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The debt explosion of the 1980s: problem and opportunity.

From 1982 to 1988, debt in the U. S. economy exploded. The ratio of debt to GNP, which had been noted for its stability for decades, climbed to a spectacular peak. While part of the excess debt stemmed from the much-discussed cumulative Federal deficits over this period, the larger part seems to have financed investment in real estate. Now, the debt-to-GNP ratio may be peaking. This change is not surprising, for a great deal of the debt created in the past few years cannot be serviced. If the debt ratio is now peaking, it would be a dramatic change from the recent pattern of rapid growth in debt. This change implies a sharp improvement in the supply and demand balance for long-term funds and is bound to lead to significant declines in long-term interest rates.

AS A FIRST STEP to understanding what a peaking of the debt ratio might mean for the future growth of the U.S. economy, let us analyze debt growth in the 1982 to 1989 period. The concept of debt discussed here is the total debt of all domestic nonfinancial sectors of the U.S. economy. By excluding financial sector debt, this series in principle measures the debt most directly related to economic activity.


When the overall debt-to-GNP ratio is decomposed into the ratios for the various sectors of the economy - households, businesses, state and local governments and the federal government - some striking differences appear. First, while the large cumulative federal deficits after 1981 have boosted the federal debt-to-GNP ratio, it is still below where it was in 1960.

Moreover, the state and local debt ratio, after rising from 1960 to 1971, fell dramatically in the following decade and at the end of 1989 was significantly below where it was at the beginning of the period. For the public sector as a whole, the debt-to-GNP ratio fell from 60 percent in 1960 to 37 percent in 1981, and then rose to 55 percent in 1989.

Thus, for many years the decline in the public sector debt ratio masked two fundamental trends: secular increases in the debt ratios of both the business and the household sectors. In the case of the household sector, the debt explosion really began after 1976. The ratio of household debt to GNP rose from .470 to .654 at the end of 1989. Moreover, 71 percent of the increase was due to mortgage debt. Though much attention has been focussed on other forms of consumer debt - credit cards, automobile debt and so forth - they really explain only a modest part of the extra debt growth.

Leverage in the business sector rose steadily from 1960 until the severe recession of 1974-75. It then paused for several years before surging again in the 1982-89 period. Behind this unusual pattern were several forces, one of which - the growth in commercial and multifamily mortgages - is so important that it has to be separated from other business credit.

In 1960 business mortgages totalled about $53 billion. At the end of 1989, the figure was over $1 trillion, a nearly twenty-fold increase. Moreover, the most rapid growth was from 1982 to 1988, during which mortgage credit more than doubled. Had business mortgage credit grown only in line with GNP since 1982, it would have amounted to $300 billion less at the end of 1989. Clearly, the wave of commercial construction that was unleashed by the 1981 tax cuts has left a major legacy for the financial markets to digest.


While residential mortgage debt has grown more slowly than business mortgage debt, in dollar terms its recent growth has been enormous. From the early 1960s to 1976, the mortgage debt of the household sector ran about 30 percent of GNP. Then the mortgage debt ratio rose steadily, averaging about 35 percent in 1980-84; it shot up to 45 percent at the end of 1988. In numerical terms, the rise in the ratio, even from the early 1980s, meant over $500 billion in additional mortgage credit outstanding by the end of 1989.

Yet new single-family home construction was not abnormally strong during this period. What seems to have happened is that the rapid growth in mortgage credit fueled a surge in home prices. The average price of an existing house in the U. S. roughly paralleled the rise in the consumer price index from 1965 to 1982. Then house prices rose much more rapidly. Figure 2 shows the average price of an existing home deflated by the consumer price index and contrasts this "real" price of housing with housing investment as a share of GNP. It seems that initially a rising "real" house price stimulated investment in residential real estate, but as prices continued to rise it began to act as a drag.

In any case, residential investment as a share of GNP in 1988 and 1989 was well below the levels of much of the 1970s. Thus, the enormous expansion in mortgage credit has primarily financed a rise in the price of housing. With the "real" price of housing now relatively high, history suggests, first, that some recent purchasers will have difficulty servicing their mortgage debt and, secondly, that during the next few years house prices will rise less rapidly than overall inflation, i.e., that "real" home prices will decline.


