Stocks Undo Progress in Household Balance Sheets

If households are ever to climb out of the financial hole created by the housing bust, stocks are going to have to do better.

Household borrowing peaked at the end of 2007, after adjusting for inflation (the nominal figure was $13.8 trillion). Families have been steadily chipping away at debt ever since then, reducing it by another 0.5% in the third quarter, according to data published by the Federal Reserve Board on Dec. 8.

Another key measure of debt sustainability are asset prices. In the wake of the property crash, the ratio of debt to net worth hit a postwar high of 27% in the first quarter of 2009.

The ratio fell to 22% in the second quarter of this year as equity markets recovered. But in the third quarter, the value of household interests in stocks, mutual funds and pensions plummeted 12% amid the turmoil sparked by the debt ceiling standoff and the euro zone crisis. With home prices still drifting down, that pushed the debt back up to 23% of households’ net worth (see the first chart).

The seesaw relationship between asset values and debt-to-net-worth ratios is a long-standing one. Households take on debt relatively gradually. Shedding it, either through belt-tightening or default, can be painfully slow. Equity prices, by contrast, can be volatile, as were home prices in the first decade of the century. Fluctuations in the value of household assets and in debt-to-net-worth ratios have been mirror images since the mid-1990s.

Other third-quarter indicators of the health of household balance sheets were a bit better, though not great. Slight declines in mortgage debt and real estate values roughly offset each other, keeping the ratio of mortgage debt to owners’ equity about flat at 158% (see the second chart).

A slight decline in disposable income offset the drop in mortgage and other consumer borrowing, keeping the ratio of debt to disposable income about even at 107% (see the third chart) after previous declines.

In all, the three metrics remain at levels well above those that prevailed for most of the last half-century.

However, household finances look much more stable based on one other benchmark. Thanks to low interest rates, the proportion of income households needed to service debt and cover other basic expenses, like rent and property taxes, fell to 16% in the second quarter (the most recent data available). That’s the lowest level in almost two decades (see the fourth chart) and a comfortable level by historical standards.

Household balance sheets in all likelihood are even healthier now, given stock prices have rebounded in the two months since the end of the third quarter. Even so, Barclays Capital analysts wrote Dec. 8 that they expect the decline in net worth to create a slight drag on consumption because of the tendency for households to adjust spending according to their wealth.