Recession Over? Household Balance Sheets Tell a Different Story

Although the Great Recession officially ended in June 2009, the strength and sustainability of the recovery is still in question. While the statistical pulse of the economy -- GDP, industrial production, personal income and retail sales -- have all risen smartly from the recessionary bottom in March 2009, the experience of the average citizen remains mixed: unemployment is still high, and there is a pervasive sense that the recovery is tepid at best.

One way to make sense of the question "is the recession really over?" is to look at the American household as a business. From this point of view, the household balance sheet is of paramount importance.

In a typical business-cycle recession, companies over-expand and take on too much debt. When income declines, they suffer a cash crunch, and must reduce expenses, capacity and debt and rebuild cash for future expansion. This is called repairing the balance sheet.

So the question becomes: have U.S. households repaired their balance sheets? If they haven't -- if they're still burdened by excessive debt, low cash reserves and stagnant income growth -- then the "end of the recession" loses much of its promise of solid recovery.

Skewed Income Growth

There is another key factor at work in the household balance sheet: the wealth effect (also called the Pigou Effect). When income and household wealth (or perceived wealth, such as home equity) rises, then consumption tends to rise as well.

If we are richer, or even feel richer, then we spend more. We all saw this in action during the 2001-2007 housing bubble, when rising home equity encouraged households to borrow and spend freely.

The front-end driver of the wealth effect is income. Though aggregate personal income has nudged higher, rising from $10.4 trillion in 2007 to $11.3 trillion in 2010, most of this increase flowed to the top 5% of households. For the other 95%, income is down to flat, meaning the economy's recovery isn't being fueled by widespread higher incomes.

The back-end driver of the wealth effect is the balance sheet of assets and liabilities. If the household balance sheet has recovered, then the recovery may well have legs.

Count the Assets

The Federal Reserve issues a comprehensive financial snapshot of the economy called the Fed Flow of Funds Accounts. Within this is the Balance Sheet for Households and Non-Profit Organizations, which offers a wealth of data on households' assets and liabilities.

Let's start with total assets: all tangible wealth, financial assets, real estate, everything up to and including the kitchen sink.

Prerecession (2007), households and non-profits held $78.6 trillion in total assets. At the bottom in the first quarter of 2009, that fell to $65.7 trillion -- a decline of almost $13 trillion.

For context, that's roughly the size of America's annual GDP.

As of June 2010, the figure had bounced back a bit to $67.4 trillion: up $1.7 trillion but still down a substantial $11.2 trillion from pre-recession levels. Net worth -- assets minus liabilities -- is also still down, falling $10.7 trillion from 2007 to 2010.

Clearly, the recovery in assets has been weak.

Deposits -- cash in banks and money market funds -- actually rose in the recession, suggesting households were turning other assets into cash:

· December 2007: $7.4 trillion
· March 2009: $7.9 trillion
· June 2010: $7.5 trillion

How About Housing and Consumer Credit?

The primary asset for many U.S. households is the family home, so home equity plays a major role in the wealth effect. Mortgage debt has declined modestly, from $10.5 trillion to $10.15 trillion. While some of this reduction in real estate debt results from households paying down mortgages, the majority of the decline stems from defaults and write-downs by lenders.

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One striking data point pops out: the tremendous increase in mortgage debt from 2004 ($7.8 trillion) to 2007 ($10.5 trillion) -- a rise of $2.7 trillion, or 35% in just a few years. In the years since the bursting of the housing bubble, mortgage debt has barely budged. That suggests households are still shouldering heavy debt loads.

The net result of stubbornly high mortgage levels and lower home valuations can be seen in homeowner's equity, which has fallen from $13.1 trillion in 2005 to $6.9 trillion in June 2010 -- a drop of $6.2 trillion.

While home equity has risen $700 billion from the March 2009 low, the $6 trillion hit to U.S. homeowners' balance sheet is a stark reminder of the long-term consequences of heavy real estate liabilities and lower real estate valuations. Owner's equity as a percentage of household real estate hovers at 40%, down from almost 60% in 2005.

As for consumer credit, one important reflection of retail sales and the wealth effect, it has barely budged from $2.5 trillion in pre-recession 2007 to $2.4 trillion in June 2010.

The Foundation Still Has Cracks

Some observers are now suggesting that U.S. households have not really repaired their balance sheets, which may in fact be getting worse. According to the Fed and the Federal Deposit Insurance Corporation, banks and other lenders wrote off $588 billion in mortgage and consumer loans from 2008 to 2010. The Fed Flow of Funds reports that total household liabilities -- bank loans, mortgages, credit card balances, etc. -- have declined from $13.8 trillion in 2007 to $13.4 trillion, a drop of $400 billion. If lenders wrote off almost $600 billion, yet liabilities only dropped by $400 billion, then it appears households actually added $200 billion in debt.

As I argued back in April (see "Why the Deleveraging of U.S. Households Matters"), the massive decline in home equity removed a key prop from American homeowners' borrowing and spending. While home equity has risen modestly recently, it is still down $6 trillion from its peak. With increases in incomes concentrated in the top strata of households, there is neither the collateral nor increased income to support further borrowing or spending.

So it looks like household balance sheets have a long way to go until they are looking healthy again. Put together still-lofty levels of debt and extremely modest bounces in net worth and income, and you get a shaky foundation for a sustained recovery.