U.S. Household Debt Reduction
Released: 2012-02-06T00:00:00

Introduction

Over the past several decades, U.S. household indebtedness has generally risen regardless of macroeconomic or financial conditions. In light of the 2007-2009 recession, however, households are reducing their debt burdens. Household debt balances fell in the third quarter of 2008 and continued to do so until the second quarter of 2011 when they rose by 0.55% before resuming their downward trend. Simultaneous declines in household income and net worth made it difficult for some households to support previous debt levels, thus encouraging them to reduce debt service obligations and work toward restoring the health of their balance sheets.

Household debt reduction (or deleveraging) may have important implications for job creation and economic recovery. Deleveraging may translate into a reduction in near-term consumption, which typically accounts for approximately 70% of gross domestic product and likely an important source of economic recovery. Deleveraging may also manifest itself in the form of above normal loan defaults that weaken the banking system and discourage new lending, which can be the source of job creation.

Moreover, when consumer spending and bank lending are curtailed, fiscal policy initiatives (e.g., tax cuts or spending increases) become less effective at stimulating the economy. For example, academic experts have proposed large-scale mortgage refinancing efforts to propel economic stimulus. In light of these recommendations, the purpose of policy initiatives (e.g., the Home Affordable Refinance Program [HARP], H.R. 363 and its companion S. 170 , the Housing Opportunity and Mortgage Equity Act of 2011) is to facilitate the refinancing of mortgages. In addition, the Obama Administration announced an initiative to assist qualified homeowners, whose mortgages are not owned or guaranteed by any institution affiliated with the federal government, in lowering their mortgage rates. If refinancing activity results in lower mortgage payments, then households may have more discretionary income to spend and, therefore, spur economic stimulus. Some households, however, are choosing to pay down current debt obligations, which means any additional income that would have gone toward mortgage interest still may not be applied to new spending. Hence, policies aimed at stimulating near-term consumption may instead enhance future borrowing capacity and longer-term consumption if households continue to strengthen their balance sheets via near-term deleveraging.

This report presents data illustrating household deleveraging since 2008 in comparison to previous trends in household credit use. It also presents various explanations for deleveraging—in particular, changes in both consumer demand and lending supply. On the demand side, job losses and declining wealth particularly associated with declining real estate values are factors that made it difficult for households to repay old loans or secure new ones. On the supply side, rising loan losses caused lenders to write off more obligations, which put a strain on lenders' (regulatory) capital reserves. Consequently, lending standards are higher and likely to remain until lenders feel more confident that borrowers have the ability to repay.

Recent Household Deleveraging Patterns

Figure 1 illustrates the Federal Reserve's aggregate household debt service burden ratio (DSR). The DSR is the percentage of disposable personal income required to make minimum repayments on outstanding mortgage and consumer debt. Beginning in the mid-1990s, the DSR rose but then declined after 2008. The DSR movements are affected by changes in the amount of household debt, changes in household income, and changes in interest rates (debt costs). Rising incomes and falling interest rates would cause the DSR to fall over time. Given the rise in real disposable income prior to the financial crisis coupled with falling interest rates, the rise in the DSR reflects household debt usage rising at a faster pace than household income growth. Conversely, the DSR might be expected to rise during recessions when incomes tend to fall. During the 2007-2009 recession, however, the DSR began to decline in 2008, which reflects a shift toward deleveraging by households as well as the refinancing of some debt at lower interest rates.

Figure 2 illustrates the quarterly percentage change in total household debt balances since 1968, and the shaded areas indicate U.S. recessions. Household debt balances consist of home mortgages, revolving or credit card debt, and nonrevolving credit, which consists primarily of automobile and student loans. Note that the growth rate of household debt declined during the 1981-1982, 1990-1991, and 2001 recessions but still remained positive. Beginning in the second quarter of 2008 through the first quarter of 2011, however, the rate of change in debt usage became negative and was sustained. Post-2008 household deleveraging, therefore, appears to be atypical compared with previous economic contractions occurring over the past few decades.

Table 1 illustrates the percentage changes in household debt usage from the second quarter of 2008 through the third quarter of 2011 by loan type. Mortgage debt represents the largest share of all household debt. A significant share of the decline in mortgage debt outstanding can be attributed to declining home equity loan balances, which can be used as a substitute for other types of consumer credit. Revolving or credit card debt use also declined, but growth in nonrevolving credit remained positive over this period.

Explanations for Household Deleveraging

Household deleveraging may be explained by factors influencing both the demand for and supply of credit. Beginning with demand-side explanations, the spike in unemployment and a decline in household net worth, which occurred during the recession of 2007-2009 and has continued along with declining home values, can lead to debt reduction either by inducing households to curtail credit use (and pay down existing debt) or in the form of defaults. On the supply side, lenders experiencing large volumes of loan losses may have also grown more reluctant to make loans. This section explains these factors in more detail.

Decrease in the Demand for Credit

"Trigger events" are defined as sudden changes in circumstances that can lead to greater loan defaults. A steep rise in unemployment is an example of a trigger event. During the 2007-2009 recession, the unemployment rate soared to 10.0%, which was the highest it has climbed since 1982. Job losses can translate into income disruptions that make it difficult to repay existing credit obligations or seek new loans.

