The critical question, as we enter 2008, is knowing the extent of the crisis in the financial sector and how it will affect the real economy.
A difficulty in ascertaining the magnitude of the problem resides in the vague information provided by financial institutions on their true exposure, not only to subprime loans, but also to increasingly nonperforming prime loans and other types of consumer credit. The total sum of the write-downs, $100 billion up to Dec.11, 2007, continue to mount. The $10 billion UBS write-down on Monday, December 10, was immediately followed by Washington Mutual slashing its dividend and offering $2.5 billion worth of convertible preferred stock to stregththen its capital. UBS' announcement occurred just four weeks after the firm indicated that it would have no mortgage-related write-offs.
The difficulty resides not only in the uncertainty over the extent of the credit crisis. It also concerns the growing certainty that not even the banks know the full extent of their nonperforming loans. They seem unable to determine the size of the "sand castles" built on the foundations of the mortgage, second mortgage, home equity loans, FICO scores, and debt-rating agencies.
A key indicator of household finances --– household debt as a percentage of disposable income – has increased by 30 percentage points in the past six years. This ratio was 100 percent at the beginning of the decade and 80 percent at the beginning of the 1990s. Home mortgages represent 74 percent of total household debt, and consumer credit represents 18 percent; together they make up 92 percent of household debt. In the nearly six years from 2002 to the third quarter of 2007, home mortgage credit grew by 75 percent while consumer credit expanded by 25 percent.
Anticipation of increasing home prices, together with increasing incomes and sophisticated financial instruments, made this growth possible, at the expense of the financial health of households and, as we are finding out, lenders.
Of course, this index of household debt ratio cannot summarize all the complexities of the economy, but it ties together many of the key elements that will make 2008 a dramatic year. Households' total financial obligations have reached 20 percent of disposable income, and the continued strength of the job market is essential to keeping this situation bearable. Should the job market weaken, household debt and debt obligations, prodded by declining disposable income, will increase. As a result, consumption will decline as households scramble to cover their monthly financial obligations. If the situation persists, sales of assets will be necessary, starting with the most liquid (stocks) to the less liquid (real estate). In Michigan, we are seeing at a state level what could happen at a national level if job conditions start to deteriorate as a result of the collapse of key industries. In many of these cases, the quality of credit, considered prime will have to be adjusted, as well as the value of collateral assets (real estate). The implications for financial institutions are critical.
2008 Economic Projections
Given this uncertainty and lack of information on the extent of the financial troubles, macroeconomic projections for the United States for 2008 are volatile. Contrast the Congressional Budget Office forecast of 2.8 percent real GDP growth in 2008 to more recent estimates by the International Monetary Fund of 1.9 percent. At this revised growth rate, unemployment will increase to 5.7 percent, triggering some of the dynamics in the consumer finance that we detailed above.
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