EconSouth (First Quarter 2004)


Consumer Debt:
How Much Is Too Much?

 

When does household debt become too heavy? With consumer spending central to economic vitality, the question is frequently asked. The answer is elusive and can vary depending on how it is measured.

Photo by Flip Chalfant
While some measures of household debt are rising, it is very difficult to determine the point at which consumer debt levels threaten continued economic growth. In fact, by some economic yardsticks, the financial stress on American households has not increased but has remained stable.

Almost daily, news outlets report information about the staggering amount of personal debt Americans have accumulated. Is it safe to conclude that consumers’ debt has become unmanageable—that the spending spree threatens to become a burden that could depress economic growth? Depending on the criteria used to assess consumer debt, not necessarily.

When does household debt become problematic? In times of exuberant economic expansion, consumers count on increasing asset values and incomes to offset the cost and potential risk of holding debt. During economic slowdowns, though, red ink can spell trouble for households overextended on credit.

In contrast to patterns during previous recessions, consumer borrowing did not ease during the 2001 recession or the ongoing recovery, which has thus far been characterized by weak employment growth. And lenders have persisted in lending, reaching ever deeper into the risk pool to extend credit. The good news is that consumer spending has steered the nation’s economy in recent years. The bad news is that household debt could further dampen the recovery. And some evidence—namely, an uptick in bankruptcies, delinquencies, and foreclosures—shows that excessive debt may be stressing some consumers. These measures were up between 2000 and 2003, both nationally and in the Southeast.

While these numbers are generally rising, it is very difficult to determine the point at which consumer debt levels threaten continued economic growth. In fact, by some economic yardsticks, the financial stress on American households has not increased but has remained stable.

A snapshot of U.S. household debt
Household demand has been the main engine for growth in real gross domestic product (GDP) since the 2001 recession, accounting for 2 percentage points of the overall 2.5 percent average annual gain in GDP between December 2001 and June 2003. But as household spending has grown, so have debts: Consumers racked up $1.1 trillion in new mortgage and consumer debt between the end of 2001 and the third quarter of 2003, bringing the total of consumer and mortgage loans held by Federal Deposit Insurance Corp. (FDIC)–insured institutions to $2.6 trillion, according to the FDIC.

Foreclosures and
the Housing Market

Recent spikes in home foreclosures are attributable to two factors, according to Suzanne Boas, head of Consumer Credit Counseling Service of Greater Atlanta Inc. One factor is lenders’ growing willingness to reach deeper into the risk pool to grant loans to individuals who would not previously have qualified, and the other factor is low down payment requirements that permit buyers to enter the market with fewer resources.

The feasibility of overextending to buy a home, choosing interest-only mortgage options, or cashing out home equity rests entirely on the premise that home values will continue to rise. While the Southeast’s housing market has thus far remained a bright spot in the economy, after a long boom it is likely poised for some moderation in growth. Most commercial forecasters believe that higher interest rates are inevitable as the economy strengthens, and studies indicate that higher interest rates slow home sales.

In Georgia, growth in home sales and in home price appreciation, especially in urban areas, has begun to decelerate. In contrast, median prices for homes in Florida metropolitan areas continue to rise at more than twice the national average of approximately 5 percent. FDIC economists observe that Florida’s rapidly appreciating house prices could put homes out of the reach of some consumers.

To be sure, debt expanded significantly during the 1998–2001 period as well. But income growth and asset appreciation, fueled by increases in the value of homes and equity holdings, reduced the ratio of debts to assets so that the proportion of a typical family’s earnings devoted to debt repayment actually decreased, according to a study of U.S. family finances in the January 2003 Federal Reserve Bulletin. But, according to other Federal Reserve data, household net worth dropped $4.2 trillion between the beginning of 2000 and the end of 2002, largely as a result of declining stock values. In addition, many consumers used home equity to pay down credit card debt or finance further spending.

