Why defusing the debt bomb means dealing with distributions

Following the near-collapse of the global financial system back in 2008, it appeared only a matter of time before the UK’s household debt time bomb went boom. In aggregate, households owed just shy of 1.6 times their total income, up from a ratio of just over 1 at the start of the century. That there hasn’t been an explosion owes much to a combination of the surprisingly resilient performance of the labour market (in terms of employment at least – pay is another story), the stickiness of house prices in most parts of the country and lender forbearance. And of course the slashing of borrowing costs by the Bank of England, with its base rate now nearing seven years at just 0.5 per cent.

That’s a mighty long time for rates to remain so low, and I’ve written before about the tricky balancing act facing the MPC in terms of preparing for the next crisis without undermining the recovery from the last one. Yet, unprecedented though the Bank’s action has been, it’s certainly brought welcome breathing space for millions of stretched households.

And, while progress has been slower than hoped, there’s clear evidence of improvements in the underlying finances of many of those who took out sizeable debts before the crisis hit. The latest NMG survey for the Bank of England paints a clear picture of hope. The chart below, taken from the Bank’s Quarterly Bulletin, details the proportion of mortgagor households that it estimates would need to ‘take action’ (i.e. would have to find money not yet set aside) for rate increases of varying magnitude. The pink lines relate to the overnight impact of rate changes, while the blue lines add in the offsetting effects of 10 per cent rises in incomes (reflecting expectations that rates will rise gradually and only in response to improvements in earnings and incomes).

Crucially, the lines have been moving inwards over the past three years, indicating that fewer and fewer households appear seriously exposed to rate changes. According to the 2015 responses, a 2 percentage point increase (with full pass through to mortgage rates, which is unlikely in practice) would require a reaction (such as working more hours, cutting spending or requesting a change in mortgage) from around 31 per cent of mortgagor households, down from 44 per cent in 2013. Assuming incomes simultaneously increased by 10 per cent, the figure is estimated to be just 2 per cent.

The improving picture is very welcome and makes sense, given the extent to which employment, earnings and incomes have picked up over the last 18 months or so. But the time bomb may not be defused just yet. The modelling is based on an assumption that a 10 per cent increase in income is felt uniformly across all households: an outcome that’s far from certain. As the Bank report acknowledges, both the pace and the distribution of household income growth will be critical to the unwinding of the pre-crisis debt legacy.

To illustrate just how critical, consider the next chart. It shows the proportion of mortgagor households within each household income quintile with mortgage debts equivalent to more than four times their gross income (a ratio we define here as ‘high’). What’s clear is that the lowest income mortgagors are significantly more likely to hold the largest debt exposure. Indeed, close to one-third (31 per cent) have debt-to-income ratios of 5+.

Given these ratios, it’s an unsurprisingly similar picture in relation to debt servicing costs, as the next chart shows. Mortgagors towards the bottom of the distribution are much more likely to be spending more than one-third of their gross income on repayments than those elsewhere in the distribution.

Of course, there are relatively few mortgagor households towards the bottom of the income distribution, with just over one-in-ten in the first quintile being in this position. As such, the 44 per cent of mortgagors who are ‘highly geared (in previous modelling we’ve defined this concept as relating to those spending more than one-third of their net income on repayments, but the NMG survey doesn’t allow for that so here we use one-third of gross income instead) converts to a total of just over 5 per cent of households in the bottom quintile. Nevertheless, more than half (52 per cent) of the total ‘highly geared’ group can be found in the poorest 20 per cent.

Clearly, some of these low income/high debt households will hope that their situation is temporary – reflecting a period of unemployment for example. Yet with employment standing at a record high, these figures are likely to have only a limited cyclical element.

And it’s not just in relation to mortgage debts that lower income households look vulnerable. As the final chart shows, irrespective of tenure, around one-in-four (27 per cent) members of the bottom quintile say they had difficulty paying for their accommodation in the past 12 months. Unsurprisingly, housing-based financial distress is felt most acutely by those with the lowest incomes.

What might the future hold? Between 1981 and 2007, net household incomes grew 1.4 times more quickly at the 90^th percentile than they did at the 10^th percentile. There is of course no guarantee that income growth will be similarly skewed in the coming years. After all, the 1980s was a period of particularly sharply widening inequality; a pattern that was much less marked in the 1990s. But it is probable that there will be some variation across the distribution.

Wage inequality has narrowed since the financial crisis – though prior to 2015 that was simply due to wages falling fastest at the top of distribution. And the introduction of a higher wage floor for over-24s in the form of the national living wage should boost wages among some of the lowest paid, but because of the way such jobs are shared across households, this does not have a direct feed through to income growth. With £12 billion of benefit cuts due in the coming years – all of which will fall on working-age households – some increase in inequality appears inevitable.

With incomes finally heading in the right direction, the unprecedented recent period of monetary looseness means that gradual rate rises are on the cards for next year. They now look more manageable than a few years ago. But the concentration of debt exposure among lower income households provides another reminder of the need to focus not just on the strength of the economic recovery, but on the distribution of its gains too.