We just passed the 10-year anniversary of the Great Financial Crisis, the worst capital market meltdown since the Great Depression. Given that the Great Recession saw the US stock market shed $7.9 trillion in value (global market lost $34.4 trillion) and cost the US economy $22 trillion, it’s understandable that Americans and investors today fear a repeat of this disaster.
That’s especially true when the financial media, always eager to attract eyeballs to boost ad dollars, frequently tout doomsday predictions like Next crash will be “worse than the Great Depression”: experts.
Such hyperbolic and alarmist articles cite super bullish experts like Peter Schiff, CEO and chief global strategist of Euro Pacific Capital, who recently said:
“We won’t be able to call it a recession, it’s going to be worse than the Great Depression…The US economy is in so much worse shape than it was a decade ago…Our prediction is that central banks will go from being feted for ‘saving the world’ in 2008 to being vilified for being impotent in the coming deflationary crash.” – Peter Schiff
The primary reason people like Schiff are so pessimistic about the next economic downturn is the belief that super high levels of debt (both domestic and international) at all levels, consumer, corporate, government, will result in a financial deluge. One that will make the financial crisis of 2008-2009 seem like a mere sprinkle in comparison. Should such doomsday prophecies prove true, stocks (SPY) (QQQ) (DIA) could be set to fall far more than the 57% decline seen a decade ago. That would be potentially double the 34% average peak decline seen in the 11 bear markets since WWII.
(Source: Moon Capital Management)
Given that this would decimate tens of millions of retirement accounts, just when so many baby boomers are either retiring or already enjoying their golden years, many investors are understandably sweating such sensational predictions.
Now I’m not going to blow smoke and tell you that high US and global debt levels are not a risk, because they certainly are. But in an effort to restore sanity to this discussion and talk readers out of making a potentially costly mistake (like staying away from stocks entirely), I’ve decided to do a multi-part series looking at the risks of another financial crisis. Over the coming weeks, we’ll be looking at the various levels of consumer, corporate, and government debt to see just how likely they are to trigger another financial cataclysm. Finally we’ll end the series with a look at how investors (including retirees) can protect their wealth should another Great Recession strike.
So let’s kick things off with a look at US consumer debt, which was the trigger point for the Financial Crisis. Specifically let’s see why it’s not likely to be the fuse that lights the powder keg of the next one.
US Consumer Debt Is Now At All-Time Highs BUT…
(Source: Motley Fool)
Many doomsday economic predictions point to US consumer debt being at new all-time highs. And indeed it’s true that consumer debt in aggregate is up about 5% or over $600 billion in the past decade.
But note that mortgage debt, the underlying trigger of the 2008-2009 meltdown, has actually fallen. That’s because mortgage lending has tightened up considerably and the days of NINJA (no income, no job or assets) subprime mortgages, are gone. What small amounts of subprime mortgages are being created are neither supporting trillions in derivatives nor owned by systemically important financial institutions (too big to fail banks).
Credit card debt and personal loans have similarly either declined or been largely unchanged, as US households have spent most of the last decade deleveraging.
What about the sharp rise in US auto and student loans? Well, that can be explained by a few key factors. For one thing the average new vehicle price has risen 27% from $28,350 in 2008 to $36,113 at the end of 2017. This is partially due to the rising popularity of cross-overs and trucks.
In addition, the average duration of a car loan has grown to 69.5 months, or nearly six years. The longest loans are for 96 months, or eight years. This is partially because 25% of car loans are now subprime (FICO score under 620), and buyers want to minimize their monthly payments. Longer duration loans with higher interest rates mean US auto debt has grown substantially.
What kind of threat does that pose to the financial system?
(Source: Business Insider)
Well, at first glance, it seems substantial. Today subprime delinquency rates have surpassed the levels of the financial crisis and are at their highest levels since October 1996. Similarly, subprime auto loan losses are approaching double-digit levels.
