Why the Deleveraging of U.S. Households Matters

Consumer debt deleveraging
Consumer debt deleveraging

There has been a lot of chatter about "deleveraging" in the two years since Bear Stearns folded in March 2008. But what deleveraging means for U.S. households and the U.S. economy is rarely specified.

In a nutshell, leverage means taking on debt, and deleveraging means reducing debt.

A common example of leverage is a stock market margin account, in which an investor borrows money against his stock portfolio in order to buy more stock. As long as his collateral -- the value of his portfolio -- keeps rising, he can continue to borrow more on his margin account to buy more stocks.

But should his portfolio decline in value and his margin debt is no longer supported by sufficient collateral, then he must either pay down the margin balance with cash or sell stocks to reduce his margin debt. That's deleveraging.

To help explain the process of deleveraging and its consequences, I prepared the chart below based on data from the Bureau of Economic Analysis, a federal agency within the Department of Commerce.

Rising Home Equity Supported Debt Bubble

For the two-thirds of American households that owned a house during the great housing bubble, rising home equity provided collateral to support more debt via refinancing, second mortgages or home equity lines of credit.

The rise in liabilities (debt) during the past decade is shown on the chart. During the heyday of the housing bubble, U.S. households were adding about $1 trillion in net mortgage debt and over $1.5 trillion in total net liabilities every year.

To put this vast borrowing in perspective, American households added $1.8 trillion in net liabilities in 2006 alone, almost 14% of the entire U.S. GDP that year ($13 trillion).

According the Flow of Funds report of the Federal Reserve, homeowner equity was 60% of real estate owned in 2005, roughly $13.2 trillion. By the first quarter of 2008, homeowner equity had fallen $4 trillion, to $9.3 trillion total and 47% of real estate owned.

Write-Downs Reduced Mortgage Debt

The chart shows what happened in 2008 as the housing bubble began deflating in earnest: Mortgage borrowing not only stopped rising, it actually fell as principal payments and write-downs reduced outstanding mortgage debt. Other net liabilities (nonmortgage debt) increased by a negligible $46 billion in 2008.

That's deleveraging: Americans stopped adding to their skyrocketing mortgage debt in 2008 and actually paid down what they owed.

The declines in housing values and the stock market hit the collateral of U.S. households hard, as net worth (financial assets and real estate) declined by a horrendous $11 trillion from 2007 to 2008.

Once collateral dries up, that leaves no basis for further leverage (borrowing), and that's exactly what the data show: Households stopped adding debt and started paying it down instead. Not only that, but the household savings rate rose as well.

Vanishing Collateral

The current Fed Flow of Funds paints a sobering picture of U.S. net worth and homeowner equity: Home equity dropped from $13.2 trillion in 2005 to a low of $5.3 trillion early last year. It has since recovered to $6.3 trillion, but that's nearly $7 trillion less than in 2005.

That's a lot of vanished collateral.

As a percentage of real estate owned, homeowner equity fell to 33.5% at the nadir last year and has recovered to 38% -- still a far cry from the 2005 level of 60%.

Two factors influence homeowner equity: rising valuations and declining mortgage balances. As the chart illustrates, Americans have been paying down their mortgage debt, increasing their equity. And though the rise has been modest, home prices in some areas of the nation have stabilized or even risen slightly from their 2009 lows. These two factors account for the rise in home equity from early 2009.

A Little Less Debt

Still, homeowner equity is down by more than half from 2005, and even with the dramatic rise in the stock market since the March 2009 low, homeowner net worth is still $10 trillion lower than it was in 2007 ($64.5 trillion in 2007 and $54.2 trillion at the end of 2009).

Even though consumer credit and mortgage debt has declined, it has fallen by very modest amounts: where households had $14.4 trillion in liabilities at the start of 2008, they now have about $14 trillion. That decline is certainly welcome news to debt-laden households, but it pales compared to the $7 trillion lost in home equity and the $5 trillion decline in financial assets ($50.7 trillion in 2007, and $45.1 trillion at the end of 2009).

Clearly, the big news is not that U.S. households have reduced their debt by a modest amount. The big news is that they have stopped adding trillions of dollars in new debt as they did during the housing bubble.

Happy Days Aren't Quite Back Yet

Some observers have heralded the stabilization of house prices as evidence that "the bottom in real estate is in." As DailyFinance reported recently, price increases are modest at best in most markets, and housing values are still declining in some markets.

Even with a rising stock market and stabilizing home prices, household collateral (home equity and financial assets) is still down by over $10 trillion from 2007.

While many pundits were ready to declare "happy days are here again" because consumer spending rose slightly in February and new home sales logged a sharp rise, the deleveraging painted by the statistics for home equity, net worth and household liabilities reveal that U.S. households are far from rebuilding the equity and collateral needed for a sustained rise in new consumer debt.