How serious are the current accumulations of debt and the rising levels of bankruptcies, delinquencies, and foreclosures? Clearly, some households now appear to be more vulnerable to the impact of job instability, fluctuations of the housing market, and rising interest rates.

A resumption of significant job creation and income growth would make it possible for consumers to navigate their red ink. But looking ahead, some analysts have doubts that consumer spending will be as big a driver of economic growth as it has been during the past few years, even if the employment and earnings situations improve. One reason is that some resources that consumers would spend on general purchases will be diverted to the cost of servicing debt, which in some cases could rise if interest rates move up as the U.S. economy gains strength.

Debt has expanded despite the recession

During previous recessions, the growth rate of household debt dropped as consumers retrenched and cut back on spending. But during the most recent recession, low interest rates and flexible loan arrangements attracted many first-time home buyers and encouraged home refinancing.

According to the FDIC, about 90 percent of the credit expansion between 2001 and 2003 was for first-time home loans and refinancing. About 50 percent of the consumers refinancing their homes took cash-outs that averaged around $27,000, thus decreasing the equity in their homes. Those who have not yet accrued significant equity or who have cashed out equity are heavily dependent on sustained rates of growth in the housing industry. Will Roberds, a vice president and economist in the Atlanta Fed’s research department, notes that 20 percent of all home loans are over 90 percent loan-to-value ratios, suggesting that some owners are vulnerable to potential declines in house values.

Growing consumer debt can also affect lenders. Credit has become easier to obtain than it has been traditionally as lenders have been extending it to families and individuals who would not have qualified during earlier periods.

A slowdown in the housing industry because of market saturation or higher interest rates could adversely affect homeowners and lenders. However, as Federal Reserve Chairman Alan Greenspan noted in a speech in February, “the financial obligations of homeowners have stayed about constant because mortgage rates have remained at historically low levels.” Greenspan also pointed out that homeowners’ financial obligations ratios have remained relatively constant despite very rapid growth in mortgage debt, partly as result of the enormous wave of refinancings of existing mortgages at lower interest rates.

Increased risks to lenders?
Growing consumer debt can also affect lenders. Credit has become easier to obtain than it has been traditionally as lenders have been extending it to families and individuals who would not have qualified during earlier periods.

Automated credit scoring has expanded and expedited access to credit, and risk-based pricing has made it possible for institutions to extend credit to subprime (higher-risk) markets at higher rates to compensate for losses they may incur. According to a report in the Feb. 3, 2003, issue of Inside B&C Lending, subprime assets at FDIC-insured institutions nearly doubled between 1999 and 2002, rising from $29 billion to $54 billion. Subprime mortgages also have risen dramatically, from $35 billion in 1994 to $213 billion in 2002. In addition, the highest increase in credit card usage between 1989 and 2001 was by families in the lowest and second-lowest income quintiles, according to the FDIC.

Subprime borrowers account for 30 to 40 percent of the $1 trillion in credit card debt nationwide and for 15 to 20 percent of the overall $8 trillion to $9 trillion in mortgage debt. Though credit card companies and lenders are throttling back loans to the subprime market, exposure in this category is still significant, says Roberds. Delinquency rates on subprime and high loan-to-value loans have typically been higher than on conventional loans, but in 2001 subprime delinquencies spiked dramatically and remained high into 2003. However, lending institutions expect to reap high profits from subprime borrowers paying high interest rates and late fees as long as default rates are not higher than lenders anticipate.

In addition to extending credit to new markets, credit card companies have intensified their marketing efforts. According to data from Synovate Mail Monitor, credit card companies issued 5 billion solicitations by mail, about 50 for every American household, in 2001.

In addition to extending credit to new markets, credit card companies have intensified their marketing efforts. According to data from Synovate Mail Monitor, credit card companies issued 5 billion solicitations by mail, about 50 for every American household, in 2001—five times as many as in 1990.

