Overview

The phrase “dismal science” is attributed to Thomas Carlyle, a 19th century English economist who, by one common belief, was reacting to Thomas Malthus’ Essay on Population, which contended that the global population would consume the earth’s resources. Carlyle was most likely lashing out, however, more generally at the classical economics of Malthus, David Ricardo and John Stuart Mill. Carlyle thought that the supply and demand dynamics of free competition led to an overriding emphasis on profits for some and abject poverty for others.

Applied to contemporary economics, dismal science may refer to the difficult trade offs of practical economic decisions. Economic principles do not work in isolation, and in fact, many contradict one another. For example, monetary policy makers must often balance spending versus saving, low unemployment versus low inflation, among many other trade offs. An advance in one constituency may come at a direct cost to another.

The fact that widespread debt deleveraging is occurring is a long-term benefit to the economy at the expense of short-term turmoil and dislocation.

This necessary deleveraging will likely continue to be a headwind toward economic growth. The most critical areas of balance sheet repairs concern household and financial sector debt. In past recessions, healthy recoveries were supported by healthy growth in credit. The challenge coming out of this stressful period will be moving the economy forward in the face of tighter credit than in recent recovery periods.

While the probability for a slower than average recovery is high, there are three signs that point away from the prolonged recession/depression scenario. First, households have already decreased their balance sheets and are not as levered as the financial sector. Second, one of the primary culprits of the current economic downturn is the shadow banking system, and the demise of this system seems to be well under way. The third sign – the most critical and uncertain – is the trade-off between providing liquidity and lending to stimulate spending against the need for future discipline and unwinding of the reflationary pressures.

Consumer Debt

The economy is going through a painful deleveraging process that began with severe stress in the subprime mortgage market (loans to higher risk borrowers) that led to the bursting of the housing bubble. Subprime mortgages accounted for approximately 7 percent of all mortgages in 2001 and more than 20 percent in 2006, the peak of the housing market. In the fourth quarter of 2008, according to the Mortgage Bankers Association, delinquency rates on subprime mortgages reached 22 percent, versus 5 percent for prime loans.

Like the subprime mortgage sector, debt across all segments of the economy grew at an unsustainable pace over the past two decades, including all household (consumer) debt. According to Bloomberg, total American debt, for the public and private sector as well as households, had exploded to nearly 300 percent of gross domestic product (GDP). In particular, for most of this decade, consumers were incented to take on more debt given healthy employment conditions, low interest rates (mainly the result of accommodative monetary policy used by the Federal Reserve in response to the collapse of the technology stock bubble bursting and to address the aftermath of the 9/11 terrorist attacks), and until 2007, rising asset prices for both equity holdings and houses. As a result, consumer debt skyrocketed from approximately 70 percent of GDP in 2000 to 100 percent in 2007. That was a bigger increase in seven years than what had transpired in the 20 years prior to 2000.¹ (Figure 1.)

During the initial stages of an economic expansion, the increase in debt burden serves as a boost to further and stronger economic expansion, which is typically bullish for the equity markets. Eventually, however, the growth in debt leads to higher interest rates, then pressure to strengthen balance sheets.

Household debt relative to personal income is really an indication of optimism over the future economic situation. The decision to borrow now is one of shifting future consumption to the present. The higher the increase in the debt-to-income ratio, the more willingness households have in general about increasing their borrowing.

The year-to-year (YoY) change in Figure 2 illustrates just how enthusiastic households were about taking on debt, and conversely just how apprehensive they have been since housing prices peaked in 2006. Household debt often serves as an indicator of consumer activity. As consumer spending accounts for 60 percent to 70 percent of GDP household debt, including auto loans and credit cards, can be a good indicator of future economic trends. (Figure 2.)