(Source: Business Insider)
But there are two important things to point out. First, delinquency rates were higher in 1996 and it didn’t result in a recession back then. Neither did loan losses being at the same high levels in late 2003. In fact, in 2003 we were at the tail end of a recession which is why subprime auto loan losses even reached that high in the first place. Why am I not sweating rising subprime auto loan losses now? That’s mostly because of who is making the subprime auto loans.
It’s not the auto companies or the major banks, but mostly smaller private equity backed firms like Summit Financial Corp., Spring Tree Lending, and Pelican Auto Finance, all of which have recently gone bankrupt. These companies borrow from big banks to fund their loans, which are then sold off as asset backed securities, or ABS. These are high-yielding high-risk income investments that other investors buy, which allows the subprime lender to recycle their capital and keep making new loans.
While the business model is similar to the subprime housing disaster, keep in mind that subprime auto lenders have been going bankrupt in large numbers for the last two years. That has barely caused a blip on the radar of the broader financial markets or banking profits. The reason that subprime auto isn’t likely to sink major financial institutions is because subprime mortgages were turned into dangerously levered bets by big banks (up to 30X leverage).
While true that in a recession such losses would rise, the point is that subprime auto lending itself is neither likely to trigger a recession nor cause a full-blown financial crisis. Rather it will be investors in subprime auto lenders and private equity firms that suffer, because major banks are not levered to the hilt on subprime-backed auto loans.
What about soaring student loan debt? That is due to two main factors.
First, the inflation-adjusted annual cost of college, both private and public schools, has more than doubled in the past 30 years. That’s because the value of a college degree has increased enormously since the Great Recession.
Since 2009 about 75% of all net new jobs have gone to college graduates. That’s because about 10,000 baby boomers are retiring each day and companies are needing to replace these highly skilled and experienced workers with people who can perform similar tasks.
But it doesn’t matter why students are taking on more debt, doesn’t $1.5 trillion in student debt potentially pose a risk of another financial meltdown? Actually no, for a couple of reasons. The first is that very little (under 20%) of student loans are securitized, and thus capable of spreading financial risk like subprime mortgages.
Mortgage-Backed Securitization In Trillions Of Dollars
Then there’s the scale of the mortgage securitizations that we saw in the housing bubble. Every single year more home mortgages were bundled into loans (including those backed by subprime NINJA loans) than the cumulative student loan burden today. That smaller scale alone means that student loans aren’t likely to cause another financial crisis. How can we be confident of this? Because student loan delinquency rates have been high or rising for about five years now and have not blown a major hole in bank balance sheets.
Ok, so maybe subprime auto loans and student loans aren’t going to cause another financial meltdown. But what about the fact that total consumer credit is once more at all-time highs? Doesn’t that mean that another crisis is imminent? Well, no actually, because we have to remember to put total consumer debt levels in context.
…That’s Not Likely To Cause Another Financial Calamity
Yes, consumer debt has never been higher in the history of the US, and is up over $600 billion since 2008. However, you have to keep in mind two things. First, the US population and economy have grown immensely since then.
- US Population 2008: 304.1 million
- US Population 2018: 328.7 million (up 24.6 million or 8.1%)
- US GDP 2008 (not adjusted for inflation): $14.7 trillion
- US GDP 2018: $20.5 trillion (up $5.8 trillion or 39%)
In the past decade, the US population has grown by the equivalent of the combined populations of Florida and Nevada. While US consumer debt is up 4.7% in the past 10 years, that’s spread out over a population that’s 8.1% larger. Thus on a per person basis consumer debt is actually lower.
And that debt is now more easily supported by an economy that’s about 40% bigger. Sure that’s not adjusted for inflation but remember inflation reduces the burden on borrowers since loans are repaid in dollars with less purchasing power. More importantly, at an aggregate level US household leverage (debt/assets) is way down over the past 10 years.
In fact, America’s household leverage ratio is now at its lowest level since 1985 (33 years). And as a nation our inflation adjusted net worth per capita is at an all-time high meaning that servicing that debt is not hard.
Now it’s true that greater wealth inequality means that any given individual may not necessarily be able to pay off rising debt with asset sales. And much of those assets are in the form of real estate and stocks, which can rapidly fall in value or are not highly liquid.
