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Sunday 26 January 2020

'Neither a borrower nor a lender be...'

TO THINE OWN SELF BE TRUE: Felix Aylmer as Polonius in Laurence Olivier’s 1948 film version of Hamlet
TO THINE OWN SELF BE TRUE: Felix Aylmer as Polonius in Laurence Olivier’s 1948 film version of Hamlet

Donnacha Fox

DO you recall the conversation with your parents about their first mortgage and registering their unease when the word "debt" was mentioned?

This recollection came flooding back to me when reading Atif Mian and Amir Sufi's seminal new book House of Debt (University of Chicago Press). Their book discusses an array of topics, from how the securitisation of mortgages exacerbated US foreclosures; how the expansion of US mortgage debt had its origins in the Asian crisis of 1998; to de-bunking the notion of housing wealth effects and humorously equating them to "car wealth" - as they are both commodities we consume.

But, essentially, House of Debt is a book about debt - and, as it turns out, Mian and Sufi, economics professors at Princeton and the University of Chicago respectively, don't like debt that much (just like my parents). If you'd like a non-consensus view of what caused the great recession and the wider lessons that can be learned following the crash then you should read this book.

In House of Debt, the authors cite reams of international evidence by (i) the International Monetary Fund (IMF); (ii) economics professors Kenneth Roggoff and Carmen Reinhart and (iii) Mervyn King, former governor of the Bank of England, and a plethora of other academics, which conclude the most severe recessions are banking crisis recessions that are preceded by a large rise in private debt.

US household debt doubled between the years 2000-2007, from $7trn to $14trn, and the household debt to income ratio exploded, from 1.4x to 2.1x over the same period.

The conclusions that recessions are more severe when accompanied by banking crises and high indebtedness aren't revelations per se, as some of the research they quote was conducted over 20 years ago. It's also not new news that one of the main causes of the Great Depression in America in 1929 was ballooning mortgage debt. (US mortgage debt tripled in the years 1920-1929, according to US economist Charles Persons.)

However, the real controversy in House of Debt is Mian and Sufi's view of what caused the financial crash of 2008. Their argument is that massive accumulation of household debt, in the hands of those who were least able to pay it back, caused consumer spending to fall.

Initially, this fall was confined to over-indebted households in certain areas of the US. As house prices started to fall in late 2005 and early 2006, the net worth of these over-indebted households began to decline rapidly and their spending contraction became more pronounced. As the house price collapse intensified what started as a localised spending decline spread nationwide, as overall demand in the economy collapsed.

Mian and Sufi conducted rigorous analysis of US data (at zip-code level) on borrowing, spending, house prices and loan defaults. They found that spending on home improvement and durable goods - such as furniture, washing machines and cars - started to fall as early as 2006, well before the collapse of any US financial institution.

US house prices fell, on average, by 30pc from 2006-2009, but in highly indebted/lower net-worth areas, they declined by as much as 50pc-60pc due to the harmful effects of foreclosure.

Because spending habits in poorer household are much more sensitive to changes in their net worth (up to five times more sensitive, according to the authors), the decimation in the price of their only financial asset (their home) meant they sharply cut back. The collapse in overall demand overwhelmed the economy and resulted in a severe economic collapse.

Economists who are suspicious of the link that household debt has with the perniciousness of the 2008 crash say the central problem with the economy during the crash was the severely weakened state of the financial sector, which stopped the flow of credit to businesses, starving them of the capital needed for growth opportunities.

Mian and Sufi call this interpretation "the banking view", which is that the accumulation of debt in the first instance is not the problem - the problem is that we've stopped the flow of debt.

They summarise the banking view as: "If we can just get the banks to start lending to households and businesses again, everything will be alright. If we save the banks, we will save the economy. Everything will go back to normal." Now, where have we heard these words before?

The authors debunk the myth that US banks failed to provide lending when they were required to. At the peak of the crisis in late 2008, bank lending to US businesses was fully functioning and honouring lines of credit. As further back-up, the authors cite surveys of small business owners more worried about sales than financing and interest rates.

The fraction of small business owners citing financing and interest rates as their major concern never rose above 5pc throughout the financial crisis.

Devastatingly for the banking view, Mian and Sufi prove there was no increase in US bank lending after the banks were "saved" (in fact, the opposite was the case) and that lending growth remained moribund, long after recovery set in.

What can be said of the Irish experience? Irish household debt as a percentage of disposable income in 2003 was 1.1x. By 2008, the ratio ballooned to 2.0x. This was an even bigger percentage rise than our US counterparts. The absolute numbers are more staggering. In 2003, total Irish household debt stood at €75bn. By Q4 2008, it was €204bn.

Remember, it took ten years to triple US mortgage debt prior to the Great Depression - we almost tripled ours in half the time!

We were repeatedly fed the narrative that 'all was fine until Lehman Brothers went bust' as the reason for our own crash, rather than seeing our home-grown, debt-fuelled, speculative binge for what it was.

How many times over the last six years, have we heard the words "supply of credit"? Credit supply completely dominates the debate about what's wrong with our banking system, to the exclusion of all other potential causes of the malaise.

There's a complete absence in the debate of individual's and business' demand for debt. Given what has happened might they just be acting rationally in deleveraging and demanding less debt?

So, if you agree with Mian and Sufi's view that excessive debt is "bad", then the good news is that Irish households (those that can afford to) are deleveraging and deleveraging fast. Private sector credit data just released by the Central Bank for June, showed that credit to households continued to contract on an annual basis, as repayments exceeded new lending. Household loan repayments exceeded drawdowns by €104m during June, following a net monthly decrease of €490m in May (the figure for April was a fall of €462m). So on a three-month basis, Irish households' loan repayments exceeded drawdowns by €1.1bn. On an annual basis, loans to Irish households continued to decline, falling by 3.9pc. Loans for house purchases, which account for 80pc of all household loans, fell at an annual rate of 3.1pc. Lending for consumption and other purposes declined 6.7pc.

Of course, another way of looking at this data is that households that can afford to are demanding less debt.

Available data puts outstanding household debt at €166bn. That is still more than twice the level of 2003, but down sharply from 2008. Counterbalancing this is the fact that the number of mortgages in arrears greater than 720 days rose 5.1pc to 35,314 accounts, with outstanding balances of €7.4bn. Buy-to-let arrears of the same duration total €4.2bn, so we still have a lot of work to do.

Pilloried economist Morgan Kelly, in a high-profile warning earlier this year about the SME sector and its debt profile, said it was vital we arrange a carve-out of defunct property loans from viable SME businesses (in a transparent way), so that the businesses themselves - and the jobs they provide - can be saved.

Former Central Bank director Fiona Muldoon warned in 2013 that up to half of SME loans were in some form of distress. With these concerns in mind the June private sector credit data trends are slightly unsettling then. Lending to non-financial corporations (SMEs), fell 7.3pc in June, following an annual decline of 5.5pc in May. Declines were prevalent across all maturity categories with falls of 8.1pc, 8.4pc and 6.1pc respectively for short, medium and long-term debt. It may well be that businesses, like individuals, are being rational in demanding less debt, and Kelly and Muldoon are overestimating the percentage of loans under stress. Time will tell.

Donnacha Fox is an executive director with wealth management firm Quilter Cheviot. Opinions expressed in this article are those of the author personally and do not necessarily reflect those of the firm

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