(Bloomberg Opinion) -- The National Bureau of Economic Research lists 29 credit contractions in the last 145 years, which works out to one every five years. We’ve now gone more than 11 years since the one started in 2007, the longest run in recorded history. But credit is a lot like a forest. Trees grow before eventually becoming old and littering the ground with dry deadwood before some unpredictable spark triggers a fire that damages the forest. So while it’s hard to guess when or where the fire will start, a map of forest conditions can provide a decent sense as to where damage is most likely — just like with credit.
Nine of the 29 NBER credit events had banking crises. Eighteen had stock market crashes, 16 caused extended contractions in credit availability, and 21 caused monetary shortages. Only two, the Great Depression and the financial crisis that began in 2008, were quinfectas, resulting in each of those four bad things plus a real estate collapse.
The graph below shows U.S. commercial bank liabilities as a percentage of assets. Capital ratios are nearly twice as high as 2008, and rules have tightened considerably on asset and capital quality. There are two important caveats. First, the graph shows aggregates. Some banks have plenty of assets; others are shakier. In a credit crisis, some banks are likely to fail, because they are overexposed to the sectors that get hit hardest, or perhaps have hidden risks or poor risk management. Second, if the credit crisis is big enough, many banks could fail. Banks won’t be unscathed by the next credit crisis, but damage should be limited unless a lot of other things go first.
The next graph shows non-financial corporation liabilities as a percentage of assets. Here again the aggregate numbers look reassuring. You hear a lot of warnings about the lowest-rated investment grade corporate bonds, speculative-grade bonds and leveraged loans, but as long as the overall non-financial corporate sector is healthy, there should be no waves of dominoes falling over.
Consumers are next. This graph shows total household liabilities as a percentage of assets and total household mortgage debt as a percentage of total home values. Both rose sharply from 2000 to 2008, and we know how that ended. But both have declined and are now near 30-year lows.
The picture is less rosy for non-mortgage debt such as credit card balances, auto loans and student loans, shown below as a percentage of household non-financial assets on the left scale and household financial assets on the right. Non-mortgage debt looks small relative to financial assets, coming in a 4.4 percent and falling. Unfortunately, households with non-mortgage debt aren’t the ones holding the most financial assets. Households have more non-mortgage debt than the sum of all their non-financial, non-residential assets, something without historical precedent.
Lenders don’t expect consumers to sell their clothes or computers (maybe their cars) to pay non-mortgage debt. Consumers reduce debt during bad times by postponing purchases, but even a lot of postponement will not make much of a dent in debt levels. Debt pressures, though, could cause a large decline in spending.
So, the vulnerable parts of the credit market in the next crisis are households with debt and no financial assets, real estate or businesses. This is a large universe of people, and their problems could cause steep spending declines. They are not equipped to weather periods of rising unemployment or wage cuts, and will be a powerful political force for radical government intervention.
I don’t expect a banking crisis, stock-market crash, bond-market meltdown or real-estate decline in the next credit crunch, nor an extended credit contraction. But many individuals will suffer, and sectors of the stock market dependent on consumer spending will be punished. I expect strong fiscal and monetary responses based on both the political situation and the clout of the group that will be hurt. That could cushion the pain at the time, but exacerbate government fiscal problems and moral hazard.
None of this is certain. In particular, if the credit crisis is big enough, it can take everything with it, like a wildfire that grows big enough to burn a young, healthy forest with little deadwood. Also, we always find surprises overlooked by aggregate data when things get bad. But today the financial system and the households that own financial assets seem reasonably prepared for the downturn.
To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net
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Aaron Brown is a former Managing Director and Head of Financial Market Research at AQR Capital Management. He is the author of "The Poker Face of Wall Street." He may have a stake in the areas he writes about.
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