A sharp, unanticipated decline in household net worth is another example of a trigger event. During the 2007-2009 recession, households saw a decline in household net worth that had not occurred in previous recessions over the past three decades ( Figure 3 ). Net worth (i.e., the difference between the value of assets and liabilities) fell for seven consecutive quarters beginning in the third quarter of 2007. The most recent decline in net worth was larger and persisted for more successive quarters than did the steep decline in the stock market of the late 1990s, which lasted until approximately 2002. Much of the decline in net worth is attributable to real estate assets that many households financed through borrowing. The Federal Housing Finance Agency and Case-Shiller house price indices show that U.S. house prices began declining in 2007, and homeowners were increasingly likely to find themselves "underwater" or "upside-down" as the amount of their outstanding mortgage balances exceeded current home values.

Academic research suggests that changes in real estate values generate a greater response in consumer spending and borrowing decisions than do changes to stock values. For one reason, most households purchase stocks with cash, which means there are no debt obligations to repay based upon the original purchase prices should their stock assets fall in value. Second, stock market declines are often short-lived in comparison to declines in real estate values, which means volatile short-term fluctuations are less likely to prompt investors to reassess longer term financial decisions. Housing assets are also typically a much larger component of household balance sheets. Hence, stock market declines tend to have a smaller impact on household consumption and borrowing decisions relative to declines in real estate prices. Given that declining real estate asset values may lead to permanent wealth reductions that would prevent existing (mortgage) debt obligations from being repaid, two possible reasons for household deleveraging are worth considering.

Deleveraging for Precautionary Reasons

Households may have a precautionary savings motive that influences them to reduce borrowing when household wealth drops. If households wish to maintain a certain level of wealth to protect against unexpected economic reversals, their consumption behavior is likely to change if those balances fall below desired thresholds. Households may reduce spending (and borrowing) and increase saving until net wealth has been restored to more desirable levels.

For example, Figure 4 shows that "cash-in" mortgage refinancings became more common relative to "cash-out" refinancings by 2008. During the mid-2000s housing boom, many borrowers pulled equity out of their homes to finance expenditures. Freddie Mac refers to this type of transaction as a "cash-out" refinance when the outstanding mortgage balance increases by more than 5%. Conversely, a "cash-in" refinance occurs when borrowers refinance and pay down some mortgage principal, which reduces outstanding balances. The percentage of cash-in mortgage refinances began to exceed cash-out refinances in mid-2010.

A corresponding reduction of home equity loan balances can represent an array of borrowing given that this type of mortgage product was used to consolidate existing debt obligations, finance new consumption, and even finance the acquisition of new (real estate) assets. Moreover, the soaring unemployment rate may have influenced many households to reduce debt obligations just in case their continued employment prospects seemed at risk. Hence, such a marked increase in cash-in refinances arguably may reflect an increase in precautionary savings behavior by households in response to an adverse trigger event, which generates greater economic and financial uncertainty.

Deleveraging by Defaulting on Loans

A negative trigger event in the form of job losses (or shifts to part-time status) is likely to disrupt income streams. A severe and persistent disruption, when coupled with circumstances that prevent, for example, the sale of housing assets for amounts necessary to pay off outstanding mortgage balances, may cause households to default on existing loans. Moreover, risky mortgage underwriting practices prior to the 2007-2009 recession made it possible for some borrowers to receive mortgages that could only be repaid assuming continued house price growth rather than income growth. The combination of relaxed underwriting standards, which allowed for rapid debt accumulation, and the unexpected trigger event, which was the large and pronounced downturn in U.S. house prices, resulted in greater household defaults on all types of loans.

Figure 5 shows charge-off rates for commercial bank loans in three categories: single-family residential mortgages, credit card debt, and other consumer loans. Charge-offs occur when lenders conclude that a debt will not be repaid and charge it against their loss reserves. During the past few years, all three major categories of household debt experienced rising loss rates.

Decrease in the Supply of Credit

The previous explanations involved factors influencing the demand for credit, but household deleveraging may also be affected by a reduction in credit supply. Rising loan losses may cause lenders to be more skeptical about extending new credit without greater assurances of repayment. Many banks may be unable to make new loans if they are still struggling to rebuild their required loan loss reserves and capital reserves, which have been diminished by loan defaults. The observed household deleveraging, therefore, may reflect both decreasing supply and demand for credit given the extent to which lenders tightened underwriting standards, lowered existing lines of credit, and restricted new lending to stabilize profitability and satisfy regulatory capital requirements.

The Federal Reserve's Senior Loan Officer Opinion Survey on Bank Lending Practices, which is conducted quarterly, asks bankers about changes in the standards and terms of bank lending as well as changes in the demand for loans. Figure 6 presents a graphical illustration of the responses collected between 1996 and 2011. The two dotted lines represent the net percentage of loan officers reporting that they expect to tighten standards for credit card and other consumer loans. The greatest tightening of loan standards over the period began in 2007.