The Deleveraging Myth: Defaults Actually Account for Most of Reduced Debt

The Deleveraging Myth: Defaults Actually Account for Most of Reduced Debt

Common knowledge is that the American consumer is now doing what he or she must do to confront life in the “New Normal” – that is, paying down debt diligently.

This perception, though, appears to be a bit “overrated” – especially if you look at things like, well, the actual data.  The WSJ reports that U.S. consumers have only reduced their debt levels at a measly 0.08% annualized rate since 2008 when you back out defaults!

The sharp decline in U.S. household debt over the past couple years has conjured up images of people across the country tightening their belts in order to pay down their mortgages and credit-card balances. A closer look, though, suggests a different picture: Some are defaulting, while the rest aren’t making much of a dent in their debts at all.

First, consider household debt. Over the two years ending June 2010, the total value of home-mortgage debt and consumer credit outstanding has fallen by about $610 billion, to $12.6 trillion, according to theFederal Reserve. That’s an annualized decline of about 2.3%, which is pretty impressive given the fact that such debts grew at an annualized rate in excess of 10% over the previous decade.

There are two ways, though, that the debts can decline: People can pay off existing loans, or they can renege on the loans, forcing the lender to charge them off. As it happens, the latter accounted for almost all the decline. Our own analysis of data from the Fed and the Federal Deposit Insurance Corp. suggests that over the two years ending June 2010, banks and other lenders charged off a total of about $588 billion in mortgage and consumer loans.

That means consumers managed to shave off only $22 billion in debt through the kind of belt-tightening we typically envision. In other words, in the absence of defaults, they would have achieved an annualized decline of only 0.08%.

A few weeks ago, we posted commentary from Andy Kessler, who believes that the U.S. consumer is just 3 years into a 7+ year deleveraging cycle.

No matter which way you slice the analysis, it sure looks like we’re in for at least another 5 lean years as consumers continue to default on pay down their debts.

But don’t worry – the recession ended in June 2009!