The Fed’s debt dilemma

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The Fed faces a debt dilemma. While quarterly household debt service of those with jobs in the US as a percentage of their compensation fell from 17.5% at the end of 2007 to 16% by the end of last year, it was largely as a result of lower mortgage bond rates. However, the major obstacle for the Fed is that quarterly total debt service of the unemployed has surged from $18 billion to $34 billion over the same period and has a direct correlation with foreclosures in the US. According to Equifax close to 4.5 million first mortgage loans – 9% of 49 million first mortgage loans outstanding − are currently in the foreclosure process or at least 90 days delinquent.

Source: Plexus Asset Management (based on data from Fedreal Reserve Economic Data and I-Net Bridge)

There are only two ways to solve the problem of the unemployed regarding their debt crisis. Firstly, the economy must grow at a rapid pace to re-employ most of those people as soon as possible. The second alternative to avoid large-scale hardship and increasing poverty is through mortgage debt forgiveness.

The original foreclosure mitigation plan by the Obama government to end the foreclosure crisis earlier fell significantly short of expectations and major changes are proposed. The plan encompasses state and local housing initiatives, tax credits, mortgage modifications and refinancing. The jury is out on how many foreclosures will be avoided, though. It is said that the changes to the foreclosure mitigation plan could result in only one million homeowners losing their homes compared to 2.5 million estimated earlier.

The government’s drive to put the economy on a strong growth path to get more people employed effectively means that the Fed will need to keep the Fed funds rate lower for longer despite the threat of higher inflation. This action is likely to lead to a further steepening of the yield curve, with the bond market discounting stronger future economic growth and higher inflation. The mortgage margins of US banks are currently at historical lows and the higher yields are likely to be passed on to borrowers via higher mortgage bond rates.

Source: Plexus Asset Management (based on data from Fedreal Reserve Economic Data and I-Net Bridge)

While higher mortgage rates will have little effect on those who qualify for the foreclosure mitigation plan, it will increase the debt-servicing burden on those with jobs. With the latter still suffocating under a debt overload it is unlikely that they will take on additional debt. Besides that, the other question is: who will buy the unsold houses? Furthermore, credit extension growth to the private sector was one of the driving forces behind economic growth in the aftermath of the ICT collapse in 2001 and the subsequent 911 to pull the US economy out of recession.

Source: Plexus Asset Management (based on data from Fedreal Reserve Economic Data and I-Net Bridge)

What is clear is that the ability to spend by the “haves” (those with jobs) in coming quarters will be severely hampered by their debt stranglehold. Furthermore, they must hope and pray that US government bond yields do not go through the roof due to higher inflation expectations or a de-rating of US government debt. As for the “have-nots”, they should wish that China’s economy continues to remain strong to prevent a double-dip recession in the US.

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2 comments to The Fed’s debt dilemma

  • Thom Mitchell

    Discussion of lower interest rates should certainly include some consideration for the retirees who are getting absolutely killed by the low rates on their IRA’s and savings.

  • Would a weaker US Dollar not be advantageous at this point – will this bear market rally in the US Dollar end soon, it would certainly stimulate US exports and so help with the recovery – I just wonder whether an imminent sell off in the equity markets may delay this and strengthen the US Dollar at the very time it should be weakening.


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