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Over the Falls: Credit, Collateral, Risk, Asset Valuations
Charles Hugh Smith

Together, these factors generate a self-reinforcing cycle of debt saturation, declining collateral and credit contraction. 

If we want to understand where the economy is going, credit and risk are good places to start. Credit/debt is how the system creates and distributes money: when a home buyer gets a mortgage to buy a house, that mortgage increases the money supply. When the mortgage is paid off, the money supply contracts. 

The mortgage is secured by two things: the income of the buyer and the house, which is the collateral for the loan. 

Risk is integral to credit. Should the income of the buyer or the value of the house decline sharply, the loan is at risk of default / loss. In the national/global economy, the cost of credit reflects trends and policies that raise or lower the risks which then influence the cost of credit: as risk rises, the cost of credit goes up. 

As macro-risks rise, the cost of credit pushes mortgage rates higher, increasing the percentage of income the buyer must devote to service the mortgage. This leaves less income for additional debt or consumption. 

Once their income is maxed out, the buyer reaches debt saturation: there is no more spare income to service additional debt. The workaround to debt saturation is to engineer lower interest rates, so the buyer can refinance debt at lower interest rates and reduce the monthly cost, freeing up more income for additional debt/consumption. 

But when systemic risks rise, lowering interest rates is no longer possible. Rates rise to reflect the risk premium generated by uncertainty and the higher potential of defaults and losses. 

Expanding credit is the lifeblood not just of consumption but of asset valuations. Home prices rise when the pool of buyers with sufficient income and creditworthiness to buy a house is larger than the inventory of available homes. When interest rates plummeted in the pandemic stimulus phase, house prices soared as buyers panic-bid for properties. 

(The same mechanism supports stocks, as corporations borrow money and use it to buy back their own shares, boosting per-share valuations.) 

Declining interest rates and rising asset valuations create a virtuous cycle in which higher asset prices provide more collateral to support bigger loans, loans which are easier to service as interest rates drop. 

This self-reinforcing feedback of higher asset prices / increased collateral enabling more debt is clearly visible in the charts below of the Case-Shiller national Home price Index, which soared 43% in the two years from 2020 to mid-2022, and the Households Net Worth which increased by a staggering $44 trillion in the two years following the pandemic stimulus. 

The risk profile of credit has changed both nationally and globally, and cost of credit cannot fall back to near-zero. I addressed this in Why Interest Rates Are Not Going Back to Zero

At the same time, productivity and wages have stagnated, leaving less income to service additional debt. As I explained in Here's How We'll Have Labor Shortages and High Unemployment at the Same Time, workers with skills that are scarce and in demand will command higher wages, while those with skills that are not in demand will not be able to find work or maintain high earned incomes. 

As risk and the cost of credit rise, the valuations of assets dependent on expanding credit decline. Not only do owners of assets such as houses feel less wealthy--the reverse wealth effect--the collateral available to secure additional credit drops. 

Together, these factors generate a self-reinforcing cycle of debt saturation, declining collateral and credit contraction: risk rises, credit costs rise, incomes and collateral decline and all the consumption and asset valuations that are dependent on credit expansion go over the falls. 

Gordon Long and I discuss these dynamics in our latest video Its a Waterfall - Risk, Collateral & Productivity. (48 min, numerous charts) 

New Podcast: Turmoil Ahead As We Enter The New Era Of 'Scarcity' (53 min) 


At readers' request, I've prepared a biography. I am not confident this is the right length or has the desired information; the whole project veers uncomfortably close to PR. On the other hand, who wants to read a boring bio? I am reminded of the "Peanuts" comic character Lucy, who once issued this terse biographical summary: "A man was born, he lived, he died." All undoubtedly true, but somewhat lacking in narrative.

I was raised in southern California as a rootless cosmopolitan: born in Santa Monica, and then towed by an upwardly mobile family to Van Nuys, Tarzana, Los Feliz and San Marino, where the penultimate conclusion of upward mobility, divorce and a shattered family, sent us to Big Bear Lake in the San Bernadino mountains.

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