Saturday, December 11, 2010


By Annaly Capital Management

Most of the headlines you’ll see related to the Federal Reserve’s Z.1 Flow of Funds report are focused on the change in household net worth. In the 3rd quarter 2010 report, released yesterday, the change was a positive one: household net worth rose $1.2 trillion, driven primarily by $1.3 trillion gains in equities and mutual fund shares which offset a drop of $649 billion in owner occupied housing value (the first decline since the first quarter of 2009). This reversed most of the $1.4 trillion decline in household net worth from previous quarter. Despite gains in 5 out of the previous 6 quarters, net worth remains $10.8 trillion below its 2007 peak.

We also tend to spend our time in the Z.1 report analyzing total debt outstanding in the economy. As far as the debt trends go, we are here to report that nothing has changed. All trends remain the same.

Total credit market debt outstanding still stands at over 350% of GDP, but has fallen for 6 straight quarters. Were this ratio to return to 300%, where it stood only a few short years ago in 2003, that would suggest a decline in debt outstanding of $8 trillion (holding GDP constant).

The chart below shows the individual sectors that are driving this deleveraging (and the one sector that is working hard to offset it).

Federal government debt as a percentage of GDP is now at 61.1% of GDP, which is a tie for the highest level ever seen in the data series, recorded in the very first month that the Flow of Funds data was first measured: 1Q 1952. Given the recent fiscal measures proposed by the White House, expected to add somewhere between $800 and $900 billion dollars to the deficit, it’s tough to see how a new record for government debt outstanding won’t be set in the 4th quarter of 2010.

Despite a ripping stock market, households continue to repair their balance sheets. As you see in the chart above, household debt as a percentage of GDP peaked out very near 100% before reversing course. In the chart below we look at household debt as a percentage of the organic and recurring income that is available to service it: disposable income less government transfer receipts.

In the chart, this ratio appears to be a trend variable. As new kinds of credit became more widely available to households, through the growth of credit cards and the development of the securitization machine, the household DTI ratio climbed. These kinds of financial innovation made debt easier to access, and households had the income to support it. However, debt-to-income ratios simply cannot be, by definition, a trend variable. There is an upper bound of debt that can be serviced. Were the household DTI ratio to return to 1.2, where it stood in 2002, the household would need to shed an additional $2.5 trillion of debt. Too loose underwriting standards during the housing boom may have helped the household explore for a short time the thin air above the top end of sustainable leverage.


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