Borrowing Levels Reach US Record, Sparking Debate
07/04/2000Dow Jones News Services
(Copyright © 2000 Dow Jones & Company, Inc.)
By Gregory Zuckerman Staff Reporter of The Wall Street Journal
"The second vice is lying; the first is running in debt." -- Benjamin Franklin, "The Way to Wealth," 1758.
Benjamin Franklin -- he of "a penny saved is a penny earned" fame -- would be stunned by America's love affair with debt nearly 250 years later.
In a nation that once saved all it could, and resisted taking on debt, Americans no longer just borrow money to buy houses. They load up on debt to purchase stock. To go on vacation. To pay the electricity bill. To buy groceries. Even to pay federal income taxes.
Americans have gone on an unprecedented borrowing binge in recent years, even as the U.S. government has started slashing its debt and is looking forward to paying it all off.
The numbers are startling. A record $4.5 trillion in debt has been accumulated by U.S. nonfinancial corporations, up 67% in the past five years, according to the Federal Reserve, and household borrowing has risen almost 60% to $6.5 trillion. "As long as I can get the money, there's no sense in not getting what I want," proclaims Matt Doscotch, a 28-year-old lawyer who is borrowing the full $200,000 purchase price for his Minneapolis home, though he has no savings and $100,000 in other debt.
More debt isn't necessarily bad, of course, as it has helped companies expand and boosted consumer demand, thus fueling economic growth. But alarm bells are starting to ring, and not just because borrowings are at record levels. Adding to concerns is the fact that companies and consumers who may be able to least afford more debt have been adding the most to their borrowings. If the economy turns down, many of the loans could go bad.
"We've expanded our access to debt in dramatic ways, which is wonderful for the country, and it's helped the economy," says Diane Swonk, chief economist at Bank One Corp. in Chicago. "But there's no free lunch. The riskiest borrowers seem to be piling on debt, and we may be building a house of cards." Adds James Paulsen, chief investment officer at Wells Fargo Corp.'s Wells Capital Management unit, "The real debt problem is lowerincome people, who have been adding debt. That's what's scary to me."
Low-income consumers and people with bad credit histories who once had a hard time borrowing money are finding it easy now. More than $160 billion of "subprime" mortgage loans to lower-credit borrowers were made last year, 11% of all mortgages, up from $40 billion, or just 4% of the total, in 1993, according to the Mortgage Bankers Association.
While home buyers once needed a 20% down payment -- and thus needed a degree of financial well-being -- today over 40% of new-home mortgages are with down payments of less than 10%, according to SMR Research, a financial-research firm. "At least a quarter of all new mortgages go to people who are basically broke, and the figure could be much higher," says Stuart Feldstein, president of SMR.
On the corporate ledger, "junk" bonds outstanding -- bonds sold by companies with the highest credit risk -- have soared to $529 billion from $173 billion a decade ago. In addition, $320 billion of syndicated loans were made last year to companies with low-grade credit ratings, up from $58 billion in 1990. Of U.S. companies with junk bonds, 5.4% defaulted on interest payments in the past 12 months, up from over 1% in 1997 and the fastest pace since the 1992, according to Moody's Investors Service. It could hit 8% this year, Moody's predicts.
But numbers don't tell the whole story, optimists counter. Despite more debt, they say, the U.S. is safer than ever from a serious debt crisis. America is borrowing more money in part because there is more money to borrow. Thanks to "securitization" -- the bundling of loans into debt securities -- lenders can sell their loan portfolios to investors, take the money from the sale and then make even more loans.
This has spread credit risks, because thousands of loans end up in these debt securities. So, some loans going sour has only a minor effect on investors who buy them, typically mutual and pension funds and insurance companies.
While the risks may be a matter of debate, there is no dispute that a remarkable cultural change is behind this voracious appetite for debt. During Benjamin Franklin's time, many Americans were suspicious of debt. This was reinforced during the Depression, when many businesses went bankrupt under heavy debt, leaving scars on a generation. Until a few decades ago, consumer borrowing for anything other than a big-ticket item -- such as a house -- was still unusual. In the 1950s, homeowners sometimes celebrated paying off their mortgages by burning loan documents at parties held to mark the occasion.
But the forces of financial innovation and Madison Avenue marketing, along with growing prosperity, combined to change attitudes about being in hock.
Ms. Swonk of Bank One remembers her father wowing friends by showing off his credit cards in the 1970s. With catchy television commercials, such as American Express's "Don't Leave Home Without It" campaign, debt became the ally, not the enemy. "By the 1980s people started thinking it was cool to spend. There was a nonchalant use of credit," says Eric Einhorn, executive vice president at McCann-Erickson World Group, the advertising agency. "People no longer feel guilty about using debt."
Indeed, the average U.S. household now sports 13 credit or charge cards, and carries $7,500 in credit-card balances, up from $3,000 in 1990. Rarely a day passes when many Americans don't get come-ons in the mail for a new credit card offering a larger credit line, introductory low-interest rates or points for free airline tickets.
Nowadays, even a poor credit history doesn't preclude someone from being deluged with offers of credit. Joan Ritz, a 52-year-old bookkeeper in Philadelphia, filed for bankruptcy last November, unable to keep up with payments on $67,000 in auto-loan and credit-card debts. But she kept getting mailings trying to sign her up for credit cards -- including three in one week in January. "On the one hand I was getting threatening letters from some companies, on the other they were making me great offers," says Ms. Ritz. "It's like feeding booze to an alcoholic."