Increases in bankruptcies may point to stressful levels of consumer debt (see sidebar). Nonbusiness bankruptcies increased by about 30 percent in the United States between 2000 and 2003. Many analysts have pointed to higher bankruptcy rates as a symptom of a significant consumer debt problem. But in his February speech Greenspan noted problems with using bankruptcy rates alone as a measure of consumer debt. “Elevated bankruptcy rates are troubling because they highlight the difficulties some households experience during economic slowdowns. But bankruptcy rates are not a reliable measure of the overall health of the household sector because they do not tend to forecast general economic conditions, and they can be significantly influenced over time by changes in laws and lender practices.”

Where the Southeast stands
There’s no doubt that the U.S. economy continues to grow, at least in terms of GDP. But what is the current financial condition of consumers in the Southeast?

Declining numbers of jobs during the recession and weak job growth since the end of the recession have largely been the result of ongoing losses in the manufacturing sector. These forces have quelled job numbers in states that have a large manufacturing presence, and especially in rural areas where many manufacturing plants are located.

Because it has a relatively small manufacturing base, Florida has been one exception to this trend. Ongoing growth in housing construction and a rebound in the state’s important tourist sector have also boosted Florida’s economic performance.

In contrast, according to Bureau of Labor Statistics (BLS) estimates, Alabama, Georgia, Louisiana, Mississippi, and Tennessee have averaged an annual decline of more than 4 percent in their levels of manufacturing employment since 1999. These losses have been devastating for many individuals and communities, especially since many of these manufacturing jobs are unlikely to return. Indeed, the most recent BLS employment projections for the United States have forecast no net growth in the number of production jobs over the next decade. The severity of the unemployment situation in rural areas is in sharp contrast with the situation for urban areas: As of the fourth quarter of 2003, about four out of five metropolitan areas in the Southeast had unemployment rates lower than their respective state average.

States hit hardest by losses of manufacturing jobs show the highest ratios of nonperforming loans to total loans. For instance, FDIC studies show that banks in Mississippi and Tennessee held the nation’s highest percentages of delinquent loans in the third quarter of 2003. The national average then was 2.2 percent while Mississippi banks registered 4 percent and Tennessee banks, 3.3 percent. Past-due loans stood at 2.7 percent of total loans in Alabama. But despite those high percentages of past-due loans, the levels of delinquent loans appear to be stabilizing in all three states.

Past Due U.S. Residential
Mortgage Loans

Note: Seasonally adjusted U.S. total delinquency rates of one- to four-unit residential mortgage loans
Source: Mortgage Bankers Association, Haver Analytics

Another indicator of financial distress—mortgage delinquencies—is especially relevant since home building has been a major economic engine in many parts of the Southeast in recent years. In Florida, in-migration combined with low interest rates has stimulated housing demand. These trends in turn have supported spending, buoying the region’s economy.

According to data from the Mortgage Bankers Association, delinquency rates on all types of mortgages increased in the United States with the onset of the recession and have remained elevated, up about 75 basis points to 4.5 percent from their low in the first quarter of 2000 (see chart).

Interestingly, coming out the last recession in 1992 delinquency rates fell steadily. The Southeast traditionally has delinquency rates above the national average, and in some states, such as Mississippi and Louisiana, the rates are typically around 2 to 3 percentage points higher than the national rate. In the Southeast, most states have recently been tracking the trends for the United States as a whole, much as they did in the early 1990s. Notably, Florida’s delinquency rates, the lowest in the Southeast, have shown signs of declining further since the end of the recession. As of the third quarter of 2003, Florida’s mortgage delinquency rate stood at almost the same level as the nation’s.

Home foreclosures are another statistic analysts watch closely. Especially in the metro Atlanta area, foreclosures continue to skyrocket (see sidebar). According to EquiSystems LLC, which monitors Atlanta-area real estate foreclosures, between 2001 and 2003, the number of homes in foreclosure in metro Atlanta rose from 19,732 in 2001 to 34,842 in 2003, an increase of more than 76 percent. A lackluster job market could make homes less affordable and dampen the housing market. Another view, however, is that a resurgence in employment and earnings will keep housing markets on track.