When the one-year change in household debt reaches levels substantially higher than the long-term average, not only do interest rate pressures begin to exert themselves in the market, but they also apply bearish pressures on the equity markets. According to one market strategist, when the year-over-year change in household credit market debt increases above 8 percent, the S&P 500 Index averages lower returns than when debt growth is under 8 percent.² In other words, a sharp spike in either direction may indicate the cyclical environment has reached overly optimistic or pessimistic levels. According to Figure 2, the magnitude of the decline in household debt growth is the steepest on record.

Financial Company Debt

The debt issued by financial companies illustrates the extent to which the crisis was “financially” manufactured. Financial sector debt relative to nonfinancial debt has steadily increased. (Figure 3.)

Over the last 10 years ending in December 2008, total U.S. domestic nonfinancial debt increased 107 percent (nonfinancial represents households, business, and state and local governments). (Figure 4.)

Over the same period, U.S. domestic financial sector debt increased by 172 percent. In 1980, financial sector debt represented 10 percent of U.S. GDP, while household debt represented 50 percent of GDP. In 1990 the financial sector ratio rose to 34 percent and household debt rose to 48 percent. At the end of 2008, financial sector debt to GDP was 149 percent and household debt was 120 percent. As a percentage of GDP, household debt increased by 3.7 times the 1980 level. Financial sector debt increased by nearly 14 times the 1980 level. (Figure 5.)

Shadow Finance

The credit market borrowing and lending as depicted in the Federal Reserve’s data does not include a wide range of other mechanisms developed by non-banks for the purpose of transferring funds between supplier and acquirers of debt. The Federal Reserve notes that the data on sector debt is not the same as the increase in its total liabilities.

New types of financial intermediaries arose during the last decade or so as a way to gain access to the exploding global demand for financial products, with the ability to access the relatively inexpensive cost of funds, and with a desire to side-step the tighter regulatory oversight within the traditional banking system. These new conduits have been collectively referred to as the shadow banking³ (or finance) system, and may represent a more modern version of Carlyle’s “dismal science.”

The shadow banking system comprises of non-bank institutions that play a significant role in private lending and the facilitations between investors and borrowers, and include entities such as broker-dealers, hedge funds, private equity funds, structured investment vehicles (SIVs), collateralized debt obligations (CDOs), various types of money market funds and non-commercial bank mortgage lenders.

Similar to traditional banks, these conduits borrow very short-term and very liquid funds. Heading into the recent credit crisis, unlike traditional banks, these entities where considerably more leveraged and chose to lend and/or invest in more long-term and illiquid investments. In addition, as is the case with banks within the longstanding fractional banking system, despite the fact that they may be healthy (i.e., solvent) there is the possibility that they could receive a run on their liquid liabilities.

Since these institutions do not accept deposits and are not subject to the same regulations as banks, they do not have access to some of the backstops put in place to ring-fence massive liquidation demands or runs. Whereas the fractional banking system provides deposit insurance programs (i.e., FDIC) and potential for access to a lender-of-last resort (i.e., the Federal Reserve).

A long period of low interest rates helped fuel the desire for leverage and profits associated with complex financial products. For example, the financial markets created lower quality mortgage securities (sub-prime mortgages), packaged them together with other securities and sold them to institutions and individuals as investment grade (good to high quality) products.

One of the types of shadow banking conduits that has been pinpointed as one of the driving forces in the rise and collapse of the recent credit bubble are Credit Default Swaps (CDSs). A CDS is a vehicle for transferring the risk of bond default from the bond owner to another party through the use of a credit swap. In essence, the buyer of the swap receives credit protection while the seller of the protection receives an income payment for guaranteeing the credit worthiness of the CDS. As a result, credit risk (especially to protect against default) is conveyed from the holder of the bond, or other security, to the seller of the swap.

CDSs are innovative in the sense that they permit entities the bifurcation of market risk and credit risk. For instance, banks have used CDSs to mitigate the credit risk embedded when making a commercial loan to a customer. Here, a bank might be more comfortable with the interest rate exposure associated with lending funds but wants to divest itself of the corporate borrower’s company specific risk or industry risk. Therefore, if the borrower defaulted on the loan, the writer of the CDS, or counterparty providing the credit insurance, is responsible for the bad asset.

