James McAndrews: Rising household borrowing
Remarks by Mr James McAndrews, Executive Vice President and Director of Research of
the Federal Reserve Bank of New York, before the CFA Society of Stamford, Stamford,
Connecticut, 5 March 2014.
* * *
Accompanying charts can be found at the end of the speech or on the Federal Reserve Bank of New York'
website.
Good evening. It's a pleasure to have the opportunity to speak with you today on the subject
of the economy, and especially the household sector. As is always the case, my remarks
reflect my own opinions, not those of the Federal Reserve Bank of New York, or the Federal
Reserve System.
National economic conditions
From the end of the Great Recession in mid-2009 through mid-2013, real gross domestic
product (GDP), or the aggregate value, after adjusting for inflation, of all the goods and
services produced within the borders of the United States, grew at a rather tepid 21⁄4 percent
annual rate. Then, in the second half of 2013, the pace of growth moved up a full percentage
point to around 31⁄4 percent.
Roughly half of this increase in the growth rate of real GDP stemmed from a strengthening of
consumer spending. While I will discuss the factors behind this improvement in consumer
spending in more detail in what follows, the main driver appears to be the substantial
stabilization in household balance sheets that has occurred over the past few years.
Household net worth has rebounded from its levels after financial crisis and ensuing
recession because of increases in asset values and decreases in liabilities. In fact, the
financial obligation burden of the aggregate household sector, or long-term financial
obligations expressed as a percentage of disposable income, is now the lowest it has been
since the early 1980s.
In addition to the firming in consumer spending, growth of exports was quite strong over the
second half of last year. Following a few years of lackluster performance, economic growth
among our major trading partners improved, providing a boost to employment and output in
our manufacturing sector. In addition, a secular trend of increasing energy exports and
declining energy imports is now providing steady improvement in our trade balance.
Another contributing factor is that federal fiscal restraint lessened substantially over the
second half of 2013. This development is in sharp contrast to the first half of the year, when
the payroll tax cut expired, tax rates on higher-income households were raised, a series of
taxes associated with the Affordable Care Act took effect, and owing to the sequester and
the gradual winding down of foreign military operations, federal spending was restrained.
Moreover, the sustained contraction in revenue, spending, and employment by state and
local governments appears to be nearing an end.
While overall labor market indicators for the second half of 2013 were not particularly strong,
the unemployment rate did fall sharply over that period, from 7.5 percent in June to
6.6 percent in January of this year. However, as has been the case since October 2009
when the unemployment rate peaked at 10 percent, this decline in the unemployment rate
was associated with an almost equal percentage point decline in the labor force participation
rate. Much has been written about the forces that are causing this decline of the participation
rate. Researchers have shown that the aging of the population is playing a role, as are
changes in behavior. But our own analysis suggests that the cyclical weakness of demand
for labor is an important contributing factor, and so we do not take as much comfort from the
decline of the unemployment rate as we otherwise might.
Looking forward, I believe that the underlying fundamentals of the U.S. economy have
improved to the point where we can expect sustained growth above the recent pace of
2 1/4 percent. That being said, I doubt that over the near term we will see growth as rapid as
that in the second half of last year. Special, one-time factors, such as very rapid growth of
exports and sustained inventory building, are unlikely to be repeated over the first half of this
year. Moreover, while there is now a much better balance between supply and demand in the
housing market, that market is still adjusting to the roughly 100 basis point increase in
mortgage interest rates that occurred in mid-2013.
Finally, with somewhat stronger growth of output, I expect inflation to gradually rise toward
the Federal Open Market Committee's objective of 2 percent as measured by the PCE
deflator. This forecast is based on the projected gradual increase in the levels of resource
utilization, which would lessen downward pressure on firms' marginal costs and prices, a
firming in global demand, and the continued upward pull exercised by stable inflation
expectations on actual inflation. Underpinning the latter assumption is the broad stability of
long-term inflation expectations across different financial and survey measures, combined
with ongoing moderate growth of wages and unit labor costs, all of which are consistent with
well-anchored inflation expectations.
As mentioned above, the key development behind the firmer tone of consumer spending
over the second half of 2013 is the significant strengthening in household balance sheets.
