Seriously, look at your household debt

BY AMANDA MORRALL

When National unveiled its debt-slaying Budget last Thursday, our household debt problem was described as a case of "excessive borrowing".

Excessive might be an understatement.

In 1990, the sum total of our personal debt was $20 billion. By 2008, our indebtedness to banks ballooned to $162b. And that is just what is owed to banks. A further $12b is owed to non-bank lending institutions finance companies and the like.

Expressed as a percentage of our disposable income, household debt in 2008 sat at an eyepopping 160 per cent. Most of it is tied up in housing.

While debt levels are largely in line with Britain and Australia, it is not what many would consider comfortable or sustainable.

Curiously, the Reserve Bank, while it has flagged the problem, is not raising alarms. Sizing up the financial vulnerability of mortgaged indebted home-owners, Reserve Bank adviser Mizuho Kida concluded that, overall, our risk was relatively low.

According to the statistics used to prepare the report (called the Household Economic Survey), the country's wealthiest (by income) own most of our household debt, 70 per cent to be exact. So presumably, the rich are in a better position than most to pay it off.

Also, the lowest income earners only own 1 per cent of the debt. So, unlike the now homeless folk in the United States who were sold mortgages that under normal circumstances they would never have received, our lowest-paid folk are relatively well-buffered from financial "shocks" of rising unemployment and plunging home prices. Further, Kida notes that debt-service ratios (a measure of our ability to pay back borrowed money) has actually fallen for the lowest income brackets. What that suggests is that debt has become more manageable for many.

Still, the statistics may be misleading. One-third of all household debt is missing from that "financial vulnerability" picture. The data used to prepare the report did not factor in all the debt related to investment properties and second homes.

Nevertheless, Kida concluded that: "Only under a severe stress scenario would we expect to see a substantial portion of households becoming vulnerable." If economists seem indifferent to mounting household debt, there may be a rationale.

Logically, it is in our best interests to cut up the credit cards, sell the boat and bach to get out of the red as fast as possible, but becoming a nation of Scrooges undermines our collective wellbeing.

The "paradox of thrift" is at play. Economist John Maynard Keynes coined the term to describe the unlikely Catch-22 situation.

Households are no different from Government in that they really ought to curb spending and boost savings but by doing so, en masse, they run the risk of prolonging our national economic misery by preventing a recovery. Either way, ASB chief economist Nick Tuffley doesn't believe there are any quick fixes for Government or households.

"It's not like you can suddenly, miraculously deliver yourself." Mr Tuffley expects a tide change from rabid spenders to moderate savers is a more likely scenario.

"Just as the last five years was part of a global cheap and easy credit period and fairly rapid lifting of debt levels, we'll go through a period where growth is subdued."

However, Canterbury University economics professor Glenn Boyle says individuals and families carrying high debt may be more vulnerable than they realise. He says "shocks in the real economy may still be to come". While unemployment and plummeting housing values are the obvious ones, Professor Boyle says it could be something more remote, such as US dairy subsidies that triggers a major economic earthquake.

"To the extent that that has nasty implications for dairy farmers in New Zealand, that could have a significant flow-through effect to the economy as a whole which reduces activity and hence employment. And that could potentially be a significant risk for people who have major debt levels." So where does that leave heavily indebted householders, particularly those bumping up against retirement?

According to Martin Hawes, one of New Zealand's pre-eminent financial advisers and investors, not a good place. Mr Hawes says householders should be treating their debt with no less urgency and action than Government.

"This is a time to be really honest with yourself. If you've made mistakes, own up to them and fix it. Be ruthless if you have to be," he says bluntly.

Hawes may be adept at reading the signs but it was neither clairvoyance nor financial genius that led him to dodge the most recent economic bullet that has levelled the bank accounts of so many in his age-group. It was a ski trip in July 2007. Hawes' partner, upon returning from a day of skiing in Queenstown, shared her astonishment at the grotesque display of wealth. The parking lot was crammed with new cars, entire families outfitted in flash new ski outfits and chomping down on expensive lunches.

Hawes says it was a turning point.

"A day after that we started to sell all our shares. We recognised that consumerism had gone mad on the basis of so much of it. We were already nervous and had sold down a bit but we talked about the ski trip and thought `This is not sustainable, the world has to jump back in line'."

Hawes recounts the story not to boast, but to underscore the level of excess that has given rise to the situation today. For the first time, baby boomers are getting a bad rap for defaulting on payments and loans, and mortgagee sales are hitting an all-time high.

Hawes' advice to householders?

"Get rid of bad debt." Bad, or "ugly" debt as Hawes refers to it, is money owed on depreciating items, for example cars, appliances, and clothing.

"People have to reduce debt, particularly for consumption items. They need to stop spending, redo the budget, and they need to apply every penny they save in order to reduce debt."

In some cases, particularly baby boomers who don't have the luxury of time, Hawes says the good debt (that's borrowed money spent on appreciating acquisitions such as property, shares or businesses) might have to go as well.

The obvious debt reduction target is the holiday home, he adds. Or at least that's the case for over-stretched boomers straining to make payments.

"At the very least it should be rented but in the vast majority of cases, people who are suffering financially and have that second home should sell," he asserts.

Mr Hawes says people need only to put themselves through the "what if test" to see how secure they are. "A lot of people are very exposed to the rental income property. Values will stop declining eventually but I could be wrong about that. I think individuals need to do a risk analysis and say: `Well, what happens if it falls another 20 per cent'?" Okay, so you do the hard work, sell the holiday home, get rid of the mid-life convertible as well as cut out lattes and $65 haircuts. Then what?

If you're a boomer, Hawes says you mercilessly retire all debt before investing a cent of it.

For the younger set, 20 to 45, Hawes believes "good debt" is acceptable, given that there is a longer time horizon for investments to appreciate.

"There is a level of debt that a young person can usefully take on provided they are buying so it can appreciate for at least 20 years, and they have security in their income, so they can make their payments."

But Hawes says this group is not an exception in needing to pare the bad debt, curb spending, and budget more carefully.

"Everyone should get rid of the bad debt and promise themselves never to take it on again."

And those precious few who have buried the debt, and have capital to spare?

"It is hard to say without looking at particular circumstances. But personally, I have started to buy shares again. I've been out of it for almost two years but I am starting to see over the last six weeks or so, some really good value companies in the sharemarket."

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