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Wolf Richter
Wolf Street

The American economy has split in two: how averages of wealth & debt paper over the profound risks.

We constantly hear the factoids about “American households” that paint a picture of immense wealth – and therefore a lack of risk for consumer lenders during the next downturn. We hear: “This – the thing that happened in 2008 and 2009 – won’t happen again.”

For example, total net worth (assets minus debt) of US households and non-profit organization (they’re lumped together) rose to an astronomical $92.8 trillion at the end of 2016, according to the Federal Reserve. This is up by nearly 70% in early 2009 when the Fed started its QE and zero-interest-rate programs.

Inflating household wealth was one of the big priorities of the Fed during the Financial Crisis. It would crank up the economy. In an editorial in 2010, Fed Chair Ben Bernanke himself called this the “wealth effect.” So with this colossal wealth of US households, what could go wrong during the next downturn?

Here’s what could go wrong:

About half of Americans do not have enough savings to pay for even a minor emergency expense. The Federal Reserve found that 46% of adults could not cover an emergency expense of $400, such as a broken windshield. They would either have to borrow the money or try to sell the couch or something. So nearly half of the adults in the US live from paycheck to paycheck.

About 15% of American households have either zero or negative net wealth, according to the New York Fed. Negative net worth means they have more debt than assets.

And nearly 47 million Americans, or nearly 15% of the population, live below the poverty line, according to the Census Bureau.

So who benefited from the “wealth effect”? Those who had the most assets. At the very tippy-top: Warren Buffet. At the other end of the spectrum, in 2016, only 52% of households owned stocks directly or indirectly. The phenomenal stock market boom left 48% – usually those below the poverty line, those who cannot cover emergency expenses, those with zero or negative net worth, etc. etc. – in the dust.

Even those Americans with good incomes have loaded up with debt to try to live the American dream. In total, it has led to this situation:

  • Student loan balances have skyrocketed by 160% over the past ten years to $1.4 trillion.
  • Auto loan balances have shot up 42% over the past ten years to $1.1 trillion.
  • Credit card debt and other revolving debt – one bit of good news, to the great desperation of economists who want consumers to borrow more to spend more – has inched up only 7% over the past ten years.
  • And households owe nearly $10 trillion in mortgage debt.

But here’s the thing about those mortgages: About 41% of the owner-occupied homes were free and clear, without mortgage, according to the Census Bureau’s study in late 2016. So the mortgage debt of $10 trillion is actually borne by only 59% of the homeowners. And many of them have paid down their mortgages to a large extent. So a much smaller percentage of Americans carry the lion’s share of that $10 trillion in mortgage debt. That’s where the risks are.

The same with student loans and auto loans: those with the least amount of savings, and the smallest net worth, or those with negative net worth, owe a big chunk of this debt.

Sure, when automakers offer 0% financing on an $80,000 vehicle, a wealthy person with a credit score of over 800 may be tempted to finance it. It’s free money. Those loans are good as gold. But at the low end of the spectrum, there are subprime auto loans, which account for about 22% of total auto loans being originated. And these subprime auto loans that have been packaged into asset backed securities and sold off to pensions funds are now defaulting at rates beyond the highs of the Financial Crisis.

Student loan defaults have reached catastrophic levels. On the surface, the number of people in default on their federal student loans surged 17% in 2016 to 4.2 million, of the 42.4 million Americans with student loans. But the Department of Education conceded in January that it had massively overstated repayment rates. A subsequent analysis by the Wall Street Journal found that at more than 1,000 schools, at least 50% of the students defaulted or failed to pay down debt within seven years.

Default rates for mortgages overall are still low, though they’re inching up. According to S&P/Experian First Mortgage Default Index, the default rate rose from 0.64% in May 2016 to 0.74% in February 2017. And they will remain low as long as home prices continue to rise, as they have been in the US over the past years. In an environment of soaring home prices, homeowners, if they get in trouble, can usually sell the home for enough to pay off their mortgage. Hence defaults are not necessary.

Defaults soar after home prices have started to sink from the lofty peaks that in many cities have already shot way past the highs of the prior crazy house price bubble. At that point, the proceeds from the sale of a home may fall far short of covering the mortgage.

In consumer credit, the risks are concentrated where people have no savings, where credit scores are lower, and where incomes are tight. That’s about half the households. The American economy has split in two, and they’re the other half.

For them, not much, if anything, has improved since the Financial Crisis. They’ve been left behind by the Fed’s wealth effect. But these are very large numbers, and they owe a large portion of the consumer debt, and their finances are fragile, and when the next downturn causes a hick-up in their lives, credit will unravel from the bottom up, as it already has begun in auto-subprime loans and student loans. But the glorious net-worth figures and other aggregate numbers and averages do a great job of papering over the issue.

And there may already be more beneath the surface. Read…  Great Debt Unwind: Consumer Bankruptcies Jump, First since 2010. Commercial Bankruptcies Spike

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