Yesterday,  the Federal Reserve released its Flow of Funds report for the third quarter. This is the best overall tabulation of the total amount of debt in the economy. It looks at only non-financial debt; the debt taken on by banks like J.P. Morgan (JPM) or Wells Fargo (WFC) is normally used to lend out to other parts of the economy. Thus, including it would result in serious double counting.

The picture that emerges is very interesting. Overall it shows that the level of debt growth in the country has slowed recently, but is still growing. This is happening despite the huge rise in federal debt. In the third quarter, total debt in the economy grew at a seasonally adjusted annual rate of 2.8%, down from 4.5% in the second quarter and 5.9% for all of 2008.

Even 2008 marked a significant slowdown in the overall rate of debt accumulation in the country. In the ten years from 1999 to 2008, total debt grew at an average rate of 7.5% a year.

Even more significant than the slowdown in total debt growth is the shift in who owes it. Households are making some pretty serious strides in bringing their balance sheets back into shape. In the 10 years through 2008 (and especially through 2007) household debt grew significantly faster than it did in other parts of the economy. The average growth rate over that 10-year span was 8.9% (9.8% from 1999 through 2007).

This far exceeded the ability of the household sector to service the debt, as over the same time frame, wage and salary growth was anemic. The growth rate in household debt slowed to just 0.3% for all of 2008, and turned negative in the third quarter of that year. In the third quarter of this year, it fell at an annualized rate of 2.6% and has now been negative for five quarters in a row.

It is not all about people paying down debt, or not using their credit cards. Defaults will also lower the total amount of debt outstanding. Thus to some extent the drop in household debt levels is a refection of the foreclosure crisis and the skyrocketing number of personal bankruptcies. Still the reduction in household sector debt, combined with stabilization of home prices and the rebound in the stock market has led to a sharp rebound in household net worth, as is shown in the graph below (from http://www.calculatedriskblog.com/).

Relative to GDP we still have quite a lot of ground to make up. In absolute terms, total household net worth is still $11.9 trillion lower than it was at its 2007 peak, but it has rebounded by $4.9 Trillion since the end of the first quarter. It is interesting to note, though, that even at its low point, relative to GDP, household net worth was still at levels that would have been considered very high from the early 1950’s through the mid 1990’s.

A big part of the debt owed by the household sector is mortgages. The growth of mortgage debt more than kept up with the growth in housing values during the housing bubble. This is surprising since under “normal” circumstances, the amount of the mortgage on a given home actually declines slightly each month, and if the value of the house is going up, then the percentage of the value that is owned by the homeowner, as opposed to the bank, should go up even faster. If a house is worth $200,000 and the homeowner has a 180,000 mortgage on it, and the value of the house goes up by 10% to $220,000, then the homeowners equity should double, all else being equal.

However, all else was not equal during the housing bubble. People started to act as if the latest kitchen appliance was a home ATM machine. This mortgage equity withdrawal is a big part of what fueled the growth in household debt during the bubble years.  Notice in the table below (from the Fed Report) that household debt growth was over 11% in the three most bubbly years, 2003 through 2005.

I find the next graph, (also from http://www.calculatedriskblog.com/) to be particularly interesting. Note that during the bubble years, as housing prices were skyrocketing, the percentage of overall household equity was merely flat rather than rising substantially. When housing prices finally fell, the amount of homeowner equity just fell off a cliff.

Keep in mind that 31% of all homes in the country are owned free and clear (mostly little old ladies that had mortgage-burning parties years ago). Those houses are included in the calculation of the total housing equity. Those houses are on average worth less than houses that have mortgages on them, so it is more like 25% of all housing by value that is owned free and clear.

On average, though, a homeowner with a mortgage “owns” much less than the 38% that is indicated on the chart. More than one in four owe more on the house than the value of the mortgage — in other words they have negative equity. For many of them, the most economically rational move is simply to stop paying on their mortgage, and live rent and mortgage free until the sheriff shows up at the door.