One aspect of that improvement is that from mid-2008 through mid-2013, total household
liabilities declined significantly after a period of quite rapid debt growth over the preceding
decade. The reduction in household debt is an extremely rare event for the U.S. economy. In
fact, this has been the only period of sustained declines in nominal household indebtedness
over the period since the early 1950s.
The household sector
In the remainder of my remarks, I'd like to focus on the finding, made public in our most
recent Quarterly Report on Household Debt and Credit, that for the first time since 2008,
households increased their borrowing on a year-over-year basis, at least in nominal terms. I'll
argue that this is an encouraging development, although we should be cautious both in
predicting future borrowing and in recognizing that the aggregate increase in borrowing may
mask the fact that many individual households remain constrained by prior borrowing and/or
a reduction of income. These households are still engaged in attempting to reduce their debt
burden by pay-downs in debt. Furthermore, I'll explain how the type of borrowing by
households has changed over time. Here too there is a reason for some caution, because
borrowing for education has become more common for U.S. households. It appears that
heavy student debt can restrain the consumption activity of those individuals who are
burdened with it. If this is the "new normal" for the economy, it might result in delayed
purchases of homes and autos for those graduates who finance their education by taking on
large amounts of debt. This is a potential development that bears close monitoring.
Why do I suggest that an increase in household borrowing is an encouraging development?
While in recent years we have certainly seen that household debt can carry serious negative
consequences, overall an increasing level of borrowing indicates that the economy is
returning to normal patterns. After all, with rising GDP and an expanding population, we
should not be surprised to see debt increasing, if only modestly. Of course, the kinds of debts
that people are taking on and the riskiness of those loans - to both the borrower and the
lender - are important issues, and I will return to them later in the talk.
Now households borrow for a variety of reasons, but we can generalize to say that
households borrow to smooth their consumption. For households whose incomes are
temporarily low, perhaps because they are just starting their careers, borrowing makes it
possible to enjoy today some of the consumption that would otherwise have to be delayed far
into the future. Another aspect of consumption smoothing is borrowing to invest in durable
goods or to make household investments, such as the purchase of autos and houses or the
funding of higher education. By borrowing, households can avoid what otherwise might be
severe and protracted reductions in their current consumption in order to make such
investments. For example, without mortgages, households would have to delay purchasing a
home until they had accumulated sufficient wealth to pay cash for the purchase, which for
most would require draconian cuts to their other spending for years. Regardless of its
motivation, the incurring of debt is predicated on expectations of the ability to repay through
diversion of some portion of their future income.
Once acquired, however, debt can impose strains on households' finances if their future
incomes do not accrue at the rate expected, or if the cost of servicing the debt rises
unexpectedly. These strains in household finances from suddenly excessive debt service
burdens are met by households in a variety of ways: through default, foreclosures, and
bankruptcy, or renegotiation of the terms of repayment, but also through continued higher
principal and interest payments accompanied by much lower consumption than the
household had previously planned.
As we see in Chart 1 (Employment declined dramatically) job losses in the recent
recession were extremely large and prolonged, a problem that resulted, in part, in significant
delinquencies in debt repayment. Furthermore, the significant decline in house values
imposed a much stricter limit on how much households could borrow if they needed, for
example, to adjust to the effects of a temporary loss of income. Recent economic research
has examined how the macroeconomy is affected when households suddenly experience
reduced borrowing capacity. Eggertsson and Krugman consider the case of households that
have borrowed up to some limit and now see their debt limit reduced; these households
suddenly find themselves over-indebted and are forced to cut spending.1 If the required cuts
in spending are large enough, then even a very active monetary policy will be unable to
offset them completely. Other research has also suggested similar mechanisms. Hall has
pointed out that a tighter household borrowing constraint can help explain the depth and
persistence of the most recent recession in the U.S.2 Mian and Sufi observe that
unemployment is much higher in counties across the U.S. where households were more debt
constrained by the fall in the price of housing.3 Their finding provides further support for the
hypothesis that it is the especially debt-constrained households that are under the greatest
pressure to reduce current consumption.
Given the effect that sudden reductions in borrowing capacity are expected to have on
broader economic activity, it is then encouraging to see that, at least at the aggregate level,
households are increasing their borrowing. This suggests that the forced cuts in spending
caused by declines in borrowing capacity are becoming less of a major concern for
households.
I'd now like to turn to some of the empirical analysis that can help explain both the decline in
aggregate U.S. borrowing after 2008 and the subsequent turnaround of this trend in 2013.
