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Bankruptcies decline (and how to watch for debt stress) [ClearOnMoney]
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Bankruptcies decline (and how to watch for debt stress)

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Commentary

Bankruptcies decline (and how to watch for debt stress)

26 May 2011 by Jim Fickett.

Currently debt stress is low, and both personal and business bankruptcies continue to decline. The credit cycle will eventually turn again and, in order to keep an eye on debt stress levels, it will be important to watch debt level, debt burden, debt distribution, and defaults.

Earlier this month the Administrative Office of the US Courts updated bankruptcy statistics through Q1 of 2011; these are conveniently available via the American Bankruptcy Institute.

Both personal and business bankruptcies continue to decline, and are now clearly past their peaks:

I have followed bankruptcies since 2007, as one indication of stress in the credit markets. It has been useful, but I think bankruptcies are not really the best indicator, and I will no longer follow them.

There are four key things to watch as harbingers of trouble:

First, debt level. If interest rates are low, a high debt level may present little current stress. However, while a high debt level cannot quickly be changed, interest rates can indeed quickly change, and so high debt makes the debt holder's situation less resilient.

Second, debt burden. For households, I will track the Fed's financial obligations ratio, the fraction of income that goes to fixed payments, including debt. This is an indicator of current stress on budgets.

Third, debt distribution. It matters who holds the debt. If all the household debt in the country was on the credit cards of billionaires, there would be little danger of defaults. At the other extreme, one of key causes of the financial crisis was that mortgage loans were given to many people who had no likely means to pay them off (and similarly with Greece and the EU). There is no standard data series to watch here (something all those economists at the Fed should work on), but it is an area to keep in mind and watch carefully.

Fourth, debt defaults. Rising defaults are probably the single most important sign that the credit cycle, and hence the business cycle, is turning. This is where bankruptcies come in, but it is probably better to watch something that affects a larger fraction of the population, like mortgage loan delinquencies, credit card defaults or, in the case of businesses, bond defaults.

Incidentally, although the three main reference pages (US personal bankruptcies, US business bankruptcies, and 2005 change in US bankruptcy law) will no longer be maintained, they contain useful background information, and I will leave them up on the site.