Debt Man Walking. “It’s the Outlier’s, Stupid”

The American consumer is alive and well and paying his bills. Scott Grannis, for 18 years the chief economist of the $487-billion Western Asset Management, is positive in his outlook and confident in the American consumer.

The Grannis Hypothesis, outlined on the Calafia Beach Pundit (“There’s Still No Household Debt Crisis”, Seeking Alpha, July 8, 2009), argues that the consumer debt burden is manageable. The pundit proves it by showing that the bills we pay every month have changed very little in the last 30 years (see chart above: ”U.S. Household Financial Burdens” {the “Grannis Hypothesis”}).

I rely on a different chart. I believe our personal debts are twice what they should be (see chart below: “Household Debts as a Percentage of GDP”). I predict $7 trillion of a total of $14 trillion of household debt will either end in default or will paralyze the bill payer (The White Hypothesis).

The White Hypothesis says we are a country with perhaps 20% of our households heavily overleveraged. Their failed-gold-rush balance sheet will lead to unprecedented mortgage and credit card defaults. The defaults lie immediately ahead and behind us. The mistake in the Grannis Hypothesis is believing that the average bill payer defines the crisis. It is the defaulting bill payer who defines the crisis. How many bill payers will default?

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Credit Mr. Grannis with pinpointing the critical issue in the financial crisis. The amount of bad debt investments will steer the fortune of the financial sector. Consumer borrowers determine the fate of a huge section of investments held by financials. Their ability to repay is the central issue. If you look at the Grannis Chart, everything is fine and well.

“At the very least, it is comforting to me to see that household finances on average have not been materially affected despite all the turmoil of the past 18 months,” said Mr. Grannis. “Indeed, as the last few data points show, debt service burdens have actually decreased in the past few years.”

I believe the debt-payments chart deceives in the same way the equity chart of real estate deceives. Let’s look at that for a minute, and draw an analogy.

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If you look at the total amount of equity in residential real estate, the total equity is still very strong (about $7 or $8 trillion), and a big number, even after values have fallen nationally by 30 percent (see chart above: “Housing Value, Mortgage Debt, Home Equity”).

If we use the property-equity chart to determine the value of mortgage collateral held by banks, then we presume foreclosures will result in full recovery of principal for the lenders. The chart tells us that $10 or $12 trillion of mortgages are secured by $18 trillion of property. If you are invested in financials, who cares if millions of mortgages go into foreclosure? There’s plenty of equity to pay the bill.

The property-equity chart misleads because it fails to differentiate between the haves and the have-nots. It is the fate of the have-nots who hold the important cards.

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My forecast for financials and the economy range between very bad and death-by-bus. It is the defaulters who will define the losses, and their fate is not accurately represented in the Grannis Chart, or in the property-equity chart. I estimate for every dollar of at-risk mortgage debt there is 50 cents of real estate.

The bill payers who hold preponderant influence for the fate of financials and the economy are not those with no mortgage and no credit cards.

The well-off possess great equity. They easily manage their monthly payments. Their very modest bills prove the Grannis debt-payment-to-income chart accurate. My guess is Mr. Grannis and his friends reside above the 90 percentile level in this chart.

Nevertheless, our world also has unhappy consumers who cannot pay their bills. Foreclosures prove it. The fall in property values proves it.

Property values have fallen 30%. This loss is not based upon a new interest in the great outdoors and a preference for life in tents. It is based upon the issuance of bad debt to insolvent borrowers who have been or will be or are in a debt crisis.

Banks issued mortgages to borrowers who began a personal debt-crisis the day they closed on their loan. Multiply this act by millions and millions and you have a property market whose values will soar and then crash (see chart above: “Inflation-Adjusted US Home Prices”).

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What does employment say about our fate? 132 million people now have jobs. Most will pay their bills and almost all will try to pay their bills. Some percentage, I will guess 10%, will default on their debt obligations.