First, as we now know all too well - and as seen in Chart 2 (House Prices Peaked and Fell
Precipitously), house prices in the U.S. rose at steadily increasing rates from 2000 through
2006, followed by an approximately 31 percent reversal that persisted through 2011. That
reversal reduced the aggregate wealth of homeowners and, in the worst case, left many
"underwater," meaning that the amount of mortgage debt secured by their home exceeded its
current value. This outcome is reflected in the dramatic decline in owners' equity in
household real estate, seen in Chart 3 (Result was a Huge Decline in Owners' Equity in
HH RE). It is interesting to note that while home prices rose during the boom, homeowner's
equity share remained constant. Thus, prior to the end of 2006, on average for each
1 percent increase in home prices, homeowners increased their mortgage debt by 1 percent
(through higher balances on first mortgages, cash-out refinances, second mortgages, and
home equity lines of credit).
When house values began to fall, so did corporate equity values, which depressed
household wealth further Chart 4 (Stock Market Wealth also Fell Sharply), limiting
households' options for reducing their debt burdens or sustaining their prior levels of
consumption.
Consequently, and in line with the logic of the research I discussed earlier, U.S. households
decreased the cash flow available for consumption by paying down debt during the recession
and early recovery. In Chart 5 (Four-quarter cash flow from borrowing) we measure the
amount of borrowing - both mortgage and nonmortgage borrowing - that U.S. households
were engaging in over time. Consider that in 2007, households were receiving in aggregate
$330 billion in cash from borrowing. These funds were available for consumption
expenditures or for household investments such as home improvements. However, with their
borrowing limits lowered as house values fell and income levels declined, households began
to pay down debt rapidly. (Of course, while many households acted to pay down debt, some
debt was written off through foreclosures and bankruptcies, and other households were
increasing debt by borrowing for home purchases, as normally would be the case. But we
exclude those kinds of transactions here.) In sum, however, households in 2010 actively
reduced their net indebtedness by $150 billion. The reversal in cash available for household
expenditures was a massive $480 billion over the period from 2007 to 2010. This fact was
established by Brown, Haughwout, Lee, and van der Klaauw in our Liberty Street Economics
blog in 2011.4
Allow me a brief digression here, because I think it touches on an important point. A lot of
people refer to this pay-down of debt as "deleveraging," but in my view that's a misuse of the
term. Since the distinction is more than just semantic, let me explain what I mean.
Financial leverage is usually thought of as a ratio. Consider a typical home purchase with
20 percent down. Here, the buyer makes a down payment equal to 20 percent of the asset
value and borrows the other 80 percent of the purchase price in the form of a home
mortgage. We would say that the borrower's leverage is 5 (the asset value divided by the
equity share). Now, it's easy to see that reducing debt and reducing leverage are the same
thing when asset values are constant. If the borrower in our example pays down half the
mortgage and the house value doesn't change, her leverage has fallen to 2.5.
Unfortunately, house values fell from 2007 to 2011. So while households were trying their
best to reduce their mortgage debt, their leverage was actually rising, since house values
were falling much faster than debt. It was really only in 2012 that leverage in residential real
estate began to fall, because house prices stopped declining faster than housing debt. In
2013, leverage continued to fall, even though net mortgage borrowing resumed, because
house values rose even faster.
I think this distinction is important, because if we think that households have been steadily
deleveraging since 2008 we might wonder whether we were getting close to the finish line.
After all, the labor market has been recovering, albeit slowly, for several years. But in my
view, the fact that households saw their leverage increasing in spite of their efforts to pay
down debt helps explain why they kept at it. Households may well be trying to reestablish a
more normal and sustainable leverage ratio. This view also underlines the importance of
avoiding busts in house prices as a fundamental underpinning of a recovery in borrowing and
consumption.
It is likely that these reductions in debt and new borrowing during the recession and the early
part of the recovery stemmed from what we might label decreases in the demand for
borrowing. As households saw their wealth decline, especially the wealth represented by the
value of their home, and as unemployment grew and remained elevated, households'
capacity to repay debt declined, and, as a result, their desired stock of debt declined as well.