In the mid 1990s there were virtually no credit default swaps. From 2000 to the end of 2007, CDS soared from $1 trillion to $62 trillion. The market capitalization of the S&P 500 Index is around $7.4 trillion.

In 2007, combined assets for shadow banking assets⁴ totaled $10.5 trillion, versus $6 trillion for the top five bank holding companies, and $10 trillion or the entire banking system. When the market assumes that all the assets financed by these institutions trade with similar credit wrappers as higher grade securities have historically traded, the assets are generally liquid and sellable at fair value. However, when the market is uncertain about the solvency of the institution issuing the credit, a vicious cycle of selling pressure and asset devaluations ensue.

Where We Are Headed

As the second quarter began, and for the first time since the credit contraction commenced, signs of reaching a point of inflection began to appear. The credit markets have improved moderately, a sign the worst may have passed. While an answer to the question, “Where are we in the economic cycle?” cannot be provided with any degree of confidence, the increasingly positive economic data (car sales, pending home sales, the uptick in the ISM manufacturing new orders index and stronger January/February retail sales) do suggest that the dramatic plunge experienced by the economy is beginning to lose its momentum.

On the consumer side, households will likely continue to reduce debt relative to consumption. Low readings in the year-over-year percent change of household debt relative to income would demonstrate that households continue to reduce their debt burden. While beneficial toward longer-term equilibrium, this balance sheet improvement comes at a cost of consumer retrenchment, or the unwillingness to spend.

If consumers, who generate almost two-thirds of domestic GDP, start to save more or borrow less, they will spend less. A decline in consumption would likely prompt businesses to retrench and defer capital outlays and potentially eliminate more jobs, creating further downward pressure on the demand for goods and services. The risk that policymakers and Wall Street is focused on is that the consumer deleveraging process could become a vicious circle given the magnitude of outstanding debt.

While it may be difficult to foresee the return of economic normalcy given the backdrop of 2008 and 2009, we encourage investors to take the long view. A more moderate economic environment will return, although perhaps not this year.

In “normal” recessions, it is common for severe contractions to result in strong recoveries, as pent-up demand gears up from policy responses. This cycle, however, is different in that consumers are required to reduce their debt burden. In previous recessions in the post-WWII period, while the growth of household debt may have moderated, it was still positive every year on a year-over-year basis. Reaching a long-run debt equilibrium going forward requires negative debt growth.

A trend toward consumer retrenchment does not necessitate sustained decline in demand. Rather, growth in consumer spending may moderate relative to recent historical trends and will be measured from lower levels. For example, housing and autos have led the decline in domestic demand, and both appear to have overshot on the downside. Just as the excessive growth in debt was unsustainable, downside demand is likely to be as well. If one believes that Americans will not live in homes and drive cars for an extended economic cycle, then the only assets one should be concerned about growing are canned goods and shotgun pellets. Just like an aggregate debt decline toward equilibrium is probable, so is a movement up toward housing and auto demand equilibrium.

When viewed from a long-term perspective, the first wave of institution deleveraging was quick and decisive. The July 2008 to March 2009 market dislocation will probably be remembered by most investors as the worst of their lifetimes. The second wave, household deleveraging, has shown signs of significant progress, but will likely require several more years to complete. Stabilization in housing prices and a rebound in the equity market will accelerate the household deleveraging process, albeit in a lower consumption and higher savings environment. The modern “dismal science” of risk-taking among corporate, financial and shadow financial institutions will be tempered for an extended period. A return to more uncomplicated and transparent financial system will be a positive development.

In future commentaries, we will provide more insight into and address the effectiveness of policy measures, including the Obama administration’s bank stress test initiative.