A deleveraging detail

Posted by Cardiff Garciaon Jun 29 21:34.

Credit Suisse have just published a note that adds a small bit of nuance to the US deleveraging narrative.

Household debt as a percentage of disposable income is the ratio typically used when discussing the progress of US debt reduction. And by this ratio, although decent progress has been made, it remains well above the 84 per cent average that prevailed in the 90s:

The deleveraging since the crisis thus far has been the result of both voluntary (frugality and paying down debt) and involuntary (foreclosures and writeoffs), with the latter still accounting for most of it.

Credit Suisse, however, point to a limitation of the debt-to-disposable-income ratio: it doesn’t take into account the prevailing interest rates on the debt owed. And as interest payments are a key component of the payments that households are actually making on their debt, the ratio isn’t a comprehensive measurement of the economic stress on households.

Credit Suisse explain, and point to an alternative:

One of the risks of an elevated debt-to-income position is that it leaves households vulnerable to such potential financial shocks as job losses and prolonged illness. As an indicator of this type of stress, however, debt-to-income ratios have some drawbacks. Most glaringly, they don’t account for the interest rates households are paying on their liabilities.

In this regard, measures of debt service burdens have some advantage over traditional debt-to-income ratios.  Debt service calculations can be thought of as the share of income committed by households for paying interest and principal on their debt. They can provide some guidance on the likelihood households will default on their obligations when they suffer unexpected financial adversity.

The household debt service ratio (DSR) calculated by the Federal Reserve is an estimate of the ratio of debt payments to disposable personal income. Debt payments consist of the estimated required payments on outstanding mortgage and consumer debt.

And the decline in this ratio looks a bit more favourable…

… and is the result of both deleveraging and the steady decline in interest rates of the last several years.

Of course, rates can go up as well as down, and the debt service ratio has a problem of interpretation similar to that of other deleveraging data — specifically, that it’s hard to know who’s doing the paying down, and of what.

Scenario 1:

The debt service ratio calculations presented above should be interpreted against the backdrop of nearly seven million fewer employed Americans today than in late 2007, with all the loss of individual and household income that implies. One reasonable inference is that the balance sheet repair of the 91% of the workforce still employed has advanced  even further than the aggregate figures would indicate.

Scenario 2:

However, there is an alternative possibility. If one assumes that households suffering from unemployment are highly correlated with those who have been foreclosed on homes and/or lost access to credit cards, then – perhaps counterintuitively — their debt service ratios would plunge toward zero, suppressing the aggregate measure. In this second scenario, the remaining 91% of the workforce still employed would have a higher DSR than the overall figures suggest.

So the ratio contributes to understanding the aggregate economic burden on households, but is best used in conjunction with other indicators that measure household balance sheets.

Full note in the usual place.

Related links:
US deleveraging isn’t just about defaults and charge-offs – FT Alphaville
Household deleveraging flattened in Q1 – FT Alphaville


This entry was posted by Cardiff Garcia on Wednesday, June 29th, 2011 at 21:34 and is filed under Capital markets. Tagged with , , .

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