Making Sense of Private Debt

What Is Private Debt?

If you or your parents have ever borrowed money from a bank or other financial institution to pay for a good or service, then you have participated in a credit market. Such markets exist so that individuals can borrow funds from lenders to make a purchase (such as a television), invest in themselves (such as through training or a college education), or invest in a business. Credit markets play an integral role in matching savers with borrowers. Without credit markets, only those with existing wealth could invest.

When individuals and businesses borrow funds, they accumulate debt. The three most common forms of debt are bonds, loans, and other securitized debt.

1. Bonds: A company or government agency can borrow money by selling bonds in a bond market. For example, when the federal government sells a U.S. savings bond, the government receives the money (the price of the bond) immediately and promises to pay the bond holder later, in months or years. That is, the government is borrowing money and the individual or entity who purchases the bond is lending money to the U.S. government. The bond purchaser (lender) then holds the bond as an asset until the debt is paid back with interest by the bond seller.¹ 
2. Loans: When a bank or other financial institution lends money to an individual or business, the borrower promises to pay back the amount of the loan with interest.
3. Other Securitized Debt: When financial institutions own loans and bonds, they can sell these to others in credit markets. They can even combine various loans and bonds together and sell them as "securitized debt" funds. For example, banks that make mortgage loans often sell the rights to collect the mortgage payments to the government housing agencies, and those agencies² in turn create bonds with payments guaranteed by the payments on the underlying mortgages. Such securities are called mortgage-backed securities, or MBS. 

Debt is generally categorized into two types: public debt and private debt. Public debt is the debt owed by national, state, and local governments. Private debt is the debt owed by households, businesses, and nonprofits,³ which are also called private nonfinancial entities. Private nonfinancial debt excludes borrowing by the government or financial firms, such as banks.

Measuring Trends in Private Debt

Figure 1 below shows private debt over time as a percentage of U.S. gross domestic product (GDP). GDP measures the value of all new and final goods and services produced in a country in a particular year and is an indicator of the income of that country. Therefore, Figure 1 measures U.S. private debt divided by the U.S. income that generates the ability to pay off that debt.

Since the 1950s, total private debt as a percentage of GDP has grown consistently: It passed 100 percent in the early 1980s; accelerated leading up to the financial crisis that started in 2007, when it peaked at over 170 percent; and then decreased to just below 150 percent by 2019. Why has private debt increased as a percentage of GDP? A big factor has been information technology. Computers have made it steadily easier to track people's use of credit and evaluate the likelihood that they will pay off loans.⁴ 

Private vs. Public Debt

The media often discuss the mounting U.S. national debt,⁵ with the national debt of the United States being defined as the public debt and other liabilities of the federal government.⁶ To pay back the public debt, government must raise revenue by taxing citizens. To pay back private debts, households and businesses can either pay lenders out of their incomes or sell existing assets. It's generally undesirable to sell assets, however, especially those needed to generate income, such as a car to get to work or a building to house a business.

Table 1: Public and Private Loans and Debt Securities, Nonfinancial Sectors, 2019:Q1

NOTE: Does not include noncredit market liabilities. Based on quarterly, seasonally adjusted data.

SOURCE: Z-1 Financial Accounts of the United States, First Quarter 2019, Board of Governors: government debt, Table L.106 and Table L.107; non-financial business, Table L.102; households and non-profits, Table L.101; accessed November 2019.

At the end of the first quarter of 2019, public loans and debt securities totaled 100 percent of GDP, with federal debt totaling over $18 trillion and contributing 86 percent of the public debt (Table 1).⁷ States and local governments contributed the remaining 14 percent. In that same quarter, private loans and debt securities totaled 148 percent of GDP, with businesses and households each contributing half of the private debt burden.

When discussing the public debt, the media often ask whether it is too large and when and how it might negatively affect the economy. Less media attention is given to private debt—even though it is at a higher level and can be just as damaging to the economy. Take, for example, mortgage debt, which was an underlying cause of the Great Recession.⁸

In the lead-up to the Great Recession, a rapidly growing number of homeowners stopped making mortgage payments and many others defaulted on their loans and lost their homes (discussed more below). Trouble in the mortgage market spread to other markets: Many banks failed, and the ones that survived viewed lending as a riskier proposition in general and were hesitant to offer loans. Therefore, policymakers decided to take action.

When the Great Recession began, the Federal Reserve (the central bank of the United States) "acted decisively"⁹ to lend money to banks on a short-term basis at low interest rates in order to provide emergency funds to failing banks and insurance companies, encourage lending, and ensure the proper functioning of the financial system.¹⁰ 

Private Debt Sectors

Home Mortgages

From the early 2000s to 2008, mortgage debt dramatically increased from 45 percent to over 70 percent of GDP (Figure 2) as more and more individuals and families became homeowners. At the time, lending standards had been lowered, allowing for riskier loans—loans to people less likely to have the income or ability to repay their debt. As it turned out, many of these people were ultimately unable to afford their homes, leading to defaults and foreclosures. A widespread decline in house prices also left many people unable or unwilling to make payments on their mortgages, which put the debt securities backed by these mortgages at risk. As many financial firms held MBS, the solvency of these firms was also put at risk and they often declined to make loans to each other or nonfinancial firms. This behavior sparked the Great Recession of 2007-09.

Regarding mortgage risk going forward, there is less concern about a housing market crisis than before the Great Recession: Mortgage credit has steadily decreased since 2009, dropping below 50 percent of GDP as of the third quarter of 2019 (Figure 2). For a discussion of private debt risks that researchers believe could lead to a crisis, see the boxed insert below.

Consumer Credit

Consumer credit includes many forms of nonmortgage debt such as credit cards, car loans, student loans, and other credit for the purchase of consumer goods and services. Since the early 1980s, consumer credit has increased from 13 percent of GDP to over 19 percent of GDP (Figure 3 below). While this is small compared with the overall level of private debt (148 percent in the first quarter of 2019), the failure of any credit market can potentially have a domino effect on other parts of the economy—as was the case for the mortgage market.

Much of the surge in consumer credit in the mid-1990s can be attributed to the increased use of credit cards for everyday transactions. Two potential areas for concern, however, are the auto and school loan markets.¹¹ In the past 10 years, student loan debt has more than doubled,¹² while the delinquency rate (the percentage of loans with missed or late payments) of auto loans has risen to its highest level since 2012.¹³

Business Debt

Companies and businesses borrow funds to invest in the buildings and equipment used to produce goods and services. In general, businesses tend to increase their debts during economic expansions to help the businesses grow. Then, when a recession hits they tend to decrease their debt and cut back on investment or in some cases default (not pay what they owe). At the time of this writing, business debt was at an all-time high of 74 percent of GDP (Figure 4 below), with corporations alone nearing $10 trillion in debt by late 2019.¹⁴ 

Conclusions

The media pays much attention to public debt and whether it negatively affects the economy but much less attention to private debt—debt incurred by households and businesses. Private debt, however, is currently larger than public debt and typically at greater risk for nonpayment. Although all debt levels are relatively high historically, total private debt is currently lower than during the Great Recession. That is, private debt has not increased dramatically as it did in the lead-up to the Great Recession. Debt from auto and student loans has been on the rise in recent years, however, which could be interpreted as a warning sign for our economy.