Household Debt Didn't Deter Lenders

By Sean Hannon, CFA, CFP, of Covestor.com

Contracting credit should be an aspect of the business cycle. As the economy grows, credit expands, investments are made and price levels rise. Eventually, we reach a point at which prudent lending standards prevent further credit expansion, borrowing stagnates and economic growth either moderates or declines.

During the decline, certain borrowers will experience hardship and default on their loans. If, during the expansion, debt levels remained moderate and loan standards prudent, defaults would be limited and economic damage contained.

Our current crisis is much different. As the credit bubble expanded earlier this decade, household debt grew from 60% of GDP to 97% of GDP. Similarly, household debt as a percentage of disposable income (measured as income after taxes) grew from 89% to 127%.

Normally, high debt levels would force prudent lending standards as the risk of loss is elevated. Instead, the credit bubble was inflated as investor demand for extra yield and the belief that asset prices only increase caused many lenders to loosen underwriting standard and create subpar loans.

As many homeowners find themselves with negative equity, the rationale for owning a home shifts and their choice is to walk away. Normally, we see economic stress cause people to lose a home they would rather keep. Currently, we have seen people willing walk away from homes prior to a true downturn in the economy. This has caught many lenders off guard and has led to tightening of credit to nearly all clients. Thus today's borrowers suffer for yesterday's mistakes.

With the access to credit eliminated and debt levels high, individuals find few options to expand consumption. If consumer spending drops, economic growth also drops. So what are the alternatives? Because the economy is dependent upon borrowed money to grow, we must rely on the one entity with the ability to borrow and spend -- the federal government.