The savings and loan industry debacle provides clear evidence that tens, if not hundreds, of billions of dollars of the real estate-related debt created since 1982 cannot be serviced. In Texas, where real estate and the oil economy collapsed together, nine out of the ten largest commercial banking institutions were either taken over by out-of-state firms or had to be rescued by the Federal government. This sorry history raises the question of how the huge growth in debt was financed.

The traditional suppliers of funds - commercial banks, thrift institutions, life insurance companies and pension funds - continued to be the major source of financing, especially for commercial real-estate investment.

Table I shows how the spectacular growth in commercial mortgages from 1982 to 1989 was financed. Note the more than tripling of holdings by commercial banks and the doubling of holdings by life insurance companies. What is most troubling about this commercial mortgage debt is that it grew so rapidly after 1985, when investment in commercial structures peaked. As in the case of residential real estate, it appears that some of the commercial mortgage credit went into a marking up of the prices of existing commercial properties.

Corporate debt has rightly received a good deal of attention in recent years. Since 1983, when stock buy-backs became important, debt has risen from 30 percent to 50 percent of net worth. Interest payments now amount to 50 percent of pretax profits. Leveraged buyouts and recapitalizations, especially in the past three years, have transformed the corporate landscape. On balance, from 1982 to 1988 over $400 billion in corporate equity was retired and replaced by debt. The magnitude of this development can be appreciated by noting that it alone explains virtually all of the increase in the ratio of corporate debt to GNP in the past twenty years.

How alarmed we should be by this surge in corporate debt is a matter of intense debate among the academics. It does not seem to have prevented a vigorous growth in capital spending, which has largely been financed internally.

However, a high proportion of this new corporate debt has been high-yield or junk bonds - particularly to finance mergers and acquisitions - and the buyers of this debt may not be prepared to assume the costs of a high rate of defaults. According to a 1989 Drexel Burnham publication, the largest holders of this debt are life insurance companies (30 percent), mutual funds and money managers (30 percent) and pension funds (15 percent). Since high-yield bonds are basically securitized commercial bank loans, they are certain to develop problems that will require time, effort and, possibly, additional funds to work out. It seems likely that high-yield bond funds that expanded dramatically during this period and pension funds will have difficulty managing this workout process and will, instead, attempt to sell their holdings at the first sign of trouble. Even life insurance companies, burdened as some are with problems with commercial mortgages and with low ratios of capital surplus to total assets, may have difficulty managing their high-yield bond problems.


It seems clear that the driving force behind the enormous expansion in private sector debt in the past twenty years has been the long-run inflationary process that gripped the U.S. economy from 1969 to 1982. Ever-higher peaks of inflation and interest rates made financial markets volatile, depressed the values of financial assets and made debt cheaper than equity. At the same time, lenders were eager to lend against appreciating real assets at high interest rates. Borrowers were willing to pay these rates because of their belief in an unending inflationary spiral - especially for real estate.

The result has been the creation of a vast amount of debt - primarily related to real estate but including corporate assets as well - that has financed the marking up in price of assets rather than the creation of productive capital. As the inflationary process that fostered this debt growth has come to an end, it has become clear that much of this debt cannot be financed out of current income streams and will have to be written off.

So far the burden of these write-offs has fallen most heavily on financial institutions. While the federal bailout of the savings and loan industry has removed one threat to the U.S. financial system, a danger exists that problems in the life insurance industry will prove to be beyond the capacities of state regulators and state guarantee funds. In contrast to the banking institutions, there is no overall federal authority standing behind the life insurance companies.

This is another reason why the outlook for junk bonds is so important. While the total amount outstanding - $160 billion or so is not large in relation to total debt in the U. S. junk bonds are highly visible. If problems continue to unfold, a severe test will occur in the liquidity of the market for them. As prices are marked down, there will undoubtedly be cases where a savings institution or insurance company is materially affected by the drop in valuations of junk bond holdings.