When Carol Perry, 35, went looking last year for a home in North Billerica, Mass., her mortgage broker suggested targeting homes selling for $260,000. Ms. Perry responded that she couldn't afford a big down payment because she earns $55,000 and her husband is on workman's compensation. No problem, the mortgage broker replied, a down payment of 5% of the purchase price would be enough.
"I gave her a look -- what about food and electricity bills, there wouldn't be much left after the mortgage," Ms. Perry recalls, who ended up buying a $200,000 home, putting down 5%.
Others aren't as resolute. Kimberly Ayscue, 38, of Franklington, N.C., who makes $12,000 a year as a computer consultant, began receiving checks in the mail from finance companies two years ago. The pitch: Sign them and the money is yours. First a $2,500 check came, then $3,000. Ms. Ayscue tossed them in the trash.
Finally, a $5,000 check came; she cashed it to help pay off some existing debts, agreeing to a steep 18% rate. But last year she began having problems making payments, and has sought help from a debt counselor. "My father is a bank president, so I should know better, but it's just so tempting," she says.
Most lenders maintain that rising debt levels aren't a major worry. While household debt is a record 101% of income, up from 84% in 1990, the cost of paying off loans has fallen with interest rates, says Richard Berner, an economist at Morgan Stanley Dean Witter & Co. The area where individuals hold the highest average credit balance is San Jose, Calif., the affluent heart of Silicon Valley, suggesting that many with big debt balances can afford them.
"Most consumers are actually in better shape than a decade ago" due to rises in stocks, home values and incomes, adds Dan Castro, head of asset-backed securities research at Merrill Lynch & Co. In fact, household debt is about 13% of assets today, about the same as a decade ago.
But pessimists counter that things look good because economic times are good. Even so, the heavy debt burden carried by many resulted in about 1.3% of all U.S. households declaring bankruptcy last year, off a tad from recent years but up from 0.8% in 1995.
What will happen, they wonder, if the economy slows sharply? Corporate profits and personal income would probably fall. So too could real-estate and stock prices. The debt burden would start to pinch if the unemployment rate, currently about 4%, goes to 5.5%, some economists say.
"Banks have been more aggressive in lower-quality lending during this expansion than in times past," says Michael Mayo, a bank analyst at Credit Suisse First Boston. "So it's hard for them to quantify the effects of a lower stock market, higher unemployment, lower incomes and higher defaults. Lower-risk lending is untested."
Any drop in home values could prompt some borrowers to simply stop paying their mortgages because so many have made puny down payments and thus have little to lose if their homes are repossessed. That's what happened in California in the early 1990s. "We're already seeing problems with aggressive loans, and one can only imagine what would happen if the economy declines," says David Olson of David Olson Research Co.
Corp. Debt Up
Companies also are borrowing at record levels. Corporate debt represents 46% of the nation's gross domestic product, the highest level ever. There already are signs of stress among junk-bond issuers. Among the high-profile companies that have defaulted on junk bonds: Iridium LLC, Planet Hollywood International Inc. and Fruit of the Loom Inc.
United Artists Theatre Co. took advantage of an overheated junk-bond market to raise money in 1998, selling $275 million of junk bonds. But other companies also were building sparkling "stadium-seating" theaters, some of which were across the street from each other. United Artists defaulted on its debt in April, as the glut of competition led to heavy losses and forced it to shut 400 of its 2,300 screens over the past two years. With United Artists bonds worth pennies on the dollar, holders have lost almost all of their investment.
Even the most worried observers agree that any problems for the financial system are unlikely to be as bad as the last downturn in the early 1990s. Back then, many financial institutions, overburdened with bad real-estate loans, went bust. Now, industry consolidation means that fewer banks are dependent on one region and its economic fortunes.
Still, this doesn't mean risk has been eliminated. In 1998, investors became nervous after the Russian-debt default, causing a freeze-up in the entire capital markets. Prices of virtually all bonds plummeted, resulting in steep losses for investors -- even those who didn't hold any Russian bonds.
Similarly, skeptics say now, a series of big defaults by corporate borrowers or a rash of problems among individual borrowers could cause similar difficulties, which would be painful.
If a batch of mortgage borrowers stop making payments, Fannie Mae and Freddie Mac, the government-sponsored agencies that buy and guarantee many mortgages, could be hurt, as could companies that sell mortgage insurance. Fannie Mae bought $4 billion of 3%-down loans last year, up from $100 million in 1990.
Meanwhile, the biggest investors in mortgage-backed securities are commercial banks, Fannie Mae and Freddie Mac, and life-insurance companies, and all could suffer losses if defaults rise. Though banks have securitized many mortgages, they still keep about 25% on their books. The top 10 bank and thrift holders of mortgage assets more than doubled their share of mortgage holdings to 15% from 6.5% of assets in 1994.
Even banking regulators can't quite put their fingers on the risks. The Office of the Comptroller of the Currency, which regulates the biggest banks, is only now trying to come up with accurate figures for all mortgage lending to lower-credit borrowers. The government itself could be on the hook if participants in programs for lower-income individuals and veterans, sponsored by the Federal Housing Administration and the Veterans Administration, stop making payments.
"Were the music to stop, and the economy hit a hard landing, those most leveraged would be in a precarious position," says John Dolan, of Hyperion Capital, which invests in mortgage-backed securities but has been avoiding bonds backed by the riskiest borrowers lately. |
