03.07.11
Economic Trends
Household and Corporate Balance Sheets
One reason for the striking severity of the last recession is the double whammy that struck household and corporate balance sheets. Balance sheets deteriorated sharply when the values of both financial and real estate assets plunged. The resulting increase in leverage (the ratio of assets to net worth) was much larger than in any of the previous eight recessions. Weak balance sheets depress real activity in a number of ways: they raise the cost of credit, they reduce its availability, and they constrain consumption and investment demand.
Household leverage reached record high levels, and corporate leverage hit near-high levels. Leverage ratios in both sectors have since decreased but remain close to their peaks, and this is likely one factor slowing the current recovery down.
A closer look at the balance sheets of the two sectors reveals some interesting differences. Households have been reducing their liabilities in the past two years, lowering the large home mortgage and consumer credit components. During the same period, however, firms have steadily accumulated liabilities, especially by raising the corporate bond component.
Each sector suffered a substantial loss of assets during the recession. Both financial assets and real estate assets experienced their largest percentage drop on record. Moreover, the contractionary effects of the losses on leverage and real activity were compounded by the simultaneous drops in the two kinds of assets. Financial asset values have since rebounded, and assets for both sectors recovered as a result, but the recovery has been only partial.
Household financial assets were hit harder by the crisis than corporate financial assets, which suggests that households were relatively more exposed to the type of financial shock that hit the economy. While corporate financial assets decreased by 6 percent, household financial assets decreased by 22 percent. After the recession, corporate financial assets have fully recovered and surpassed the previous peak, but household financial assets are still well below their pre-crisis levels.
Household and corporate real estate assets began to fall, respectively, four and two quarters prior to the beginning of the 2007 recession. When the recession started, they had already decreased by 7 percent and 3 percent, respectively. The overall percentage drop in real estate assets was by far the largest on record for both sectors, −27 percent for households and −35 percent for corporations. For both sectors, real estate assets are currently close to their post-crisis lows.
One reason the corporate sector experienced a larger percentage decrease in real estate assets is that it was relatively more exposed to commercial real estate prices than residential real estate prices. The percentage drop in commercial real estate prices was larger than in residential real estate prices. Depending on the price index considered, commercial real estate prices dropped by between 40 percent and 45 percent, while residential real estate prices dropped by between 11 percent and 32 percent.
Although real estate prices seem to have bottomed out, they are not showing any clear sign of recovery yet. Consequently, leverage in both sectors continues to be high and close to peak, likely weighing on the current recovery.