US Households: Unhappy Speculators

The economist Hyman Minsky divided financing techniques into three categories: Ponzi finance - where principal and interest on debt cannot be paid out of earnings but only ever more borrowing; Speculative finance - where interest on debt can be paid out of earnings but principal must be rolled over; and Hedge finance where both principal and interest on debt can be paid out of earnings.

From 1952 to 2007 the ratio of debt to income for US households rose from about .35 (hedge financing) to about 1.3 (speculative financing). Even two years into the Depression, the ratio has only declined a bit.

In times of economic contraction - especially when a major asset bubble bursts (i.e., housing), speculative financing units run into two significant problems. Routine debt service becomes more burdensome, and more critically, the ability to refinance becomes often impossibly difficult.

Consider the case of otherwise solvent households with exotic interest-only mortgages with impending punitive resets. The reset payments are unsupportable, and yet there is typically no way to roll the mortgage into a conventional mortgage as the value of the collateral is typically less than the mortgage balance. The underwater position also almost always prevents a sale to terminate the mortgage since that will require bringing too much money to the table.

Barring a sudden and extremely improbable surge in house values, these households will be ruined by the trap. Even many households with fixed rate mortgages will find those unsupportable in the face of income loss, and have no non-bankrupting exit strategy due to their underwater position. Another trap is facing households with sudden rate hikes on large credit card balances.

The distribution of the pain of the speculative unwind will not fall evenly on US households. A substantial number - perhaps 1/4 - have little to no debt and at least adequate resources. Another substantial number - also perhaps 1/4 - have no debt because of too-low income and too-few resources.

This puts the burden of the pain squarely on the roughly 1/2 who have substantial debts. We suspect that most of these households' net worth will be wiped out, creating ever more cascading failure throughout the economy. The end state will be a poorer USA, but one where debt revulsion is so strong, households will once again be Hedge financial units.