Palisade Research - Tue, May 29, 2018

Drowning in Debt: Delinquencies Are Surging and It's Only Getting Worse

images of businessmen falling head over heals

Lately there's been concerning news about Americans and their ability to service their debts.

Two weeks ago I wrote about the alarming rise in subprime auto loan delinquencies - a 22 year high.

What's puzzling is that the last time delinquencies were this high - the U.S. economy was in a deep recession.

That's why I asked myself: "I'm sure if individuals are having trouble paying their car loans - then they must be having trouble paying all other loans."

And that's what we're seeing. . .

After years of steady relative health, credit-card users are now having a harder time making payments on their balances.

Just look at the sharp rise in delinquencies since 2017. . .

line chart of interest rates and new delinquencies on credit card debt since 2003

There is a strong correlation - both historically and logically - between interest rates and credit card debt delinquencies.

As rates rise, outstanding debt burdens become difficult to service.

So, until the Fed reverses their tightening - things will only worsen for credit-card users from here. . .

That's why a serious question needs to be asked: with auto loans, student loans, and credit card delinquencies all on the rise - and we're not even in a recession - what can we expect from here?

The only Keynesian economists I find worthwhile is Hyman Minsky. I've written about him before, especially his work on volatility - formerly known as the Financial Instability Hypotheses (FIH).

Minsky wrote that in the economy, there are three debt-to-income stages: hedged, speculative, and ponzi. . .

1. Hedged - lowest risk - is when an individual makes enough cash-flow to service both debt interest and principle. Basically, they can pay off all their liabilities if needed to. From an investors perspective, hedged is just like finding 'Net-Net' stocks - the Ben Graham value approach of finding stocks with cash/current assets well above the company's total liabilities - offering a huge margin of safety.

2. Speculative - medium risk - is when an individual or company makes only enough cash-flow to service the interest on their debt. They must also roll their maturing debt into new debt once it comes due.

3. Ponzi - highest risk - is when an individual doesn't make enough to cover even their interest. They must borrow more to simply pay back old debts. This is an unsustainable situation and will implode on itself. Eventually there will be huge liquidations as individuals sell everything to raise cash and pay off debts. This will trigger a deflationary recession.

Minsky noticed that economies start out in the 'hedged' phase. But over time as markets stay calm and individuals believe the economy is healthy - they start borrowing more debt and begin just paying the interest only.

Putting it simply, they feel confident and safe so they start becoming more speculative.

Then eventually the economy will slow down - as it always has and will - which causes unemployment, deflation, and rates to rise. This is fatal for debtors - which pushes the economy into the 'ponzi' phase.

And not too long later - an economic recession.

So, what does all this mean for today?

It comes down to two simple questions. . .

First, are individual's disposable incomes - the actual amount of their paychecks that goes into their pockets - keeping up with their outstanding debts?

Second, is the amount required to service the outstanding debt manageable? And is it becoming more difficult or easier?

Looking at the Fed's own data - we can see the economy is in the tail end of a 'speculative' phase and heading towards the 'ponzi' stage.

line chart of real disposable income change per person as a YoY percentage versus personal interest payments change in billions of dollars, since 2008

Since the Fed began raising rates in December 2015, interest payments have trended much higher.

Meanwhile, disposable incomes have decreased and are flat. . .

This isn't a good sign.

I need to also mention that the higher inflation continues to run - which is already well above the Fed's 2% annual target. And they have no plans of stopping it - the less 'real' disposable income people will have.

Thanks to the near-decade of low-rates and easy money from the Fed, most investors and consumers suffer with a sense of false confidence about the economy.

For instance, traders using cheap margin to buy and sell global assets, companies using debt to buy back their shares, and home owners simply re-financing their mortgages with lower rates to use the extra debt to buy things.

When only low interest payments are due - this bubble can float on.

But now as rates are rising and the Fed is attempting to tighten, it will cause problems.

Minsky was on to something when he studied the booms and busts of economies throughout history and how they flow like clockwork.

The cheap debt and speculative years are ending. Now it's time for financial tightening.

And unfortunately - as we're seeing - it looks like many can't afford this tightening. . .

So far, the mainstream media hasn't put 'two-and-two' together with all of this. They treat each poor economic news story as if it's an isolated incident, rather than interconnected symptoms of a worsening disease.

The rising delinquencies in various debt markets - and much more - are signaling deepening cracks in the supposedly 'healthy and growing' economy.

What comes next won't be exactly 'a good time'.


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