Thursday, December 1, 2016

Debt Main Driver Of Both American And World Economy

It is very important to understand and keep the concept of debt before us because such a great deal of our economic system is about debt. It has become the main driver of both the American and global economy. For a long time I have had a problem as economist and others pointing to the auto industry as proof the American economy is on the mend. Today in America we see a land where even unemployed students are buying new cars. Claims that the auto market is hitting on all cylinders is a simplification of the situation and not giving enough focus as to where the sales are coming from. The facts behind what is pushing this market forward are very disturbing. This unsustainable trend in new car sales is being created by the combination of lower rates, loosening underwriting standards and voracious demand for new securitizations by Wall Street and pension funds that will do just about anything for an extra 25bps of yield.

Loaning More On Autos A Growing Problem
A large number of auto loans this year were to subprime borrowers. Subprime loans now account for 36.5% of all outstanding auto loans. The main reason lenders are willing to write these notes is because they are often able to charge these high-risk borrowers more than double what prime borrowers pay, subprime loans can be very profitable for lenders if borrowers do not default. Average rates for subprime loans were 10.36% in the fourth quarter of 2015, for deep subprime borrowers, rates averaged 13.31%, this is at a time when new car buyers with excellent credit paid 2.7% interest. Artificially low-interest rates have sucked yield-thirsty pension funds to purchase every subprime auto securitization they can get their hands on as they ignore the massive auto loan bubble waiting to pop.

The latest report from Edmunds reports that 32% of trade-ins having an average negative equity balance of $4,832. This means many of these buyers are simply rolling that negative equity into a brand new 7-year loan at a 2% interest rate. The amount of negative equity car buyers are rolling has also reached a record high confirming these shoppers are not deterred to absorb a significant financial hit in order to get into a newer vehicle. Another concerning part of this report is that the percentage of used cars being traded in with negative equity values also continues to spike and currently stands at an all-time high 25% with the average balance of the negative equity also, continuing to rise to $3,635 for Q3 2016, up from roughly $2,750 in Q3 2011. 

Growing Debt Looms As A Global Problem
This is not just about auto loans, the debt bubble forming extends to many sectors of our economy. The average student loan debt is now $33,000. Until the Obama administration went Keynesian much of student loan debt was primarily held in the private sector. When Obama entered the White House total student loan debt was $620 billion and delinquencies totaled $50 billion. There are now $1.3 trillion of student loans outstanding, with the Federal government accounting for $830 billion and guaranteeing a large portion of the rest. Delinquencies have skyrocketed to $125 billion and these loans are not aging well. Going forward it is clear another taxpayer bailout is in the cards or someone will be forced to take massive write-downs. 

While I have focused on student and auto loans I'm aware this subprime buying binge has broadly spread to a wide range of consumers. Is was best said by someone who wrote: "Only a University of Phoenix, African Studies major is more of a subprime risk than the millions of ecstatic Escalade drivers cruising around our urban ghetto paradises." The Federal Reserve has been pumping in trillions of dollars of liquidity into the economy and much of it has resulted in pulling future consumption forward. These policies will soon become a headwind to both future sales and growth. This creates future problems and is more proof of just what an infusion of money from the Fed can produce and how it distorts economic reality. The basis of such an economy is unsustainable and because it has been able to exist for so long does not mean it can continue. 

It is important to remember not all debt is created equal. A mirage is a naturally occurring optical phenomenon in which light rays are bent to produce a displaced image of distant objects. Joining the idea of a mirage and contagion with the reality of collapsing debt forms an interesting subject. It is important to remember all debts and obligations do not come due at the same time. Also, it must be noted when a bill is not paid or defaults it often starts a long and drawn out legal battle, this collection process that may extend years without harsh consequences. This, my friends, is the reality of modern life in America and much of the world, debt will always be kicked down the road and this is a good reason not to be the lender when reality hits.

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