in 1996. Mortgages on primary residences now account for 77% of household debt, up from 67% in 1996.

The rise in mortgage debt reflects the increase in both the percentage of households owning a home, which has risen to 69% from 64% in 1994, and the average price of a home. The average loan-to-value ratio in the housing market has been stable, near 45%, although new homeowners do have higher ratios than older, more established households, whose ratios have dropped as home prices have escalated.

Nonmortgage debt has been stable as a share of household income. Both credit cards and installment loans have dropped as a share of household debt. However, that may be influenced by refinancing of credit card and installment loans into home mortgages, either through cash-out refinancing or home equity loans. Consolidation of existing debt was the No. 2 response when consumers were asked why they took out home equity loans, right after home remodeling.

Signs of distress among households have been few, with default and loss rates coming down from their recession highs. The new bankruptcy bill did cause a temporary spike in credit card losses in the fourth quarter, but the rise was less severe than expected, and the offsetting drop in losses in the first quarter took the loss rate down to a 15-year low. The surge in bankruptcies that came before the Oct. 17 effective date of the new bill was greater than expected, but it seems to have come from households that were going to go bankrupt quickly anyway.

Households seem less interested in the amount of debt outstanding than in the debt service costs. Low interest rates have kept debt service costs relatively stable as a share of household income. In the fourth quarter of 2005, debt service was 13.9% of after-tax income, a record high but not much above the 12.3% of 1986, when debt was lower but interest rates were higher. If we add in lease payments and property taxes and insurance, total financial obligations were 18.6% of income, compared with 17.7% in 1986 (see chart 2).

Chart 2

In addition, despite the debt, the household balance sheet looks healthy. Although liabilities are at a record high, assets have more than kept pace. Net worth is 579% of household income, below its peak of 620% at the end of 1999, but well above its average of 494% from 1960 to 2005. This reflects, in part, the same rise in homeownership that is seen in the mortgage data, as well as the recent recovery in the stock market. In buying a house, families are acquiring an asset that more than balances their debt. But the balance sheet optimism must be tempered by two questions: First, will the assets retain their value, and second, are the people with the assets the same people who have the debt?

The asset valuation generally looks more secure than it did in 2000, when the stock market hit its peak. The price earnings ratio is 16 (based on forward operating earnings) for the S&P 500, not much higher than its historical average and lower than the "Fed model" would estimate. (The Fed rule of thumb is that the price/earnings ratio should be the inverse of the bond yield. At a 5.1% 10-year yield, the ratio "should" be 19.6.) Housing prices are now the primary worry, since they have risen to their highest level in recent history as a ratio to household income. Standard & Poor's has discussed this issue recently (see "As Housing Slows, So Slows The Economy?" published May 15, 2006, on RatingsDirect, Standard & Poor's Web-based credit analysis system, at Our conclusion is that a period of flat home prices is more likely than a sharp national drop, although declines in the most overvalued regions are certainly possible.

It is also encouraging that the overall leverage ratio in housing has remained constant. Total mortgage debt is 45% of the aggregate value of housing, about the same as it was 10 years ago. There is, however, evidence that new homebuyers are more leveraged than ever, with the median first-time homebuyer putting up less than 5% of the value of the house. This has been offset by older homeowners, however, who have seen the value of their homes go up and the balance on their mortgages go down.

The distribution of debt is very democratic in the U.S. The 2004 Federal Reserve Survey of Consumer Finances (SCF) shows that the ratio of debt service costs to income is amazingly equal through the 90th percentile of the income distribution, with ratios ranging from 16% to 20% (see chart 3). Only the top decile, with a ratio of 8.5%, is significantly different than the rest of the population.

Chart 3

Wealth is much less evenly distributed than income or debt. The distribution of household income hasn't changed much in the past 15 years, according to the SCF, except at the very top of the income distribution. Even the 95th percentile of families has income that is 4.3 times the median incomeùalmost exactly the same ratio as in the 1989 survey.

The distribution of wealth, however, has become markedly less even. The 95th percentile of income earners has 12.9 times the median household's wealth, compared with 9.3 times in 1989 (see chart 4). Most of this shift occurred from 1998 to 2001, when the stock market had its final surge, but the ratio remained high even in 2004, after the 2000-2002 bear market.

Some of the shift has been caused by the increased concentration of wealth in the cohort aged 55 to 64. The rise in 401(k) plans during the careers of these baby boomers has implied increased asset ownership. The median wealth in this age bracket was 2.68 times the median household wealth in 2004, compared with 2.01 times in 1995. In addition, a higher percentage of the population falls into this age group than in the past. This change in distribution is encouraging, since these are the households that will soon be dependent on their wealth in retirement.

However, that is only part of the story. Even within age and income groups, the inequality in wealth has widened. Reasons for this are unclear, although the increased return to education appears to be a factor in the distribution of both wealth and income. The options gains in the late 1990s, especially in the technology sector, and the recent changes in tax laws are also factors.

Chart 4

Will Americans Have Trouble Paying The Debt Back?

There are few signs of major distress among American debtors. Credit card losses spiked in the fourth quarter, but that appears to have been a transient response to the new bankruptcy act. Losses plummeted in the first quarter to a 15-year low. Bankruptcies surged in early October, as filers beat the Oct. 16 effective date of the new bill, but plunged thereafter. The pattern of losses and bankruptcy filings confirms our belief that most of those filing were individuals who would have filed soon anyway.

Repayment rates for credit cards have risen sharply in recent months. This may reflect the Federal Reserve's push to raise minimum repayment rates to prevent balances from growing. The minimum payments were high enough on most cards so that they were not affected by the change in calculation, but some clearly were. Although most banks report that less than 10% of their credit card holders made their minimum payment in March (April Federal Reserve Senior Loan Officer Survey), four of the 27 banks reported that more than 30% of their holders did. These banks are clearly catering to a different client set than most of the large banks, and it is these customers that we worry about.

Delinquency rates, usually a good indicator of future losses, have been dropping for credit cards and mortgages. The delinquency rate for consumer loans, at 2.68%, is the lowest since the Fed began collecting the data in 1987. The delinquency rate for residential mortgages edged up in the fourth quarter to 1.66%, compared with 1.41% one year earlier, but the 1.41% was a record low.

Our model suggests loss rates will remain low. We had expected a sharper spike in advance of the new bankruptcy bill, and expect the bill to have a slightly lowering impact on losses. Low unemployment will help keep delinquencies and losses down despite higher interest rates (see table). The risk will increase if the economy falls into recession, perhaps as a result of another oil price spike.

The research report is extracted from RatingsDirect, the real-time Web-based source for Standard & Poor's credit ratings, research, and risk analysis, at To learn more, please click on About Ratings Direct.
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