Foreclosures will lower the total amount of mortgage debt outstanding, and have played a role in the rebounding of the total equity percentage to its current level from its bottom of 33.5% earlier this year. Massive government support for the housing market has also played a role in the stabilization and incipient turnaround in housing prices. These government supports include a massive increase in market share by the FHA, which is offering loans with down payments as low as 3.5%.

In effect, this is playing the same role that the sub-prime lenders did during the bubble. I fear that it will end the same way for the FHA. There is a very high probability that the FHA is the next Fannie Mae (FNM) or Freddie Mac (FRE). The additional tax credits, initially to just “first time home buyers” and now to “move-up buyers” as well has also supported the value of housing assets.

The value of an outside subsidy to a transaction is generally shared between the buyer and the seller. The Fed is artificially suppressing mortgage rates through its purchase of $1.25 trillion worth of GSE-backed paper (or about 25% of the amount outstanding) has also played a big role in keeping house prices up.

However, what is going to happen when those artificial supports are removed? The Fed is due to complete its mortgage-backed paper buying program by the end of the first quarter. The tax credit is due to expire in the spring, and eventually these loans the FHA is making are going to come back and bite it in the hind quarters.

Over the prior 10-year period, non-financial business debt matched that of the overall economy, growing at an average of 7.5% per year. It didn’t slow down as much as the consumer did last year, but it did slow down — with full-year growth of 5.2%. it did drop sequentially in each quarter last year though, and that down-trend has continued this year as well. It turned negative in the second quarter of this year, falling at a 2.2% annual rate, and the drop accelerated in the third quarter to a 2.6% annual rate of decline.

I would note that business investment spending hit an all-time record low as a share of the economy in the second quarter at 11.03% of GDP, and basically stayed there in the third quarter, rising only to 11.04% of GDP. If businesses are not spending much putting up new buildings or buying new plant and equipment, it is easy to see why they would not be taking on much in the way of new debt. Businesses have also slowed the pace of share repurchases over the last year, which is another source of debt growth.

As households and businesses get their balance sheets back into shape, it positions them to start spending again, spending that the economy needs badly to get rolling again.

In contrast to the private sector, government debt growth is starting to accelerate. State and local debt grew at a 5.1% annual rate in the third quarter, up from a 3.6% rate in the second quarter and a 2.0% rate for all of 2008. It is, however, still down from the 7.0% average growth rate in the decade from 1999 through 2008. States and localities are hurting without question, with tax revenues declining sharply. They cannot however borrow for operating needs, just for capital projects.

Federal debt is the cause of what debt growth there is in the economy right now. Even on that front there is a bit of good news (just a bit). The growth rate of the debt slowed to 20.6% in the third quarter from 28.2% in the second quarter and 24.2% for all of 2008. The second half of 2008 was very different than the first half, though — the rate of increase peaked in the third quarter of 2008 at 39.2%.

Of course, the 20.6% growth in debt in this year’s third quarter is coming off a much larger base than a year ago. Over the decade, federal debt growth had averaged 5.7%. However that decade-long growth rate is also a bit deceiving: federal debt actually fell for the first three years. From 2002 through 2008, it grew at an annual rate of 9.6%.

So what are we to make of this shift from private sector debt to public sector debt? Collectively, all the households and businesses in effect ultimately are the ones that owe the public debt. They are the ones that will have to pay the taxes which in turn pay the interest on the debt and the principal when it comes due. Thus at a macro level one could say that it really doesn’t make a difference if the household or business sector owes less, but it is offset by higher government debt.

There is one big difference, though. Governments pay much lower interest rates on their debt than do individuals, or even businesses. Thus the economy is in effect taking part in a massive (if most likely unintentional) interest rate arbitrage. If we were a totally closed economy, this would not make much difference, since the lower interest rates mean lower interest income to savers. However, we are a net debtor nation (the largest net debtor nation the world has ever seen). Thus, this interest rate arbitrage is ultimately a net plus for the economy.

Growth of Domestic Nonfinancial Debt
Percentage changes; quarterly data are seasonally adjusted annual rates


Read the full analyst report on “JPM”
Read the full analyst report on “WFC”
Read the full analyst report on “FNM”
Read the full analyst report on “FRE”
Zacks Investment Research