Then there’s the true have-nots. It’s a pretty big group. About 15 million persons don’t have jobs who want one. Of the 15 million, 6.5 million are new to life without income since the recession started in December 2007 (“Meltdown 101”, Minneapolis Star-Tribune, July 2, 2009).

This group of 15 million will not do well in paying their bills. If we isolated them on a Grannis Chart, the debt-payment-to-income ratio would be a catastrophe. We hope all of these people have money for food. We hope they have a family or friend to go to live with if they can’t keep their house. This group very definitely does have a household-debt crisis. We don’t expect them to do well on their credit cards or mortgage.

Let’s add conjecture and big picture guesses. We have a workforce of 150 million. Assign all job holders and job seekers an equal amount of debt. Project those who have no job cannot pay their debts. About 10% of debt cannot be paid and is a loss.

Go negative in the analysis. Guess that 10% who do work will default on their debts. Guess this bottom group of 20% of households had double the average debt level of those who will pay their bills.

Now we have 20% of households defaulting on 40% of consumer debt. We are approaching losses of approximately $6 trillion — based on a market basket of household debt equal to 100% of Gross Domestic Product (GDP) of $14 trillion (40% of $14 trillion = $5.6 trillion = Round to $6 trillion).

To put that number in perspective, I estimate the total equity held by the financial sector at the onset of the crisis equaled about $1.5 trillion ($15 trillion of assets * 10% = $1.5 trillion of equity). If $6 trillion disappeared in the financial sector, and granting my assumption of $1.5 trillion of initial equity, then the financial sector will go completely broke FOUR times. You only have to go bankrupt once to go bankrupt.

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The Grannis Chart shows manageable monthly payments, but fails to make sense of defaults past and future for households. Mr. Grannis fails to comprehend the role of persons who fail to meet their financial obligations based upon hardship and irresponsibility. It’s called not having a job, or borrowing more than you can pay back.

We need a Grannis Chart of these persons, but none is available (that I am aware of).  If we had this chart, and historical data, the title of the chart would say: “Welcome to the biggest household debt crisis ever.”

The correct analysis places greater emphasis on GDP as a measure of income and a description of debt-paying capacity. If that emphasis is correct, the implied loss for financials from consumers alone, based upon excess household debt, and using 1980 as the base year, is $7 trillion, as the chart shows (see chart to right: “US Private Sector Debt. As a % of GDP”).

Ponder our catastrophe in residential mortgage loans. It tells you what is true. We are going to lose 40% or 50% of property values. That means $8 trillion or $10 trillion of $20 trillion of value will disappear. Is it logical to assume 40% or 50% of mortgages are bad loans? I think it obviously logical, but 40% or 50% of mortgages cannot disappear if the debt-payment-to-income ratio of 18% in the Grannis Chart guides our conjecture. Which is right? The property crash or the 18% debt-payment-to-income ratio?

Use more subjective evaluation. Did Americans in general take on too much debt? Did those borrowers at the margin take on exceptionally high amounts of what is now unpayable debt? Do we have a property bubble? Did the bubble depend upon the issuance of unpayable debt?

Why did global equity markets lose $17 trillion of value in 2008?

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I run with a different crowd than Mr. Grannis. In the past month I have suggested chapter seven bankruptcy to four clients. This is the start-over bankruptcy.

The lenders to these borrowers are going to lose a ton of money. All debt disappears for the borrower in chapter seven. Who knows what percentage of their mortgage debt will be repaid in the foreclosure sale? My guess is 50% of their mortgage debt will be written off (see chart above: “Total Delinquencies and Foreclosures”).

A person like me has a great advantage over a person like Mr. Grannis. I am constantly dealing with the real world, with the finances of every-day borrowers, with the real problems that people face. The fact that four old clients, all in their fifties and sixties, are all going back to ground zero via bankruptcy tells me a new wave of defaults is beginning.