At the same time, banks too were suffering from heavy losses on mortgages and other
lending, and reduced the supply of credit available to households. We can see this in Chart 6
(Banks and Lenders Imposed Tighter Mortgage Lending Standards) which shows the
sustained tightening of lending standards reported by banks starting in 2007. Furthermore,
Chart 7 (Origination by Risk Score: First Mortgages) shows the percentage of prime first
mortgage originations by the credit score of the borrower. The chart reveals a quite dramatic
tightening of credit standards during 2008 and 2009. Here we see that the share of new
mortgage borrowing by applicants of all credit scores below the highest quartile declined,
while that of the highest quartile increased from about 40 percent to 70 percent. This
suggests that lenders were far more selective in their underwriting standards for mortgages
than they had been in the period between 2000 and 2006.
Many of these powerful forces of demand and supply that together led to the decline in
household borrowing, and hence to the fall-off in resources available for consumption, have
either diminished or slowly reversed as the economic recovery that began in 2009 has
continued. First, equity values, which dropped 51% between October 2007 and March 2009,
as measured by the S&P 500 index, have recovered significantly, rising by almost 140%
percent through the end of 2013 Chart 8 (Stock Market Wealth also Fell Sharply,
2nd half). In addition, as seen in Chart 9 (House Prices Peaked and Fell Precipitously,
2nd half) house prices have finally begun to recover, and have been doing so on a broad
geographical basis. House prices are up 21 percent since their nadir in 2011. This has
helped restore owners' equity in their homes Chart 10 (Result was a huge decline in
Owners' Equity in HH RE, 2nd half). In sum, as seen in Chart 11 (Household Net Worth),
aggregate household wealth has recovered substantially as a percent of disposable income,
albeit with a lesser contribution from housing and a greater contribution from corporate
equities.
At roughly the same time, starting in 2011, we've seen a substantial loosening in
nonmortgage lending standards by banks, an important sign of normalization in credit
markets, as Chart 12 (Standards have loosened since 2011 on non-mortgage products)
suggests. Perhaps not surprisingly, mortgage standards have only in recent quarters begun
very slowly to reverse the significant tightening that followed the housing bust; see Chart 13
(Banks and Lenders Imposed Tighter Mortgage Lending Standards, 2nd half).
Broad increases in wealth, continued recovery in the overall economy with higher levels of
employment and income, a relaxation of credit standards, and historically low interest rates
have led to improvements in delinquency rates and increases in both demand and supply for
borrowing by U.S. households. In 2013, we see the consequent increase in household debt.
In the last quarter of 2013, aggregate consumer debt increased by $241 billion, the largest
quarter-to-quarter increase since 2007. More importantly, as shown in Chart 14 (Total Debt
Balance and Its Composition, in 2013 total household debt rose $180 billion, marking the
first four-quarter increase in outstanding debt since 2008. This is at most the beginning of a
turnaround, of course: for example, once we adjust for inflation, debt per capita has just
barely stopped falling, as Chart 15 (Real Household Liabilities Per Capita) suggests.
Further analysis based on our Consumer Credit Panel shows that the growth rates in auto
and student loan borrowing have been positive for some time now. The reversal in overall
borrowing during 2013 was driven by increased credit card and mortgage debt among the
young and those with high credit scores. While this suggests that lenders are concerned
about the safe underwriting of such loans, it also points to the overall importance of
borrowing by younger individuals. Not only did borrowers under age forty-nine take on more
credit card and mortgage debt in 2013, they also did most of the borrowing to finance auto
purchases and college educations. This is not new - historically, younger individuals account
for most new loan originations, while older individuals on average pay down their outstanding
debt. Nonetheless, while borrowing for such things as cars and houses is up among younger
individuals, it remains somewhat subdued.
Now, this overall picture - young borrowers getting loans while older borrowers are reducing
their debts - makes sense, and it is consistent with a growing population and improving
income prospects for the young. The fact that (unlike 2006) we now see reductions in
mortgage debt for the least creditworthy borrowers tells us about how unusual lending was
during the credit boom of the mid-2000s, and it is instructive and reassuring to see that
today's patterns look different.
In spite of the improved outlook for income growth and consumption implied by these
changes in the way households view and use debt, some imponderables remain on the
horizon. For one, the dramatic increase in student debt implies that a fundamental change
has taken place in the way we finance higher education in the U.S. A combination of rising
college costs, reduced subsidies from cash-strapped state governments to their state
universities, and cutbacks in home equity loans and other sources of financing has left new
college attendees with larger debts.
