A Bloomberg headline from earlier in the week caught my attention: “U.S. Downgrade Seen as Upgrade as $4 Trillion Debt Dissolved.” As someone that analyzes the data closely – and disputes the entire notion of deleveraging – I had to read on:
“U.S. debt has shrunk to a six-year low relative to the size of the economy as homeowners, cities and companies cut borrowing, undermining rating companies’ downgrading of the nation’s credit rating. Total indebtedness including that of federal and state governments and consumers has fallen to 3.29 times gross domestic product, the least since 2006, from a peak of 3.59 four years ago… Private-sector borrowing is down by $4 trillion to $40.2 trillion. Reduced borrowing means there is less competition for the U.S. Treasury Department as it sells debt to fund spending programs to help the nation recover from the worst financial crisis since the Great Depression. Credit-rating firms are discounting the improvement even as debt, equity and currency markets suggest the U.S. is more creditworthy than before Standard & Poor’s stripped the nation of its AAA grade in 2011. Deleveraging in the private sector may allow households to boost spending, which accounts for about 70% of the economy, and increase their capacity to pay taxes.”
The data and Macro Credit Analysis always pose challenges, so I figured it was worth a deeper dive. This requires going directly to the Federal Reserve’s own Z.1 data.
Total system Credit Market Debt Outstanding ended Q2 2012 at a record $55.031 TN. As a percentage of GDP, this was 352.6%, down from 371.6% at the end of 2008. I’ll attempt to explain why this actually does not reflect system debt deleveraging.
Total system-wide Credit Market Debt combines Total Non-Financial Market Debt along with Financial Sector Credit Market Debt (FSCMD). Total Non-Financial Market Debt ended Q2 at a record $38.924 TN - and 249% of GDP. This compares to Q4 2008 total Non-Financial debt of $34.479 TN - and 240% of GDP. The post-2008 decline in total debt and the improvement in the ratio of total debt/GDP are predominantly explained by the contraction in Financial Sector Credit Market borrowings. Total FSCMD peaked at $17.123 TN during Q4 2008, or 119% of GDP. Total FSCMD ended Q2 2012 at $13.838 TN, down $3.285 TN to 89% of GDP. There are crucial Credit Dynamics at work here worth exploring.
Combining Non-Financial and Financial Sector debt incorporates an element of double counting. Say a new homeowner takes out a $100,000 mortgage to buy a new home. This would add $100,000 to Household Mortgage debt (a component, along with Corporate and Governmental borrowings, of Non-Financial debt). If this mortgage was then securitized and sold into the marketplace, this would as well add $100,000 to Financial Sector (MBS or ABS) Market liabilities/debt.
Perhaps there’s still some value in using Total System Credit, despite the double counting. Yet it has become a flawed aggregate for the purpose of supporting the “deleveraging” thesis. Interestingly, during the Mortgage Finance Bubble, most analysts were content to proclaim “double counting!” – and then conveniently disregard myriad ramifications of an unprecedented financial sector expansion. In fact, the combination of Non-Financial and Financial proved among the best indicators of mounting systemic fragilities. Why? Because it captured the “double the risk” dynamic associated with aggressively (I’m being kind here) intermediating Bubble-period Credit risk. Indeed, the total debt aggregate went parabolic right along with systemic risks during the “terminal” phase of Mortgage Finance Bubble excess.
Importantly, the doubling of FSCMD between 2001 and 2007 reflected the intensive risk intermediation required to transform increasing quantities of risky mortgage debt into instruments perceived as safe and liquid (“money”-like) stores of value in the marketplace. Even poor quality mortgage loans were pooled and structured into mostly top-rated marketable securities. Indeed, “Wall Street Alchemy” and the “Moneyness of Credit” were instrumental in creating the capacity for the Credit system to easily double mortgage debt during the Bubble. And from the Financial Sector perspective, this dynamic was fundamental to the near doubling of FSCMD during this period, largely through the expansion of MBS, ABS, GSE obligations, and sophisticated Wall Street off-balance sheet “special purpose vehicles” and such.
Financial Sector Credit Market Debt ended year 2000 at $8.168 TN. GSE issues (agency debt and MBS) and Asset-Backed Securities (ABS) ended 2000 at $4.320 TN and $1.504 TN, respectively. The market debt of Depository Institutions, Finance Companies and REITs combined for $1.506 TN, while Brokers & Dealers, Holding Companies, and Wall Street Funding Corps ended at a combined $831bn.
Let’s fast-forward to December 31, 2008, after mortgage Credit had more than doubled. FSCMD ended the year at $17.123 TN, up 110% in eight years of historic “Wall Street Alchemy.” The process of transforming increasingly risky debt into beloved instruments (specially-made for leveraged speculation) saw GSE debt/MBS jump 89% to $8.142 TN. ABS, largely “private-label” Wall Street mortgage-backed securities, ballooned 174% to $4.123 TN. Depository Institutions, Finance Companies and REITs saw their combined Market Debt increase 70% to $2.227 TN. Meanwhile, at the heart of the “alchemy,” Brokers & Dealers, Holding Companies, and Wall Street Funding Corps combined for Market Debt of $2.204 TN, an increase of 165% in eight years.
