Unrealistic Expectations of Debt Risks
by Alasdair Biggs
Sub-prime Bust: Financial Advisors and Wall Street commentators always quote incorrect statistics with regard to debt, this is endangering the entire credit system.
The approach to debt of the Fed under Greenspan and Bernanke, plus the fiscal policies of the US government over the last 6 years, have gone beyond anything previously known for the world’s foremost economic power. Massive expansion of broad money (M3) through credit creation by the Fed, which has subsequently spread around the globe, is a catastrophe waiting to happen. Indeed, this is so clearly the case, in that issuing ever more credit will eventually lead to a sharp pullback in liquidity, that informed observers are at times left aghast at the widespread complacency in the market place. One wonders of the people with large brains who work at the Fed, and for investment banks, do they have some idea of the trouble which has been brewing?. With all this loose credit which has been flooding the mortgage markets, the financial markets and even personal spending for the last decade, surely they can see a storm on the horizon?
When one looks at historical debt levels in comparison to income levels (not asset valuations) you can see that currently the US and others are at a a truly astronomical level of indebtedness. Most 'analysts' or 'advisors' will compare debt levels to asset value levels , such as comparing mortgage debt to house price valuations. The house, share or fund holding, or car etc in this case being the asset used to measure against the outstanding debt and interest owed. Often quoted by economists and the like, this measure of debt currently has the US consumer merely to a level of excess, significantly above average but not to an unprecedented degree of indebtedness.
The error made here is that when you incur a debt, you have to pay it off someday, it will not go away unless you clear it using cash. Whereas, an asset value can change, and quickly, assets can go away by becoming less valuable.
In reality, if your house goes down in value by 50,000 dollars and your shares by 10,000 you now have $60,000 less assets than you did before, so suddenly your debt to asset ratio can change a great deal as your debt will not go down along with your notional asset value. Sadly, you can only reduce debt with flows of cash income, be they earned in a job or re-levered with a different lender (i.e. borrow from one new credit provider to pay off another) or even earned through good investments.
Clearly, the current most popular choice, for literally tens of millions of consumers, is rolling debt over to another creditor (or re-leveraging as it is known), which in turn means your debt will not go down much, perhaps a little due to a better interest rate. Even more sadly, typically your debt will likely over time increase due to costs, late payment charges and unpaid interest accrued. Yet your debt may inflate most of all due to extra debt being taken on, the temptation to raise the debt you carry by say 10%, thus allowing you to extract a cash flow to buy a new flat screen tv or indeed as statistics troublingly often demonstrate, just to pay the bills when your financial situation has taken a short term dip. This is called equity extraction and is most commonly of the cash out mortgage variety.
At some point in time you have to pay off some debt capital, as opposed to just interest payments, or else forever be doomed to paying a larger and larger share of your income in interest. Such a fate is not welcomed by many so eventually people realise they have to reduce their indebtedness.
Thus, in order to pay off your debt, you have to use your INCOME. So if you have a mortgage at 4 times your income level, plus say $25,000+ in credit card, car loans and university loans, you are economically now a debt slave. To show this I include a fictional yet typical example here: -
An example of typical personal debt
Say Mr A Mugh earns $40,000 per year after tax and insurance (annual salary of $60,000) and bought a small apartment this year for $240,000 with a 100% mortgage paying 6.5% interest per annum he will have to pay almost $20,000 per year in mortgage payments. This twenty thousand comes out of his income and is a direct drag on his economic activity, i.e. his spending.
He still has to deal with his $25,000 in credit card, car loan, tv loan and store card debt. On these he pays much higher rates of interest, but say he is reasonably smart he can keep this down to an average of say 9%. Mr A Mugh will therefore pay $2250 per year in interest only charges on this debt. If he wishes to pay this debt off over say 10 years he must also pay off capital of $2,500 per year.
Hence his debt service outlays are about $25,000 per year on take home earnings of $40,000. Leaving him a measly 300 bucks per week to pay utility bills, food and clothing and any property taxes, plus of course enjoyment, holidays etc.
