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What's Really Eating the Markets? U.S. Debt

A credit bust is coming and it won't be pretty.
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A gigantic credit bust is about to happen in America. The prospect of that, not political or international events, is what's driving the stock market down.

As stocks plunge from their recent highs, pundits have been quick to look for catalysts. But few experts are giving enough weight to the massive debt mountain that is about to collapse with serious consequences for the U.S. economy.

Fed chairman Alan Greenspan has been able to keep the U.S. economy afloat since the stock market bubble popped in 2000 by setting interest rates low enough to unleash a tidal wave of credit to households, chiefly in the form of mortgages, home equity loans and credit-card debts.

But now, with interest rates on their way up, that flow of credit is likely to contract, causing a further rise in personal bankruptcies, a slump in house prices and a slowdown in the economy. The U.S. has of course been through credit busts before. But because of the amount of debt creation over the last 10 years, this crackup is going to be worse than any we've seen in the post-war period.

And past experience shows that it will only take a small rise in interest rates from their historic lows to trigger the crunch. In other words, watch loan growth shrink -- and house prices start dropping -- soon after the Fed starts to increase its federal funds target rate. Economists expect a hike in the federal funds rate as early as the June 29-30 meeting of the Fed's monetary policy-setting committee.

Greenspan and his lieutenants at the Fed, not to mention a large swath of Wall Street economists, go out of their way to dismiss the notion that the average U.S. borrower is over-leveraged and that financial distress is right around the corner. They are always quick to say why interest rates won't have to go up by much, citing high productivity and low inflation. But even if rates do start going up, they don't see big problems. For example, in 1994, the Fed increased its federal funds rate aggressively, taking it from 3% at the end of 1993 to 6% at the beginning of 1995. The move did cause some disruption in the bond markets and on banks' balances sheets, but it didn't tank the economy. Indeed, from 1995 to 1999 there was scorching growth.

However, figures clearly show that households are loaded to the gills with debt and even if interest rates only go up by a tad -- a highly unlikely outcome -- it will be enough to set off the worst credit crunch in decades. The more dependent on debt an economy becomes, the more harm will be done by a rise in interest rates. This was clearly seen in 2000, when it took only a 1.75 percentage point increase in the federal funds rate to trigger the Nasdaq slump and a jolting pull back in business investment.

And the fed funds rate, currently at 1%, may have to rise by well over that amount to bring them to a level that dampens the inflationary pressures building in the economy. Why can we be so sure that such a move would hurt the economy?

First, it would slow mortgage-related lending and thus lead to decline in house prices in many parts of the economy. In turn, that would damage the banking sector, which is far more exposed to mortgages than it has been in the past.

Debt growth has been heady. Outstanding household mortgages have been growing at 10% or over since the end of 2001, according to Fed statistics. All through 2003, mortgage growth was 13%-plus, which is a red-hot rate, given that the average growth rate for the last 20 years is 9%. Moreover, at the end of 1993, just before the 1994 rate hikes, mortgage debt was growing at only 6%.

The impact of this debt growth on house prices has been to push them up to ridiculous levels. House prices were rising by 8% nationally at the end of last year, and at much higher rates in large states like California (13.8%), New York (11.62%) and Florida (11.34%). The 20-year average growth nationwide growth rate is only 4.8% and at the end of 1993 house prices were only going up by 3%, clearly indicating that this time is different.

There are other indications that house prices are way too high. Looking at the value of residential real estate as a percentage of disposable personal income is a nice way of showing how out-of-whack prices have gotten with incomes. That ratio is now at 182%, which is over 20 percentage points higher than its last peak in the late eighties, just before the last real estate bubble burst, Paul Kasriel, economist at Northern Trust points out. Sure, low mortgage rates make housing seem affordable, but mortgage rates will certainly rise back up to average historical levels. In April, the average mortgage rate was only 5.83%, compared with a 20-year average of 8.69% and 7.17% at the end of 1993.

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And household balance sheets are hardly strong enough to take a drop in house prices. The equity that people have in their homes has plunged as a percentage of real estate assets since the mid-1980s. It is now 55%, compared with a 20-year average of 61%. Repayments on all types of household debt and leases are at a very high percentage of disposable income, which means any increase in rates will bring down spending on goods and services. And even if individuals wanted to carry on borrowing, banks may be reluctant to extend credit at recent rates, since mortgage-related assets now account for 59% of banks' earning assets, a record high and massively up from around 30% in the mid-eighties.

The housing market takes time to drop when credit spigot gets turned off. But the slide in house prices in certain areas will happen. This close link between debt growth and sales can be seen in the auto market. Even though automakers like




still grant incentives like 0% financing to consumers, they are having real problems hitting sales targets. What clearer sign could there be that people are maxed out and that auto prices are going to have to come down before cars sell?

People look back and note that, on a nationwide basis, house prices have never actually fallen. That could easily happen this time around, and the drops in some states could be brutal.

The Fed under Greenspan will do all it can to keep rates as low as possible. But it won't succeed. If inflation numbers come in as high as in recent months, the hikes could happen fast and furious. Indeed, we could easily see the fed funds rate at 4% or over, compared with the current 1%. At the moment, the Fed is lending at sharply negative real interest rates. The fed funds rate of 1% minus the latest inflation rate of 2.3% gives a negative real interest rate of 1.3%. The 20-year average is a


rate of 2.4%. To get to 2.4% now would mean hiking the fed funds rate to 4.75%. No economists expect that to happen any time soon. But it shows that a fed funds rate of over 3% is a real likelihood over the next 12 to 18 months.

Market pundits and all debtors have gotten so used to the idea of rates being low that they just don't foresee the cost of borrowing ever going back up to the average levels of the past 20 years. There is no way that productivity has created the sort of environment where real interest rates can remain negative for long periods of time.

Keeping the economy afloat by inflating a credit bubble is the stupidest thing any central bank could do, but they do it again and again. The Fed under Greenspan took that stupidity to a new high. And America is about to pay with the greatest credit bust of the last 50 years.

In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to