An Explanation of Debt and Why You Need To Understand It

January 21, 2003

The total of all debt in the US, households, business's and government was in excess of 31 trillion dollars as of August 2002.  

The GDP of the US is about 10.5 trillion dollars.

The debt to GDP ratio in the US is now at an all time record of 295%.

The previous record was 264% reached in the early 1930's and was one of the hallmark precursors of the great depression.

The current record level of debt in the US does not include the additional debt that will be incurred as a result of the current federal government stimulus plan, the necessity for every state of the Union to increase municipal bonds sales in an attempt to offset their budget deficits, the additional mortgage debt and consumer debt that has been added since this past August by US consumers.  Each of these individual segments is also growing at a record pace of their own.

The debt situation is even worse for the Japanese government and business sectors. The debt to GDP in Japan when measured just across these two sectors and without the debt of consumers is over 300%.  That number nullifies the low individual consumer debt level in Japan because all sovereign debt must ultimately be born by the citizens.

The levels of sovereign, municipal, and business debt in Europe show similar patterns. The municipal debt burden there is worse than the US and the consumer debt falls in between the US and Japan.  

When measured over all segments the debt levels of the three largest economies of the world as a percentage of their GDP are at levels no mature economy has ever been able to withstand without collapsing; ...EVER. 

The GDP of the US is about 10.5 trillion, Japan 3 trillion and Germany 2 trillion.

At the peak of the US equity markets in early 2000 the market capitalization of all US equities was about 17 trillion dollars.  This was just over half of all equities in the world combined.  In other words the US equity markets where worth more than all other equities in the world combined.

Since then over half of the US equity market capitalization has vanished, about 8 trillion dollars. Ironically however, the market capitalization of the rest of the worlds major markets has dropped even more as a percentage of their market capitalization's meaning the US still represents about half of the world market capitalization.

The vanished equity valuations, in excess of 16 trillion dollars world wide, is about equal to the combined GDP's of the three largest economies of the world, the US, Japan and Germany.  

These number would not be so ominous as indicators IF world economic activity continued to grow during this time and debt levels did not increase on a real dollar basis.

In other words economies, governments, business's and households can afford to lose asset values only if debt does not rise in real terms and incomes continue to grow.  I.e. you can afford to watch your 401K drop by half as long as you have a job.  

That however is not the case.

The rate at which paper asset wealth, stocks, decreased in value left behind a debt valuation shock. During the 1990's it was increasingly prevalent for companies to borrow against their paper asset valuation.  As paper asset values have dropped very quickly companies have been unable to borrow against their stock or even refinance existing debt to lower rates and costs because they lack the collateral to support the loans.  

This is exactly what brought down Enron.  It's stock price dropped below a bond trigger level that forced a call feature on their bonds. The bonds were called due by the holders.  The bonds could not be refinanced and the company had to declare bankruptcy.  It was after this fundamental issue that the fraud became apparent, not before. The fraud did not bring down Enron, the economy and their ludicrous leveraging did.  They were not prepared for any market consolidation and got hammered when it happened.

Most companies today are in even worse shape in this respect than they were when Enron went under.

The US and state governments are also in far worse shape today than they were then.

Most households today are in a similar situation with one caveat.  Housing valuations have increased faster than debt levels over the past couple of years.          

Because of the unique differences with respect to how mortgage loan rates are set versus commercial loans, mortgage rates have fallen as commercial rates have risen.

I will not discuss why this is here but will do so at another time.

However, as global economic activity has slowed and is continuing to do so the prospects for a net reduction in personal incomes in the US is increasing a probability.  I.e. as economic activity decreases, revenues and earnings fall, capacity utilization decreases, unemployment increases, and job creation decreases as a result.

If personal income growth begins to slow, and I believe it will, lenders will begin to become more restrictive with mortgage loan qualification guidelines, EVEN if mortgage rates continue to fall; as I believe they will.  

This will leave fewer buyers in the markets capable of qualifying for a loan even as the rates fall.

Thus far the Government Sponsored Enterprises, Fannie Mae, Freddie Mac and the Federal Home Loan Banks along with the Veterans Administration and Federal Housing Authority have been able to adjust mortgage qualifying guidelines to offset this.  

They have done so by adjusting the three main categories of underwriting; Character, Capacity, and Collateral.

For a fuller explanation of these read "The 3 C's of Credit" at <http://www.myhomelender.com/3Cs.html>http://www.myhomelender.com/3Cs.html

Character is a measure of credit worthiness.  In the past couple of years the GSE's have relaxed these guidelines to allow borrowers with credit blemishes to qualify for loans.

Collateral is a measure of downpayment available and other liquid assets.  In the past couple of years this has been brought down from a 5% downpayment requirement to no money required.  This is also the primary reason the housing market has been so strong over the past couple of years.  A reduction of this magnitude so quickly results in a parabolic increase in the number of potential home buyers and at a much faster pace than existing supply can absorb.  The result is a bidding up of home prices, especially for entry level homes.

Capacity is a measure of income versus loan amount.  This criteria has not changed much and is the last place the lenders have available to adjust in order to keep home buying strong, especially for entry level homes.  

However, as the adjustments to character and collateral requirements have been so lowered over the past couple of years the ability to now lower income requirements is probably not acceptable to mortgage backed bond buyers and will most probably not occur.

In other words the GSE's have now done everything they can do to keep housing strong.

If the US domestic economy and global trade continues to slow as it has over the past couple of years, and as I believe it will,  the next major phase of the economy will be brought on by a debt crisis coupled with a real estate and hard asset crisis.  Which occurs first is meaningless because they will go hand in hand.

As the asset bubble collapse outlined above has left behind a debt burden on governments, companies and households the prospects for a debt correction or evaporation of debt values is increasing worldwide.

If this occurs, and the prospects for it are increasing, it won't matter how low mortgage rates go for borrowers without an income to qualify for the loans.  

However, this will not stop monetary and fiscal authorities from attempting to postpone this inevitable problem by driving long treasury yields down which should drag mortgage rates down. On a marginal basis this will make borrowing costs much lower for the most qualified borrowers. 

This is also not a bad thing, it is their job, as we outlined last week.

In the absence of another solution they must continue to abide by their traditional remedies even if the prospects for them to succeed is dimming.

Tomorrow we will discuss how to properly prepare yourself for the prospects of a debt, income and hard asset contraction crisis.

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