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Our ability to service our debts has decreased over the past forty years because our incomes have gone nowhere yet our debt level has had to increase as asset prices rose.

Debt Matters

November 1st, 2012 by Kurt L. Smith
  • The narrative of the financial crisis is only beginning to be written.  Slowly but surely every one of us will be able to sum up the crisis in two words: Debt Matters.  As the Federal Reserve continues its policy of buying treasury and mortgage bonds we can debate whether this will end the crisis or just end badly.  We should however already be able to agree: Debt Matters.

    As the use of debt has exploded over the past forty years, real wages have decreased.  Families once able to make ends meet on one spouse’s earnings have long required both spouses work.  In order to make it work we merely had to work harder.  No American exceptionalism here; Americans set the pace for the most hours worked in the world.

    But more work and more hours worked along with lower wages was also not enough.  One must also borrow money in order to make it financially.  This began in earnest thirty years ago with automobiles.  New car prices zoomed from $7K in 1980 to over $20K by the early 1990s.  Let me walk you down to our credit department…

    Inflation has often been the excuse/culprit in rising prices.  But tripling?  Sounds like tuition prices of late!  Perhaps the surge in new car prices in the 1980s could better be explained by the expansion of credit in the auto loan market.  Perhaps the pricing power one could achieve by lengthening auto loan terms from three years to five years in the 1980s allowed for a tripling of prices.  Perhaps leasing, an alternative financing, gave dealers the lower rates needed to support higher prices.  Perhaps the availability and willingness of car buyers to utilize credit (or the necessity of buyers to use credit) matters.

    Thankfully skyrocketing new car prices, in real money terms, peaked in the late 1990s.  Inflation, a seeming stable of everyday life every day of your life, evidently has left out car prices over the past fifteen years.  Why this has been the case seems little studied but the once mighty auto industry is but a shell of its former self.  Did the peak in auto pricing have anything to do with the destruction we later saw in this industry?  Most of us don’t live in Detroit so perhaps we are simply glad auto prices did not continue to soar to the moon.

    Is this where the housing industry is headed?  The explosion of housing prices over the past forty years was truly dazzling.  So was the increase in debt.  In 1990 US mortgage debt totaled less than $3 trillion.  In 2008 the figure was almost $12 trillion.  Even the rise in home prices, truly amazing as they were, could not keep up with that torrid pace, falling shy of a triple from 75 in 1990 to a peak of 190 in 2005 (Case-Shiller).

    Like auto prices, home prices were not as correlated to inflation as they were thought to be.  The auto industry and the real estate industry would have had you believe inflation was responsible because inflation works its magic seemingly every day of your life.  The trend line most economists love to extrapolate into the future did not foresee looming, destructive change.  Even now, after the peak in two of the most expensive assets families will ever buy, one hears little as to why the prices of these expensive assets rolled over or plunged instead of continued ever higher.

    Prices rise more when there is a greater amount of credit available.  This supply of credit is not a one way street — it must also be demanded in order to effect a transaction.  We have all heard of undocumented loans being given to those who couldn’t otherwise qualify for a loan (a fraudulent activity) but there were also those who, faced with higher and higher prices, simply said “no, we cannot afford it.”

    Obviously something caused auto prices to peak and something caused home prices to peak.  I simply posit Debt Matters.  As prices rose so did the debt service of many borrowers.  More of your income was going to auto prices (then) and home prices (now).

    Our ability to service our debts has decreased over the past forty years because our incomes have gone nowhere yet our debt level has had to increase as asset prices rose.  We wanted/needed a new car.  We wanted/needed a new home and taking on the additional debt was a necessity to make it work.  Not only that, the growing financial sector was willing and able to get you into the car or home of your dreams.  More debt, less income: a rotten combination.

    Unfortunately the debt story is not solely in autos and homes nor is the story over.  Businesses of all shapes and sizes, public and private, have taken on tremendously more debt (as a percentage of assets, equity, you name it) and what is the current result?  If you said high prices to go along with the high debt you would be getting the message.  Throw commercial real estate into the mix as well, not to mention the percentage of cash flow that goes towards business rent or debt service to pay for high real estate costs.  Higher prices supported by higher debt loads holds true for businesses just as it did for families.

    Auto prices rolling over and home prices falling off a cliff were not anticipated.  Years later we will continue to write (rewrite) the narrative but by then what is the point?  Yes, there were disasters and one could grab onto any narrative and ride that philosophical horse into the ground.  Current horses include labor unions, wage deflation, globalization, private equity, competition, deregulation, government regulation, et al.  This doesn’t help the person that wanted a new car years ago or happened to want a new house in 2005.  Living the American Dream includes a house and a car (or two).

    As more and more debt is piled up, more and more income is devoted to debt service.  With incomes mired not just in a several year downtrend but a multi-decade downtrend, our ability to handle more debt has always been diminishing yet more debt was the only way to achieve (or possibly achieve) our piece of the American Dream.  This is the fact we were able to ignore for many, many years.  Now with skyrocketing debt and even higher debt service this situation will become more in focus.

    By focusing on wages and family income one can see the importance of jobs.  Yet with high asset prices and already high debt service, we also see how jobs are not even enough.  Families are working longer and being paid less yet they no longer have the ability to borrow more in order to keep the American Dream alive.

    For us however we can see parallels in the debt/asset pricing relationship as the debt monster continues to seep into every (remaining) asset class.  These danger signs are not new, but now after even further leveraging (more debt) the risks are greater still.

    Nobody forecasted 2005 would be the (end) top for residential real estate.  Even Economist Robert Shiller was years early but early matters because late is too late.  Nobody will be able to pinpoint the top for commercial real estate, business rents, farmland, Stocks, Commodities or any of the other myriad asset classes for you to sink your Cash into.  They will however suffer the same fate as autos and homes and the reason is simple: Debt Matters.

     

    Cypress – Fairbanks Independent School District, TX
    S&P: AAA (AA- Underlying)    Fitch: AAA (AA Underlying)
    Permanent School Fund Guaranteed
    DUE 2/15 DATED 11/1/12 MATURITY: 2/15/2038
    SALE AMOUNT: $75,965,000

    YEAR MATURITY COUPON YTM*
    1 2013 2.00% 0.20%
    2 2014 3.00% 0.34%
    3 2015 4.00% 0.46%
    4 2016 2.00% 0.57%
    5 2017 4.00% 0.71%
    6 2018 4.00% 0.88%
    7 2019 5.00% 1.09%
    8 2020 5.00% 1.36%
    9 2021 5.00% 1.61%
    10 2022 5.00% 1.83%
    11 2023** 4.00% 2.08%
    12 2024** 3.00% 2.36%
    13 2025** 4.00% 2.31%
    14 2026** 5.00% 2.25%
    15 2027** 5.00% 2.31%
    16 2028** 5.00% 2.37%
    17 2029** 5.00% 2.43%
    18 2030** 5.00% 2.49%
    19 2031** 5.00% 2.54%
    20 2032** 3.00% 3.12%
    21 2033** 5.00% 2.66%
    22 2034** 5.00% 2.74%
    23 2035** 5.00% 2.81%
    24 2036** 5.00% 2.88%
    26 2038** 3.375% 3.45%

    *Yield to Worst (Call or Maturity) **Par Call: 2/15/2021
    Source: Bloomberg
    This is an example of a new issue   priced the week of 10/22/12
    Prices, yields and availability   subject to change

     

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