None of these persons fit a bad-credit profile or an irresponsible-person profile. They all have a history of outstanding credit scores and hard work and strong savings. They have been ruined first by bad investments in real estate. Two of four are self-employed, and bad times in business have killed the chance for a turn around and getting through it. One of four borrowed irresponsibly on credit cards. Negative equity for all of them destroys all reason for struggling to keep up. In a way they have all been impoverished to their debt for years. It’s obvious they should pull-the-plug.

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Mr. Grannis says a focus on total debt outstanding is a mistake. “Comparing outstanding debt to income would show a rising trend,” said Mr. Grannis, “but that is misleading since it compares the stock of debt to the flow of income.”

I suggest Mr. Grannis analyze a trillion dollars of write offs already taken and $1 trillion to $3 trillion more to come based on the estimates of reasonable parties (see charts above: “Loss Estimates vs. Write-Downs and Capital Raised”). These write-offs all depend upon a huge subset of consumers with a terrible household debt crisis. Not all of these losses are consumer losses, but a huge percentage is.

The most notorious fabrication we are now living through in the stock market says that the losses outlined above have been considered and priced into the rally. Really? Somebody is going to fork out $1 trillion to $3 trillion, and the owners of financials will not be affected? And the rest of the market can go about its business?

Based on the Grannis Chart, we have not had a financial crisis or a household debt crisis in the last two years. He is literally saying there has been no problem for consumers in the United States economy. The title of his story is “There’s still no household debt crisis.” We haven’t had a consumer debt crisis and we will not have a consumer debt crisis.

I know Mr. Grannis is aware of it, but let me re-state our recent history. We have had a major financial crisis. I believe it is based upon the wildest debt bubble in the history of man and money. The crisis is not over. The property market has already far surpassed the Great Depression in its destructiveness. Wild fear may return to the markets at any time. I think it is likely. My hypothesis is that we are in the largest debt crisis ever, even if the Grannis Chart shows all is A-OK.

Consumers are the Superman default-creators of this debt crisis. And remember, because of leverage, if 10% of debt assets fail, then financial lenders, as a group, are completely broke and totally bankrupt. They have to start from scratch, just like my clients filing chapter seven.

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Mr. Grannis has 30 years as an economist. He worked for 18 years at a major debt manager. He appears to be main stream and trust worthy. He may prove that persons of position and authority are blind and incapable.

If I had to judge him, which is my job here, because you may turn to him to manage your money, I would guess he does well in a world where who-you-know defines your success. He has done well in the who-you-know world. Let me state the obvious for the reader. You don’t want the who-you-know people to manage your money.

Look for clues to whether you can trust him based upon his use of language. It reveals the person and the world he lives in. Mr. Grannis describes a monthly payment on a bill as a “flow”. He describes the amount of a person’s debt as their “stock” of debt. Using these kinds of words makes you sound smart even if you are dumb.

Mr. Grannis is a person who interviews well. He has the air of authority. He can talk the talk of economics, but I don’t see evidence here that he can think the think. I would be lying if I say I find his position better than laughable.

My suggestion is that you listen to what he says and run the other way. Use him as a proxy for the intelligence produced from thinking by committee. If those are the thoughts you respect, you have your man.

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Mr. Grannis reminds me exactly of Kenneth Griffin, CEO of Citadel Investment Group, and the man in charge of $15 billion.

Mr. Griffin was interviewed in December 2008 by Fortune. He said found the systemic financial crisis mysterious and irrational.

“The idea that the largest banks in the world would simultaneously fail, need government support, government guarantees, and/or government intervention to survive was not in my range of realistic scenarios,”  said Mr. Griffin (“Citadel Under Siege”, Fortune Magazine, Dec. 9, 2008).

This is the thinking of a major hedge fund manager who has been responsible for billions of dollars. Yet anybody performing basic calculations on property values and their mortgages could predict the financial crisis (See “Unmanageable Loss: Manageable Catastrophe”, New Mortgage News, April 1, 2008).

