Peak Credit & What That May Mean
A: Peak credit, sounds like I hit my limit on my credit cards! I guess its kind of true. For owners of home equity lines of credit, you may have noticed a decrease in your available credit line recently. Why is that? Because credit has peaked, and is now contracting! As banks work to repair their toxic balance sheets, capital must be raised and cash hoarded; that means less lending for us consumers. Peak credit, the idea that our system of borrow now & pay later has reached its pinnacle, is a scary notion. So lets figure out just how out of whack we actually went, before discussing what credit deflation may bring in our future.
Yves Smith, of NakedCapitalism, was one of the panelists with me on the Inman Bull vs Bear debate a few weeks ago. I recall her mention of total credit debt as a percentage of GDP, but didn't really think much about it until I got back from San Francisco. Looking back at the video of the debate, Yves stated on the panel:
(5:56 into the video) - "...right now we got a level of debt to GDP which is OUT of proportion, way out of proportion, right now debt to GDP is 350%...never been that high, the highest it was at the depth of the depression was 260%, and its only went above that level since basically 2000, we had a parabolic increase in debt to GDP, but this is at a level that is just not sustainable in the long term, so the question is...what's going to make this break?"Interesting stuff. Below is a chart (courtesy of Austrianenginomics.com) that visually shows you what our total credit market debt is as a percentage of our GDP. Look closely and you will realize something very interesting when comparing the two spikes (the first starting after the Great Depression & the second from the past few decades as our economy was driven by debt & credit):
The use of debt in the 1930s was a direct response to the Great Depression! We used debt to get us out of the depression. Recently, we used debt for an entirely different reason: TO SUSTAIN ECONOMIC GROWTH! My two questions are, who are we going to borrow from this time to get out of this mess + how are we going to service our current levels of debt?
Yea, thats right. That huge runup that you are looking at above is the amount of debt that we have taken on to fund our growth for the past few decades. This is giving the term 'peak credit' a whole new meaning isn't it!
When you hear Mish discuss peak credit and credit deflation, now you know what he is talking about:
Peak credit has been reached. That final wave of consumer recklessness created the exact conditions required for its own destruction. The housing bubble orgy was the last hurrah. It is not coming back and there will be no bigger bubble to replace it. Consumers and banks have both been burnt, and attitudes have changed.So where does this leave us? Unfortunately, we are far from finding out as we are only in the beginning phases of credit deflation and credit destruction. The system that has drained every ounce of umph from available credit, is in fact, broken. That is why you are not seeing lending rates fall with the 325 basis points of fed easing seen thus far, and instead, seeing tightening lending standards implemented. It's a new world of tighter credit and higher costs of credit. For now, we still need to let the process unwind, delever, re-price risk, or whatever you want to call it.Some choose to call what is happening "credit deflation". In this regard "credit" is an unnecessary label. Deflation is about the contraction in money supply and credit. The conditions now are very similar to what happened in 1929. The primary difference is that prices of many goods and services (notably energy and food) have been rising.
That is what worries me. How bright is our economic future when the credit system is deflating, the cost of credit is rising, and we already took on huge loads of debt? Lets face it, we have been a society built on credit, and now:
a) credit is contracting
b) the cost of debt is rising
Unfortunately, I wonder how much more debt we can afford to take on for future stimulus and to bail out troubled institutions that are too intertwined to our financial system to allow to fail. On the consumer side, credit is not being dispersed the way you would hope; those that need credit, can't get it, while those that don't need it continue to get new offers via snail mail. Looking ahead, I see three endings to this story:
1) we continue to service the debt as rates rise
2) we pay off the debt
3) we default on the debt
Its hard to imagine the US defaulting on our debts, but its also hard to imagine that Fannie Mae and Freddie Mac may be nationalized by this time next year! The key element here are the foreigners holding massive amounts of dollar based assets; our debt. I would expect the bond market to be hit at some point, as treasury prices fall and yields surge; especially if foreigners slow down purchases of our debt or decide to dump some of their holdings in. The next big bubble to burst could very well be the bond market resulting in double digit treasury yields. This is not a new argument, but to me, is probably closer than some people would like to admit.
Back to peak credit, I think we have seen it. How we adapt is anyone's guess. One thing is for sure, is that the credit platform that we have gotten used to for the past few decades, has vastly changed, and psychology with it. There comes a time when we will have to pay off our debts, and like with our pesky credit card bills, paying off debt is no where near as fun as spending it!
Comments (8)
How's business? Any new listings or buyer's in contract? It seems like things are poised for rapid and deep price cuts beginning after LAbor day as buyer's begin to accept that things have truly changed.
Posted by mh23 | August 5, 2008 8:54 AM
MY LISTINGS
18 W 48th - IN CONTRACT
2334 2nd Ave - OFAC, contract out + backup
702 Ocean Parkway - about to come off market
MY BUYERS
4 contracts signed in past 6 weeks, 1 about to be fully executed today; 7 contracts signed in 2008 from buy side, 3 closed already.
I usually do about 10-12 deals a year or so, and that is just me, on my own with no help from assistants, other agents, handing out referrals, etc..
