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Thursday, February 10, 2011

Household Deleveraging: Why Is Consumer Debt Falling?

Mark Jickling
Specialist in Financial Economics

Darryl E. Getter
Specialist in Financial Economics

Household balance sheets have been a subject of recurrent legislative interest. Over the past decades, Congress has enacted consumer bankruptcy reform; legislation to guide credit card lending and predatory lending; a range of mortgage modification programs; tax provisions to encourage saving or change the cost of borrowing; initiatives to expand mortgage lending to lowand middle-income families; and has established a new federal agency to monitor consumer finance. Such activity has taken place against a backdrop of over four decades of steadily rising household debt.

In the third quarter of 2008, the amount of debt held by U.S. households began to fall and has continued to decline for nine consecutive quarters. This trend is unprecedented in postwar U.S. history. The process of debt reduction, or deleveraging, by American consumers has important implications for the economy. Debt is generally used to finance consumption, which accounts for about 70% of gross domestic product. Falling debt implies slower consumption growth, which in turn slows business investment. Thus, continued household deleveraging may become a drag on the economic recovery and limit the effectiveness of legislative efforts to create jobs.

The ultimate impact of deleveraging depends on uncertain factors: (1) how long the current trend continues, (2) how far household debt balances fall, and (3) whether deleveraging represents a lasting change in consumer behavior or simply a reflection of the recession and financial crisis that began in 2007, which caused significant losses in wealth to consumers and serious distress to lenders.

Debt balances are determined by three trends: (1) new borrowing by households, (2) repayment of existing debts, and (3) charge-offs, or writedowns, of debt that lenders believe is uncollectible. All three appear to play some part in recent deleveraging. Charge-off rates for mortgage debt and other forms of consumer credit rose well above historical norms after 2007 (though they began to decline in 2010). Consumers have accelerated repayment of certain debts, including mortgages, where many refinancing transactions now involve payment of principal to reduce the debt outstanding. Household borrowing appears to have fallen, yet it is difficult to disentangle supply and demand effects. Are consumers voluntarily reducing use of credit to improve their finances or are lenders more stringent about making new loans? The answer appears to be both, based on the limited evidence available.

Why would consumers change their attitude toward debt, after many decades of increased borrowing? One plausible explanation involves losses to household wealth from falling stock and home prices. Loss of wealth, particularly in real estate, may trigger defaults on debt and may spur households to seek to restore precautionary wealth balances by increasing their saving. The loss of stock market wealth in 2000 did not lead to deleveraging. What is different since 2008 is the drop in the price of houses, assets on which many households still owe money. The last time a significant drop in house prices occurred was during the Great Depression, which was also the last time sustained household deleveraging happened in the United States.

This report presents information that documents household deleveraging and discusses several possible demand and supply explanations.

Date of Report: February 8, 2011
Number of Pages: 28
Order Number: R41623
Price: $29.95

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