The debt problem, in essence, is the cost to financial institutions and the public of the writing-off of excess debt. Based on the preliminary bill for the bailout of the savings and loan industry, the cost will be considerable. Still, this cost may yet produce some long-term benefits. Indeed, the very problems of the real estate sector offer an opportunity both to increase the amount of savings in the U.S. economy and to channel more of them to productive use in the industrial sector.

Real Estate investment Less Profitable

The overbuilding of commercial real estate is leading to lower price increases and, in some areas, actual price declines. Residential real estate in many areas of the country also is undergoing a measure of price deflation. Based on past experience, it would not be surprising if "real" home prices declined moderately over the next four to five years. Existing home prices nationwide would probably rise but less rapidly than the inflation rate. Looking further ahead, it is unlikely that the profit potential of real estate will seem quite so bright as it has during most of the past twenty-five years. Moreover, the financial institutions that have been responsible for the enormous growth in mortgage credit during the past seven years are not likely to be as aggressive in the immediate future.

Long-Term Financial Assets

Two of the preconditions for a shift of funds from the real estate sector to stocks and bonds and other financial assets are in place: (1) The outlook for real estate as an investment during the next few years is cloudy at best; (2) financial institutions are likely to be more careful and less generous in extending credit for the purchase of real estate. A third precondition is a noninflationary monetary policy that reinforces the lessened attraction of real estate by increasing the appeal of long-term financial assets.

What do we mean by such a policy? Fundamentally, it is one wherein the Federal Reserve finances real economic growth in line with the long-run potential of the economy, tightening when the economy moves above and easing when it moves below its potential. If long-term investors became convinced that the U.S. economy would never again experience a sustained acceleration of inflation as it did from 1965 to 1980, the uncertainty premium in long-term interest rates would decline significantly. Long-term financial assets would gain in attractiveness. During the past thirty years, the share of equities, including mutual funds, in household wealth has fallen from 40 percent to about 20 percent. It is not too much to hope for a meaningful reversal of this trend.


With debt growth sharply lower and household holdings of financial assets higher, a fundamental improvement would occur in the supply and demand balance for long-term capital. Household savings would be higher because less would be invested in real estate (on which interest is paid) and more would be invested in financial assets (on which a return is earned). With a smaller Federal deficit, long-term real interest rates on U.S. Treasury securities could easily move down from the current 3 1/2-4 percent level to 1 1/2-2 percent, their historic norm. Such a development would go a long way toward restoring the attractiveness of long-term industrial and public infrastructure investment so desperately needed for America's international competitiveness.

The debt problem, which is primarily a real-estate debt problem, is serious and will involve significant costs as it is resolved. However, if this painful process results in a shift of long-term capital away from real estate and toward productive investment, it will have proved to be an enormous opportunity as well.


Since this article was prepared in April 1990, the problems posed by the debt explosion have become widely recognized. That they extend far beyond the savings and loan industry is shown by the dividend cuts and other drastic measures being taken by leading commercial banks and life insurance companies. It is clear that restoring the health of our financial system will take not only time but an extended period of lower interest rates. Thus, it is crucial that the federal government's claim on the nation's savings flow be substantially and steadily reduced.

* Thomas W. Synott III is a Senior Vice President, U.S. Trust Company, New York, NY.
 Table I
 Commercial Mortgages
 (billions of dollars)
 1965 1975 1982 1985 1987 1988 1989
Total 55.5 158.0 299.4 478.1 648.7 696.4 740.2
Commercial Banks 14.4 46.9 102.6 181.0 267.3 305.2 344.2
Savings & Loans 8.0 29.1 51.2 94.2 120.6 107.4 103.5
Mutual Savings Banks 4.5 13.4 15.1 19.9 26.3 29.0 29.9
Life Ins. Companies 16.8 45.2 93.5 127.7 166.7 184.1 189.6
Other 11.9 23.4 37.0 55.3 67.7 70.6 72.8
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Title Annotation:debt ratio in the United States
Author:Synnott, Thomas W., III
Publication:Business Economics
Date:Jan 1, 1991
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