Previously, let us say as an example, he was paying only $1,200 per month rent and was spending $2,500 on credit per year. Mr A Mug was previously spending $28,000 per year after rent. Now as we have seen he will only have $15,000 a year to spend due to his decision to start paying off debts and own his own home. His reduced spending effectively will hurt the places he spends his money, yet his debt to asset ratio has improved as he now owns a home, whereas before he had no assets. At the same time as debt to assets improving, his debt to income ratio has worsened from about 0.6 to over 4.5, and he is now spending less money on consumption, which is 72% of the US economy.
In order to get back to his old spending levels he will have to grow his income by a staggering 30% in real terms (i.e. above inflation matching wage increases of say 3.5% per year). The major problem here for most of the good people of the USA is that median income levels have been flat or falling for 5 years.
Real world effects
The scenario I have described above is quite indicative of the current prevailing culture of debt and is not an extreme case and in fact such a case is not untypical of mortgages rated well above sub-prime, i.e. your normal employed US citizen with a wife and kids is very very often in such a situation. Sadly, there are millions of cases worse than indebted to say 5 times income.
Unless a person wants to always be in debt to everybody’s favourite high street creditors they really must pay off some debt. Therefore, in order to gain the cash income to pay off some of your debt, and not just keep treading water until the day you die, they have two choices:-
1) to earn more money (yet we cannot all earn more money, indeed about half of the US population is now earning LESS money in real terms than in 2000)
or
2) to sell some of your assets, car? house? pension savings? (what other sellable assets do most people have, perhaps a few grand of shares at the very most)
When debt levels are more normal and the economy functioning well, the majority of people will successfully take option (1) and will gradually pay off their mortgage and other debts, preferably before they retire.
The favourite statistic used by those who deny there is a serious problem with debt levels in US society, is the Debt to Asset ratio, which is currently quite normal (pretty high certainly, yet still normal), the problem here is that this balance can change overnight. Debt will not go down when your shares do or your house has a lower value. Debt is constant unless you pay it off using CASHFLOWS, earnings from work or investing etc.
Unless you sell your house or rent it out you will receive no income from this asset. Hence regardless of the value of your house, it is your income which will pay those mortgage bills or pay off that car loan or store card balance. Yet try telling this to an analyst or loan advisor, all they will do is quote you the debt to asset ratio, which assigns current market value to your house and investments, even though market value is purely notional unless you actually sell the asset and receive cash to ‘book the gain‘.
Cashflows, i.e. income, is used to service and pay off debt, unlike the notional value of your assets. As of the end of 2006, Debt to Income ratios in the US currently stand at 132% of after tax income for every man woman and child in the USA. This is a record high and has increased from 108% since 2002 alone! Nominal personal debt has increased in this time from $8.46 trillion to $12.8trillion in the last 5 years. (figures extracted from Federal Reserve - Flow of Funds data). We are at historically unseen debt levels when compared to income levels, there has never been anytime in history where people had so much debt compared to their actual income. Indeed when looking at long term figures there has never been any period where debt to income levels have come close to today’s levels.
The Great Deception
Any fool can comprehend the details above. Apart from the lucky few percent who can pay off their debt by selling off good investment assets, most people will have to pay off their debts using their income from their jobs (the same income as mentioned above is on average going down slightly every year in real terms). Again I state, any fool can see the truth of the matter once it is explained to them.
Given the rather obvious nature of debt to income, and that a person’s assets will not pay off any of their debt at all, unless they are sold, why oh why do mortgage advisors, and financial analysts and economists pretend that assets are used to pay off debts? Continually they will fire off to anybody who will listen that the debt to asset ratios of US households are normal (if a little high) and as such people who are concerned that Credit Boom will lead inexorably to Credit Bust are simply fools or troublemakers. These same advisors and commentators seem to believe that your house will magically pay off your debts simply by its very existence. They will then doubtless fail to mention that you have to sell the house first and move into rented accommodation in order to achieve the asset-enabled debt freedom? In other words, for your assets to pay off your debts you must first lose your home (willingly or otherwise) and start renting again!!
This statistic, along with deeply suspect inflation and unemployment data, is widely used to justify the Goldilocks view of the US economy, being those Federal Reserve briefings view of the US economy- the all is pretty rosy view of the US economy. Such a view is likely what you will find if you consult a financial advisor, the very same one who will advise you on what mortgage to take out with his or her firm.
