Friday, February 20, 2009

Who owes who what

The Federal Reserve publishes their quarterly flow of funds report. It is a fascinating document with all kinds of interesting figures.

One table shows the assets and liabilities in the US credit markets. So it shows you who owes who what.

Here are some statistics. Everything is in Trillions of dollars.

The total credit markets $51.80T. The following table shows who owes the debt and who owns those same credit market instruments as assets. Categories less than $1T are not shown.

Borrower 2009 2004
Household and Non-profit $13.92T $9.50T
Non-farm, non-financial, corporate $7.01T$4.97T
Federal Government $5.80T$4.03T
Issuers of asset-backed securities $4.21T 2.21T
Government Sponsored Enterprises $3.15T $2.60T
Non-farm, non-corporate, business $3.75T $2.20T
State and local government $2.22T$1.57T
Rest of World $1.96T$1.25T
Commercial Banks $1.46T $0.66T
Fianance Companies $1.28T $1.00T
Total US credit market debt $51.80T $34.60T
Rest of world $7.85T $3.84
Commercial banks $7.85T $5.99
Domestic non-financial sectors $6.15T $4.79
US Agency and GSEs total mortgages $4.89T $3.32
Issuers of asset-backed securities $4.11T 2.12T
Households and Non-profits $4.09T $3.04
Insurance companies $3.79T $3.11
GSE credit and equity instruments $3.02T $2.56
State and local governments $1.48T $1.12
Pension funds $2.37T 1.51T
Mutual funds $2.37T $1.51
Finance companies $1.621T 1.201T
Savings Institutions $1.32T $1.29

One thing that is trivially true but also something that most people don't think about is that debt nets to zero. All debts or liabilities are someone else's assets. The net debt of the world is zero. This table above shows that the net debt in the US is $7.85T-$1.96T = $5.89T. This is the difference in the gross amount that we lend to them minus what we owe to them. The rest, $45.9T, is debt that we owe to ourselves. That is it nets out to zero inside America. But who are the borrowers and who are the savers?

Basically it breaks up into three groups. There are the net debtors: households, non-financial businesses and government. Then there are the net savers, banks, pension funds, insurance companies and mutual funds. You can also include "rest of world" here. Then there are what you can call arbitrageurs. These are entities that have large gross debt but little net debt. That is, they borrow from the capital markets but invest in other debt instruments. These are: GSEs, issuers of asset backed securities and finance companies. This would also include hedge funds, investment banks and the like.

So do we have too much debt? Remember debt is a gross measure. Much of this debt is just due to the rise of the arbitrageurs. Whether that is good or bad is hard to say. All of this extra leverage helps with liquidity. It makes it easier to borrow and therefore probably lowers interest rates and lubricates the wheels of industry. Whether or not it does anything else useful is hard to say. It also of course adds complication to everything and we have been paying the price for this over he past few years.

There is clearly too much household debt. As you can see from the table above, household debt grew from $9.50T to 13.92T from 2004 to 2009. Most of that is mortgage debt but is also made up of credit card debt, home equity loans, student loans, auto loans etc. During that time, average salaries did not increase. People simply over-consumed. Now their assets, homes and stocks, are falling in value and so they are getting poorer and they will have great difficulty servicing this large debt load.

Businesses also borrowed heavily. Corporate and non-corporate together increased their borrowing from $7.17T to $10.76T. Earnings may have increased over that period but they are now dropping at the fastest pace since ... well maybe ever. They won't be able to service this debt either. According to Standard & Poor’s, nearly 66% of nonfinancial companies have below investment grade ratings. They are predicting a default rate for this group of about 14% in 2009.

We may have about $7T of unserviceable debt which is roughly the increase from 2004. Much of that will be restructured, foreclosed on etc. Maybe only 30% of that will becomes losses. But even still that is $2.1T. We can see above where those losses will show up - with the savers: banks, pension funds, insurance companies and mutual funds and the "rest of world".

So in total, it looks like this. Savers who wanted to accumulate more wealth loaned money to people who bought either consumables (e.g. steak dinners), over-priced assets (e.g. houses) or unproductive capital assets (e.g. steak house restaurants). These tuned out to be bad loans. All that principal will not come back to the savers. But the wealth that was lost by the savers didn't all go up in smoke. All the extra steak dinners might be gone but the houses and commercial real estate and businesses are not. They might have less value than everyone thought but they are not valueless. So part of the loss in wealth is just a realization that it wasn't real wealth to begin with. We as a country are really no poorer than in 2002. We just thought we got rich in between. There has of course been a transfer of wealth between many individuals but not much in the way of real net loss.

This isn't quite right though. We did increase our US net debt by about $3.3T since 2004. That works out to be about $33,000 per american family. We have assets in return however even if we might have over-paid for some of them (like houses). With our assets falling in value and wages falling due to unemployment we have to spend much less. We need to save more. This will be the main dynamic of the next few years. The world will have to adjust to a US consumer which is spending a lot less. This adjustment is likely to be very painful. Our economy is out of balance. We have too many of somethings like restaurants and retail stores and too little of other things like factories for exporting goods. Since the economy is out of balance much of the investment will be required to restructure it to the new reality. This is likely to sop up any actual economic growth for a few years.

There are some groups that are likely to benefit. Poorer people who had no or negative equity to begin with may now have large negative equity especially if they bought a house with no money down that has plummeted in value. If they walk away and declare bankruptcy, their net worth goes from a large negative number to zero. It has increased. Since they will no longer have to service this debt, they will have more discretionary income. They will be richer. Their creditors however will take the loss. This is a rather direct transfer of wealth from rich to poor. This commonly happens in depressions.