There's been a tremendous amount of attention to the growth of student loans in recent
years, and our data indicate some of the reasons why. First, student loans are the only form
of debt that grew consistently even through the depths of the crisis and the long period of
debt paydown. Second, the growth in educational debt, like that of auto loans, is
concentrated among the lower and middle credit-score groups.
Unlike other types of loans, student debt continued to grow steadily during and after the
recession; now, at almost $1.1 trillion, it comprises 9 percent of household debt and
represents the second largest source of debt for U.S. households after mortgages. Student
loans provide critical access to schooling, given the challenge presented by the increasing
costs of higher education. Those with college degrees earn a high return on their educations;
they are much less likely to be unemployed, and they earn on average twice as much as
those with only high school diplomas.
Our research indicates that the large growth in student debt, and an associated high level of
student debt delinquencies, has been associated with a reduction in mortgage and auto loan
borrowing among younger people. While younger individuals were previously much more
likely to finance home and car purchases by age thirty, Chart 16 (Proportion of Borrowers
with Home-secured Debt at Age 30) shows that those with student debt are now less likely
to do so than those with no student debt, as shown by Brown and Caldwell in a Liberty Street
Economics blog post in 2013.5 In fact, our research suggests that student debt appears to
have replaced or crowded out other types of debt, so that the difference in average total debt
held by student-loan and non-student-loan borrowers has remained stable over time.
We suspect that this decline in taking on other types of debt by student-loan borrowers partly
reflects increased uncertainty about the future. However, in addition to a possibly reduced
appetite for borrowing, a reduction in access to credit is also likely to play an important role,
despite the comparatively high earning potential of those with a college education.
Consumers with substantial student debt may not be able to meet the stricter debt-to-income
(DTI) ratio standards that are now being applied by lenders, particularly on mortgage loans.
We believe that student debt growth among new graduates has been higher in the most
recent years than growth in their incomes. In addition, delinquency in repayment has become
more prevalent among student borrowers, and those with past delinquencies are likely to find
it much more difficult to borrow. This decline in credit accessibility is also captured by credit
scores. During most of the first decade of the 2000s, those with and without student loans
had comparable average credit scores at ages twenty-five and thirty, but since 2010, student
loan borrowers have had significantly lower average credit scores. As a result of tighter
underwriting standards, higher delinquency rates, and lower credit scores, consumers with
educational debt may on average have more limited access to housing and auto loans and,
as a result, more limited options in the housing and vehicle markets. This disadvantage may
compound the difficulties of young people who enter a depressed labor market; in addition to
facing a spell of unemployment that may lead to reduced earnings for a considerable period
of time, they may also face tighter future credit constraints as a result of delinquencies on
their student loans.
In this light, the recent increase in borrowing among younger individuals is consistent with an
improvement in labor market prospects and some loosening of credit standards, although the
increase in borrowing by younger age cohorts is modest and remains below their pre-crisis
level. The high level of student debt may create the risk of a drag on future consumption
growth. In fact, while highly skilled young workers have traditionally provided a vital influx of
new, affluent consumers to U.S. housing and auto markets, the unprecedented growth in
student debt and the persistently high student loan delinquency rates are likely to dampen
the influence of this group in today's marketplace and may represent a structural or
longlasting change in household credit markets.
To summarize, I have reviewed the many positive signals we should take from the fact that in
2013 we observed the first year-over-year increase in borrowing by U.S. households since
2008. The willingness of U.S. households to increase their debt levels in aggregate likely
reflects the restorative influences of significant turnarounds in house prices and stock market
values since their lows in 2009-10, somewhat better employment outcomes, and much
stronger household balance sheets as a result of write-offs and pay-downs of earlier
indebtedness. In addition, a gradual loosening of credit availability is likely to have
accommodated the increased demand for credit, although mortgage lending continues to be
subject to high credit standards. Together, these developments bode well for the
macroeconomy, suggesting that U.S. households can return to more normal patterns of
borrowing to smooth consumption and to invest in autos and houses.
Still, despite the return to more normal patterns of borrowing, it is worth pondering the
significance of the recent change in the composition of household debt as student loans have
grown to be the second-largest category of household debt after mortgages. While these
loans provide critical access to schooling, they may constrain the consumption choices of
young people, especially those who graduate in periods of poor employment prospects.
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