Warren Buffet talks about the tide going out and leaving naked bathers for all to see. I am sure his investors wish he had been more fully dressed in 2008. Every one of his top managers failed to anticipate the financial crisis. Graham & Dodd understood balance sheets, but did they understand macroeconomics?

If you look again at those numbers in “Unmanageable Loss”, you know we are in a household debt crisis of immense proportions. The numbers now are far worse than they were a year ago. How in the name of God could Mr. Grannis or Mr. Griffin imagine that we will lose 40% of all residential property value and not enter a massive banking crisis? Residential mortgages are the largest financial asset category bar none. The more property values fall, the more mortgage loans default. The more mortgage loans default, the greater the crisis.

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If economists cared to provide relevant research, they would give us the debt-payment-to-income chart for the 15 million unemployed and for perhaps 20% of the most highly leveraged employed persons. And they would include a chart of how much debt these persons have. And we could reasonably project the losses financials would incur from insolvent households. Give Mr. Grannis this chart and he will rethink his hypothesis.

I am not saying it’s easy to get those numbers. I am saying the practitioners of economics are so perversely incompetent as a group that they don’t know these basic numbers are essential — starting not today but 100 years ago. Who can even imagine the catalogue of folly in the list of “research” subjects which professors are conducting today at our colleges and universities? What we need is a Grannis Chart of the 45 million most highly leveraged borrowers.

It is astonishing to watch a financial crisis and see basic factual data is unavailable or is wildly wrong. Earlier in this story I guessed at systemic equity capital in the financial system of $1.5 trillion. I don’t know the real number. How many of you have that number? How can you make sense of systemic financial losses of between $2 trillion and $4 trillion if you don’t know the starting equity capital level?

My favorite mistake is in measuring negative equity. The most aggressive position I have seen is Edward Pinto, former chief credit risk officer at Fannie Mae, who estimates negative equity is equal to $1 trillion by the end of this year (“How Serious is the Mortgage Problem That Will Confront President Obama”, see page 13, January, 16, 2009).

The Economist, a rock-solid source on business, put the estimate at $500 billion recently (“Can’t Pay or Won’t Pay?” The Economist, February 19, 2009). If we are now at 30% down from the peak, and use $20 trillion as the high value, then $6 trillion of property has gone away. And only $500 billion of mortgages are unsecured? I beg to differ. I say we are headed to a world with $5 trillion of bad mortgages (“Killing Catastrophe”, New Mortgage News, February 2, 2009).

We are flying through a financial crisis with bad information about the debt-payment-to-income ratio of the most highly leveraged households. We are flying through the financial crisis without knowing the volume of “unsecured” mortgage debt when the property bust is the most significant event. The most important number we need is to measure negative equity in all of its different permutations. Nobody has good numbers on it.

“There is no obvious reason,” said Mr. Grannis, “to think that we are now in some brand new era in which households will be behaving differently than they have in the past.”

If you haven’t fallen off your chair right now, I sincerely hope you are tied down and enjoying torture in a sadomasochistic exercise. Let’s review why it is obvious that we are in a new era.

Last year investors lost $17 trillion in global equity markets (see chart above: “Four Bad Bear Markets”) The Fed and Treasury have used about $3 trillion just to keep the lights on. Financial firms have announced losses of $1 trillion on US-based loan-assets. It is reasonable to believe this number will double or triple or quadruple. American homeowners have lost $6 trillion of equity. They may end up losing $10 trillion. What in the name of God is that going to do the residential mortgage market?

If you don’t think these numbers are signs of a household debt crisis, I want to know more about life in the Grannis-Griffin-Pinto camp. Please send a post card and tell me: What’s it like on Mars and to be totally completely and indisputably out to lunch forever with no chance ever of return to earth? I know the human brain turns into a vegetable on Mars (see picture above). I have always wanted to know what it sounds like when a bug is eating your brain? Does it affect your digestion?

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Michael David White is a mortgage broker in Chicago.

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Good stories on this subject:

“Consumer Debt Picture Shows One Sign of Improvement” July 25, 2009. WSJ.