Now, let’s update the data for the post-Mortgage Finance Bubble backdrop. As noted above, Total FSCMD ended Q2 2012 at $13.838 TN, a decline of $3.285 TN since the conclusion of 2008. GSE debt/MBS declined $626bn, or 8%, to $7.517 TN, a rather modest contraction considering their dismal financial circumstances. Notably, ABS dropped $2.267 TN, or 55%, to $1.856 TN.
The three Trillion-plus contraction in FSCMD did reduce Total System Market Debt – in the process seemingly improving debt-to-GDP ratios. It is not, however, indicative of true system deleveraging and surely doesn’t reflect an improvement in our nation’s overall Credit standing. Far from it. From a Macro Credit Analysis perspective, the decline in FSCMD is instead reflective of fundamental changes in both the type of debt now fueling the boom and the corresponding nature of system risk intermediation.
First of all, mortgage debt is about to wrap up its fourth straight year of post-Bubble contraction. Problem loan charge-offs have played a significant role, as have individuals using lower debt service costs (and near-zero returns on savings!) to speed the repayment of outstanding mortgages. And, importantly, the decline in home values and the steep drop in transaction volumes have reduced demand for new mortgage debt – hence the need to intermediate mortgage Credit. That said, the biggest factor behind the drop in FSCMD has been the activist Federal Reserve.
The Fed’s balance sheet is separate from the Financial Sector. Federal Reserve Assets ended 2007 at $951bn. Fed holdings ended Q2 2012 at $2.882 TN, up $1.931 TN, or 203%, in 18 quarters. The Fed essentially transferred $2 TN of Financial Sector liabilities to a secure new home on its balance sheet. Some may refer to this as “deleveraging,” but I won’t.
Importantly, the Fed’s moves to collapse interest rates and monetize debt (in conjunction with mortgage assistance programs) incited a major wave of mortgage refinancing. And through the refi process, large quantities of private-label mortgages (previously included in FSCMD as ABS) were essentially transformed into sparkling new GSE-backed mortgage securities – and many then conveniently found their way onto the Federal Reserve’s rapidly inflating balance sheet. This provided critical liquidity that allowed highly-leveraged Wall Street proprietary trading desks, hedge funds and banks to de-risk/de-leverage. This bailout accommodated deleveraging for the financial speculators, yet for the real economy the boom in Non-Financial debt ran unabated.
As noted above, Total Non-Financial Market debt ended this year’s second quarter at $38.924 TN and 249% of GDP – both all-time records. Garnering all the focus from the deleveraging crowd, Total Household Debt has indeed declined since 2008 – having dropped $787bn, or 5.8%, to $12.896 TN. At the same time, Federal debt has increased $4.689 TN to $11.050 TN. Non-Financial Corporate debt increased $434bn since ’08 to end Q2 2012 at a record $11.990 TN. State & Local debt has expanded $101bn since ’08, ending Q2 at about $3.0 TN. The data is the data - and Deleveraging is a Myth.
A 100% increase in Federal debt and 200% growth in the Federal Reserve’s balance sheet are surely not indicative of system de-leveraging. Such extraordinary Credit developments do, however, have profound effects throughout the markets and real economy. The ongoing Credit expansion has inflated incomes, spending, corporate earnings and securities prices, in the process sustaining for now the U.S. economy’s Bubble structure. And I would argue strongly that the data support the thesis that our system remains dominated by Bubble Dynamics.
Also keep in mind that, in contrast to risky mortgage debt, federal debt requires little intermediation. The marketplace absolutely loves it just the way it is, conspicuous warts and all. For now, at least, it is “money” and shares money’s dangerous attribute of enjoying virtually insatiable demand. The only alchemy necessary is to keep those electronic “printing presses” running 24/7. It is, after all, the massive inflation of federal debt that is inflating incomes, cash-flows and profits, equities and fixed-income securities prices, and government tax receipts and expenditures – in the process validating the “moneyness” of the ever-expanding level of system debt (Ponzi Finance).
The history of money is a sad state of affairs. Failing to learn from a litany of previous monetary fiascos, “money” is these days being abusively over-issued. And when the marketplace inevitably decides that over-issuance (in conjunction with only deeper structural maladjustment) has sufficiently impaired the “moneyness” of federal and related debt, there will be no one to step in to backstop Washington’s Creditworthiness. There will be no entity left with the wherewithal for backstopping system “moneyness,” as the Treasury and Federal Reserve have done for Trillions of intermediated mortgage debt since the bursting of the previous Bubble. Moreover, in the meantime, outrageous fiscal and monetary policies will continue to foment uncertainties that will impinge the type of sound investment and wealth creation necessary to get our economy on sounder footing.
Source: Prudent Bear
