U.S. households continued to repair their tattered balance sheets in 2011. Outstanding household debt (which includes mortgages, credit card balances, and other types of consumer loans) fell further this year and is now down 5 percent from its peak in 2008. To be sure, a lot of this decline has occurred through defaults on household debt: Data on charge-offs by financial institutions suggests that the dollar volume of such defaults since the beginning of the financial crisis is about two-thirds as large as the total decline in household debt over this period. Defaulters suffer negative consequences such as reduced future access to credit, and they can also face personal disruptions like the loss of a home. But, defaulting does remove debt from their balance sheets just as more traditional forms of deleveraging would.
One important benefit of this deleveraging is lower monthly debt payment obligations. The decline in debt outstanding, together with the low interest rates that have prevailed in recent years, has reduced required debt service payments for the nation as a whole to their lowest level as a share of after-tax household income since the mid-1990s. The share is now nearly 3 percentage points below its peak. In other words, on average, households now have discretionary monthly cash-flow that is about 3 percent higher than where it would be in the absence of the deleveraging.
These trends represent real progress toward the necessary strengthening in households’ financial positions. However, we still face significant challenges related to household debt. One issue is that yet more deleveraging is needed. This need can been seen most easily in the statistics on the number of “underwater” borrowers-those that have mortgage debt that exceeds the value of their homes. According to Corelogic, 22 percent of all residential properties with a mortgage are underwater, with the average underwater borrower having about $65,000 of negative equity. Many of these mortgages are likely to be unsustainable over the long run.
There is no easy solution to the problem of negative equity. Banks are unlikely to engage in wide-scale principal reductions because of the substantial cost of doing so. The government could induce more principal reductions by subsidizing them, but such a program seems unlikely given our federal budget challenges, not to mention the political controversy surrounding the issue of what many Americans perceive to be a “bail out” for irresponsible borrowers. Meanwhile, many underwater borrowers are left in limbo because they cannot sell at a loss and may not be able to pay their mortgages. Moreoever, there is a great deal of uncertainty about future possible defaults and their consequences for communities and the financial system. The implications for the economy are not good.
A second issue is that new borrowing remains difficult for many households. The problem is not just that some prospective borrowers have weaker credit histories because of job loss thanks to the lingering effects of the financial crisis and other misfortunes. Banks are also more conservative in their lending practices now such that many households who would be able to get loans in normal times cannot find financing for their purchases. Similarly, there are creditworthy households who are having difficulty refinancing into a lower interest rate loans in order to save on their mortgage payments and free up cash for other purposes. To this point, Fed Chairman Ben Bernanke said last June that, “roughly about the bottom third of people who might have qualified for a prime mortgage, in terms of, say, FICO scores, a few years ago, cannot qualify today.” Credit conditions are thawing and recent changes to the Home Affordable Refinance Program are designed to increase banks’ willingness to lend, but we have a long way to go.
Consumer spending has perked up of late. Retail sales have increased at a solid clip over the last three months, and purchases of vehicles have reached their highest level since the middle of 2008. A reduced debt service burden and slightly easier access to credit likely lent support to this spending. If hiring picks up in response to the increase in demand, this faster pace of purchasing is likely sustainable. But, it is hard to see consumer spending being really robust in 2012 until we resolve our lingering debt problems.
Overall, then, consumer deleveraging in 2011 strengthened household balance sheets further, which should, in turn, help more Americans to open their wallets and start spending again. But, important household-debt-related headwinds remain and are likely to continue to hold back the economic recovery in 2012.