In the long run, says Roberds, job and income growth will be critical to the economy’s ability to process the accumulation of debt. The big question, he says, is “When is the job market going to come back? It hasn’t yet—it’s just quit bleeding. If we see a return in jobs, I believe that we can feel better.”

Making sense of household financial obligations
Are consumers being engulfed by their accumulated debt, one mishap away from financial calamity? Or are they managing their debt adequately through the steady appreciation of their assets? Depending on the criteria you use for evaluation, either scenario is possible.

During the economic expansion of the 1990s, Greenspan noted, both debt service ratios and financial obligations rose modestly. But in the past two years, he points out, both ratios have been essentially flat. These patterns seem to show that households are managing their debt. “Overall, the household sector seems to be in good shape,” he said, “and much of the apparent increase in the household sector’s debt ratios over the past decade reflects factors that do not suggest increasing household financial stress.”

When it comes to consumer debt, opinions and data series point in various directions, and it’s important to maintain a nuanced perspective on consumers’situations.

Particularly during periods of recovery, it’s difficult to determine the point at which household debt burdens become a significant problem that could affect the nation’s overall economy. When it comes to consumer debt, opinions and data series point in various directions, and it’s important to maintain a nuanced perspective on consumers’ situations.

 

Some Consumers Are Especially Vulnerable to Debt


Problem debt comes in two basic forms, according to Suzanne Boas, head of Consumer Credit Counseling Service of Greater Atlanta Inc., an organization that works to help households resolve debt issues (see Q&A article). Behavioral debtors are people who habitually overspend: compulsive and impulsive shoppers, gamblers and risk-takers, and those who can’t distinguish wants from needs. Situational debtors are people who become overly reliant on credit when they’re confronted with life crises such as illness, accidents, the loss of a spouse, divorce, or unexpected job losses. Boas says sometimes the two categories merge. People who are managing to juggle high levels of debt can slide into insolvency rapidly when faced with a blow to household finances.

Many households live from paycheck to paycheck, she says. “They have no cushion to respond when an emergency hits,” she notes. “Given the low savings rate among Americans, too many households are just a paycheck away from serious financial problems.”

Boas, whose organization also serves some markets in south Florida, observes increasing numbers of elderly people accruing debt. For example, senior citizens, particularly in Florida, are opting for reverse equity home loans to compensate for stock market losses and to cope with the rising cost of health care. A climate of low interest rates has also compromised the investment income many seniors depend on.

Some consumers face particularly large financial obligations. For example, while homeowners’ debt service ratios have remained relatively stable, the rise in the ratios for renters has been steep.
Alan Greenspan
Federal Reserve Chairman

Students are another vulnerable group. In addition to using credit cards to finance their living expenses, educational debts are increasingly onerous. The average student loan debt among full-time students who borrowed for college in 2000 was $17,000, compared to $9,200 in 1992, according to the American Council on Education. In 1993, only 5 percent of seniors graduating from college had debts of $20,000 or more whereas 33 percent of seniors graduating in 2000 had debts of that amount.

Angela Lyons, an assistant professor of economics at the University of Illinois who has researched students’ finances extensively, says increasing numbers of students are assuming responsibility for the financial burden of their educations. At the same time, education costs are rising, and financial aid grants are drying up.

Some consumers face particularly large financial obligations. For example, while homeowners’ debt service ratios have remained relatively stable, the rise in the ratios for renters has been steep, said Federal Reserve Chairman Alan Greenspan in a speech in February. He noted that in recent years, renters, who typically are younger and have lower incomes than homeowners, have been using a higher fraction of their incomes for payments on student loans and used-car debt. “This trend might be worrisome if it indicates greater difficulties in becoming financially established,” he said.

 

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