So let’s instead look at what percentage of household disposable (post tax and mandatory cost of living) income is going to paying interest costs. In Q1 2018, the figure was 10.2%, one of the lowest levels in the past 40 years. But what about rising interest rates? Won’t that cause rising consumer debt defaults that might tank the financial system yet again?
Probably not, for two reasons. First, note that interest rates are not expected to rise nearly as high as they hit in 2000 or 2007. At that time households were spending 12.5% and 13% of disposable income on debt service.
Second, we can look at the St. Louis Fed’s financial stress index to see the state of the overall US financial system today. This is an indicator consisting of 18 metrics tracked on a weekly basis by the St. Louis Fed. A reading of zero is correlated to the average financial stress over time. Today that reading is -1.3, indicating below average financial stress. That’s despite high and rising auto and student loan delinquencies.
Thus we have further proof that today’s consumer debt levels are just not likely to cause another financial crisis, but probably won’t even trigger a mild recession.
So does that mean that another financial crisis will never be triggered by consumer debt (or any kind of debt for that matter)? Of course, not. Financial crises have been with us for over 400 years, and will happen every few years. But it’s important to remember to put such periods of financial turmoil in context.
Another Financial Crisis Will Happen One Day But Isn’t Likely To Cause An Economic Meltdown
Since 1982 there have been no less than seven major financial crises including:
- 1982: Latin American sovereign debt crisis: resulted in IMF bailout
- 1980’s US Savings and Loan crisis: resulted in over 700 S&Ls going bust
- 1989 US Junk Bond crash: resulted in bankruptcy of Drexel Burnham Lambert, the fifth largest investment bank of its day
- 1994’s Tequila Crisis/Mexican Currency crash: resulted in $50 billion US government bailout/loan guarantee
- 1997-1998 Asia/Russia Currency Crisis: Resulted in $40 billion bailout by IMF and Fed orchestrated bailout of Long-Term Capital Management, a hedge fund with $126 billion in AUM at its peak
- 2000-2002 Dot Com Bubble: Nasdaq fell 80% peak to trough, many tech stocks fell more, numerous went bankrupt
- 2007-2009 Financial Crisis: subprime mortgage/toxic derivatives-based meltdown
And note I’m not even including more minor periods of financial market turmoil like the euro sovereign debt crisis of 2009 to 2014. Yet despite numerous financial crises since 1982, there have been just four recessions in the US.
With the exception of the Great Recession, all have been mild, averaging just a 1.5% peak to trough dip in GDP. And most of those were not directly caused by any of the above financial crises, but rather a normal part of the business cycle.
The point is that there is a 100% certainty that we will have another financial crisis in the future. In fact, one usually happens every 4 years. But unlike the catastrophe of 2007-2009 that many fear is returning soon, most of these are like the euro crisis and result merely in stock market volatility. They don’t usually cause negative GDP growth, and certainly not a recession “worse than the Great Depression”.
Bottom Line: Consumer Lending Isn’t Likely To Cause Another Financial Crisis So Don’t Panic And Sell All Your Stocks
Financial crises are something that have existed for centuries, effectively since modern capitalism started. Asset bubbles driven by rampant speculation, misallocation of capital, and yes, excessive debt, are something that will always be with us.
So while it’s true that another financial crisis will occur at some point, it’s important to remember that most of these are relatively minor, and far less devastating than what occurred during the Great Recession. It’s impossible to pinpoint when and where the next crisis will spring from. But looking at the actual US consumer debt data today, it’s not likely that consumer debt will be the trigger point of the next major capital market meltdown.
In coming weeks, we’ll explore the risks that corporate and government debt pose to the economy and stock market. We’ll also explore the best ways for investors, including retirees or near retirees, to protect their wealth, and to avoid being impoverished even should another financial meltdown strike.
Ultimately the goal of all investors should be to take a balanced, evidenced-based approach to risk management. That means being aware of global and domestic economic risks. But in a way that doesn’t let these fears of potential worst case scenarios scare you out of buy-and-hold long-term investing. That’s because market history shows this is the best way for building wealth and achieving your retirement goals.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.