On the Wall Street analysis level, the irrelevant and misleading debt to asset ratio, along with afore-mentioned suspect inflation and unemployment data, is used to justify a bullish view of the market and the new paradigm economy drivel. “Things work differently from how they used to”, “the old rules do not apply”, all the same rubbish being touted to the public as was the case in 1999 with the technology boom and hence bust.
The pressure is immense on Wall Street analysts to be overly positive, in order to please clients and gain their business. Afterall, if you tell a prospective investor the economy is in trouble they are much less likely to use your services to buy and sell shares or indeed anything else. Time after time Wall Street analysts will present rosy pictures of debt issued by their customers, those investment banking fees for bonds issuance are just too good to miss!!
This same pressure to present a rosy view is also widely at play in the personal debt market.
Delusion as a Sales Trick
When an individual is determining their own propensity to acquire more indebtedness, generally, the individual will look towards their debt level and compare it to their income. This is only the natural response of a person to compare anything to the income they receive, the yardstick of measurement as it were. Yet when they see financial reports, they are deceived into thinking otherwise by the widespread use of comparisons of debt levels to asset values. This faulty comparison leads them to an overly optimistic view of their own finances. Such assessments (of debt to asset values) reduced the perceived level of risk in taking out more debt. Whereas comparing debt to your own income level will leave a person with a more realistic view of the risk they face, afterall, as noted above, the income level will be used to pay off the debt unless a person wishes to lose their assets in order to pay their creditors..
Taking in combination the teasing of the individual with advertisements for more or cheaper debt “oh it such a nice thought to have that holiday” and the perversion of the individuals perception of debt risk, and you have a heady combination. People are bombarded with offers telling them that more debt is a good thing, yet most people would actually ignore unreasonable offers if they have realistic expectations of risk. Even your average individual knows when to stop, although clearly some will always fall for marketing.
What actually makes so many of these people take on more debt than they can afford, is a reduced perception of debt risk. People are fed a line by financial advisors and Wall Street analysts that their debt level should be compared to something other than their income. In other words , they are fed the unrealistic expectation that taking on so much debt is a low risk business, because the current value of their home is so high and homes don’t go down much in value, do they?
Unrealistic expectations are fed down the chain from the serious Wall Street economists and financial analysts, who are read by your local financial advisors. They in turn will tell Mr & Mrs Jones who come through the door, that of course it is normal to buy a house with a 4 times earning mortgage and no down payment.
I state again, all of this unrealistic expectation of risk free indebtedness comes from the false usage of debt to asset levels as a barometer of relative debt accrued over any given period of time. The only value comparable to debt levels is income, as it is income which pays off debt. Other than the top 10%, most people who end up relying on assets to pay off debt are those who lose their homes, either through repossession or being forced to sell and go back to renting.
Unrealistic expectations lead to weak debt structures, and this is now what the US economy is swamped by (or soon will be - literally). Weak debt structures, risky debt masquerading as good quality debt. Again, just like so much else it is all built on a pack of lies fed down from the top end analysts to your local financial advisors and then on to Joe public.
The situation is actually enabled on the macro financial level by unrealistic expectations of debt risk created by the vast hedging industry where debt is repackaged into bundles which then have derivatives created off them. The perception is that the risk level is this reduces, it is not, it is simply moved about. Let us face facts, you cannot reduce risk by creating a potential liability of tens and hundreds of trillions in the debt risk hedging markets. All you do is move the risk around, perhaps even creating new risk.
Risk is repackaged and moved on and indeed greater risks than would otherwise have been are taken on by financial institutions because their analysts too believe the lie that debt can be mitigated by asset values or risk reduction exercises. Hence the system is further overloaded, in endemic fashion, CREDIT OVERLOAD, from top to bottom, from the macro level tens of trillions of dollars to those with a $5,000 credit card debt.
So watch out for the coming big credit crunch, when unrealistic risk expectations are dashed and risk is again measured correctly at every level of the economy, just as in 1929, the only promise I can make is that it will hurt, it really really will hurt.
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