Debtors repent by walking away, not by paying off

‘New frugality’ a deception

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A common refrain these days is that Americans are learning to save more and spend less, depending less on credit cards and unsustainable increases in mortgage debt to finance lifestyles that many can’t afford.

The unprecedented debt splurge of the past decade was a major cause of the financial crisis and recession, while the sluggish recovery is blamed on the hangover from that debt binge as consumers cut back on spending and try to pay off debt. Household debt has fallen by a record $900 billion since 2008, while the savings rate is up to a healthy 6 percent.

Although that sometimes painful but virtuous “deleveraging” process has been a boasting point for President Obama and other political leaders looking for positive trends in the economy, a closer look shows that it is not all or even mostly the result of moral rectitude and improved spending habits on the part of the public.

Rather than paring down what they owe, millions of consumers have simply stopped paying the bills, forcing banks to write off hundreds of billions of dollars in mortgages and credit card debts as uncollectible.

Defaulting on the debt, while not as commendable as paying it off, in the end produces the same statistical result once banks charge off the loans: lower debt, lower consumer spending and an increase in cash savings.

“Appearances are deceptive,” said Harm Bandholz, an economist at Unicredit Markets, who said that top officials at the White House and Federal Reserve have not entirely owned up to the ugly truth.

By Unicredit’s analysis, “the entire decline in household debt is attributable to a massive surge in loan defaults” and the resulting debt write-downs by banks, he said. “There is no deleveraging going on.”

Fed Chairman Ben S. Bernanke in recent testimony lauded the large increase in savings and reduction in consumer debt since 2008, saying that was necessary for consumers to “repair” their finances and eventually resume a more normal pace of spending.

Only in a footnote in his written testimony did Mr. Bernanke concede that “some of the reduction in household debt burdens is the result of defaults and write-downs rather than higher savings.”

But Mr. Bandholz said economic figures the Fed itself compiles show that, by his conservative estimate, banks have had to charge off as uncollectible about $425 billion in mortgage debt and about $200 billion in consumer loans — primarily from credit cards.

That accounts for most of the debt reduction in those categories reported by the Fed in the past two years, he said.

“There are two ways that debts can decline,” he said. Repaying the loans would be “the cleanest solution” for consumers and the economy alike, but instead people are forcing banks to resolve the problem by going into default.

By and large, “households have not yet begun to actively repay their debt,” he said, despite the “new frugality” often noted by the media.

An analysis by the Wall Street Journal last month also found that defaults accounted for most of the reduction in consumer debt seen since 2008.

Other analysts say it is difficult to know exactly how much debt is being repaid and how much is going into default and being written off as a loss by lenders. But clearly the share expunged through default is huge.

“We know that over the past 18 months, banks cut credit limits for 58 million cardholders,” citing escalating delinquencies, said Bill Hardekopf, author of the Credit Card Guidebook.

“If issuers keep this up and cut 45 percent of the spending power on credit cards, they will be forcing consumers to continue to reduce their usage of credit cards and find alternative forms of payment like debit cards and cash.”

While stopping repayment may seem like a simple and easy way to get out of debt, the mounting defaults and bankruptcies have made it hard or impossible for borrowers to later obtain new loans. That forces them to spend out of cash or use debit cards that tap into only the cash they have in their bank accounts.

Consumers in default or bankruptcy do not kick the debt habit on their own. Surveys show many whose credit was cut would like to get more credit, but banks have been unwilling to accommodate them, Mr. Hardekopf said.

Whether by choice or under the gun, consumers thus are becoming more frugal, saving more and spending less.

“It appears that consumers have come to realize that — now is the time to balance saving versus spending” after years of going ever more deeply into debt, said Ezra Becker, director of strategy at TransUnion.

“It remains to be seen whether this dynamic will be short term or a new paradigm for consumer behavior.”

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