I think Im at about 8 now with hopefully 2 more coming in. So, for me, Im having a productive year. I do spend 40% of my time on UrbanDigs and related things with UrbanDigs, so Im happy with activity. Most of my business came in past 2 months. However, right now, Im about to take off a few weeks and dont see many new deals in pipeline for next few months. Maybe 1-2 new deals, unless something pops up as they usually do.
Posted by Noah | August 5, 2008 9:40 AM
Checked out the Austrianenginomics.com site based on the reference in your post. It scared the crap out of me until I realized that that site ignores the concepts of savings (although the savings rate in the US is admittedly paltry) and the fact that reality is played out over a series of periods - so debt does not need to be paid back from GDP in any given year. A corporation or government can carry a debt burden into eternity (if they last) so long as investors are willing to take a subordinated interest in the cash flows of that entity and refinance maturing debt. The cost of debt will certainly fluctuate over time based on supply and demand of/for credit. And while there may be a negative impact of debt being 350% of GDP (that a significant percentage of production must be used to service debt), so long as interest rates plus maturities in any given year are not higher than 28% of the debt burden the US can continue to service that debt. The potential for borrowing to increase productivity in future periods may mitigate the damaging costs of borrowing.
Consumers are definitely different due to our limited lifespan. One would imagine that an unsecured consumer lender is sensitive to this issue and will demand repayment from those that it believes will experience a diminished revenue stream (retirement from work, or life) in the near term. Therefore it seems valid concern that the aging US population will have an issue with ballooning credit as consumers will have to crimp spending in order to divert their income to pay down maturing debt.
Secured loans to consumers, such as mortgages, are somewhere in between, I suppose. So long as the loan is secured by an asset, the life of the borrower doesn't matter as much. I do agree with Austrianenginomics.com that houses should generally be a depreciating asset, ignoring demographic trends that drive demand to live in particular areas, as will most other consumer assets securing loans. So, over time the amount of debt outstanding on those assets should need to decline line with the decline of their value (to maintain a similar debt/capital or interest coverage ratio or whatever makes a lender comfortable that the value of their loan is protected by the underlying collateral).
The reality of course has been different. The abundant supply of credit provided consumers increased purchasing power and drove demand for housing faster than supply. Keep in mind that houses are unique assets, so I'm not saying that the total number of houses in the US was too small relative to demand, but that consumers demanded houses that provided an improved quality of living (space, location, whatever) over what was available to them at the time. That is why housing prices accelerated faster than inflation (some one did have an interesting chart to show that housing prices basically kept on par with inflation throughout much of the prior century, but I can't recall the source).
As the supply of credit wanes so does the purchasing power of consumers to purchase property. So, it is no surprise that housing prices need to fall, as do prices for a lot of goods.
I've sort of forgot where I was going with this comment at this point. Anyway, I hope housing prices in NYC do fall soon (no mention of the NYT article about the oversupply of one bedrooms yet?) so I can get serious about buying a place.
Posted by david | August 5, 2008 11:56 AM
I am not sure if I understand this logic well. If the debt is increasing, I am sure the assets are increasing as well (debt is an asset for someone else). If you chart, the mutual fund/institutional investors assets as a % of GDP-it will show you similar increases-no?
I assume these debt numbers are not net of assets held.
Posted by Anonymous | August 5, 2008 12:12 PM
P.S. any chance I could get you to answer my question in the "At what point are you committed to a broker?" thread? I'm trying to figure out if it is pointless trying to do the apartment hunt solo (in terms of the potential to save money). Even though I haven't been provided the best advice from the broker I used to look at a couple of places - the response to my question of what is a reasonable bid for a particular apartment was not answered with any attempt to do comps but instead "whatever the buyer is willing to pay that the seller is willing to accept" - I suppose if it isn't going to save me money by not using a broker then I might as well use one.
Thanks.
Posted by david | August 5, 2008 12:12 PM
Noah,
That is a scary looking chart, and I agree that we are going to be on the downside of it for some time. I don't think we will go back to the old lows though as I believe that the volatility of cash flows in the US has lessened over time, which allows for an increase of debt load overall. I have seen a similar chart of household cash to GDP and it has a very interesting 15 year or so cycle, in which it vacillates between 65% and 83%, going back to the end of WWII when households were flush with cash as there wwere no consumer goods to buy during and just after the war. I believe we are in one of those 15 year corrections. The debt problems are federal and individual in nature, not corporate. The positive thing is that with US business very competitive globally, corporations will grow over the next number of years, US consumers will save, while others around the world spend and the federal and individual debts will be worked down...a bunch of the individual debt will be wiped away quickly by defaults and will simply eat up bank capital.
Posted by jeff | August 5, 2008 2:33 PM
This is spot on here in Tucson Arizona where the real estate market is bottoming we have seen many homeowners getting their HELOC's cut off. It does pose a problem due to many using that equity as a safety net/ (personal savings accounts). I think this situation is going to continue for quite some time which should help move the real estate markets nationwide to a more healthy state then they otherwise would be since people now have to be much more responsible about borrowing due to banks inability to loan to whoever whenever as had been the case.
Posted by Michael Oliver | August 6, 2008 1:48 PM
"The next big bubble to burst could very well be the bond market resulting in double digit treasury yields."
As a matter of fact, S & P projects just that:
http://djomama.blogspot.com/2006/12/first-world-government-junk-bonds-on.html
Posted by jomama | August 29, 2008 1:58 AM