The Debt Boom

We’re starting to see a major change in the economy.

From 2008 to 2012, many consumers were going bankrupt, while those who had the means were paying off as many loans as they could. As a result, household debt service payments and financial obligations in this country dropped to levels unseen since the early ‘80s.

But after bottoming in 2012, levels have been slowly creeping higher.

You can blame auto and housing loans.

Just read this from Bloomberg Business:

Accelerating increases in auto loan debt and mortgage credit helped propel total borrowings of U.S. households to the highest level in more than five years, the Federal Reserve Bank of New York said Thursday.

Household debt rose by 1.8 percent, or $212 billion, in the third quarter to $12.07 trillion, the most since the first quarter of 2010, according to the New York Fed’s quarterly report on household debt and credit…

Auto loan balances rose 11.9 percent from a year earlier to $1.05 trillion, reaching the highest level since the survey began in 1999…

The level of overall household debt was 3 percent, or $355 billion, higher than a year ago in the third quarter of 2015, though it remains 4.9 percent below the peak of $12.68 trillion reached in the third quarter of 2008, the report showed…

Mortgage debt jumped 1.8 percent, or $144 billion, from the second quarter, according to the report. Mortgage originations increased to $502 billion from July to September.

Credit card debt rose 1.6 percent, or $11 billion, in the third quarter to $714 billion. Student loan balances increased 1.1 percent, or $13 billion, from the second quarter to a new high of $1.2 trillion.

That’s a lot of new debt. But it’s not surprising to see in an economy that virtually relies on debt issuance in order to expand.

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As James Dale Davidson and I have explained before, in a debt-based economy, economic expansion comes from more debt. Debt, in essence, equals liquidity. If you subtract debt from the economy, the money supply shrinks and the economy struggles.

But if you add debt, the economy tends to expand.

That’s what we’re seeing right now.

Consumers are having an easier time getting a plethora of loans. And because they dropped debt service levels since 2008, they can mostly afford these new loans.

That said, not all is perfect. An increasing percentage of car loans is being issued to subprime borrowers. In the first quarter of 2015, they made up nearly 20% of all auto loans outstanding. That’s more than $178 billion worth of subprime car debt.

Once the economy gets into an official recession, these will be the first people to begin missing payments and go into default. Banks could easily lose $40 billion, maybe more, from just this one slice of debt.

And student loan borrowers are increasingly making late payments. Right now, more than one in four student loan borrowers are delinquent on their payments.

Finally, realize that a credit cycle always ends in the extreme. People are going to borrow money, make a few payments, then get so comfortable with their new debt (and newfound ability to pay it off) that they’ll get more loans.

Eventually, once the economy really starts crashing, these consumers will find themselves unable to keep paying off their loans.

That’s when the defaults will come.

It’s all a cycle. And right now, we’re in the credit expansion part. Eventually, troubles overseas, combined with higher interest rates domestically, will be enough to trigger a downturn that the government can no longer deny.

Making matters worse is the fact that governments and businesses around the world never actually deleveraged.

Instead of cutting debt, they got more of it.

So once the “debt explosion” part of the credit cycle comes back around, all those entities that are overloaded with debt may have some tough choices to make.

While I don’t expect that to happen this year, rising interest rates and economic weakness abroad will ensure that this turn of events eventually takes place.

In the meantime, check out our portfolio here.

There are no major updates for this week, but we are keeping an eye on Aircastle Limited (NYSE: AYR), which seems to keep losing a little value every week.

If we don’t see some stabilization soon, expect an exit notice.

That’s all for this week.

Take care,
Charles Del Valle
Charles Del Valle
Editor, Strategic Investment