Consumer spending spree

Bill Bonner
The Daily Reckoning
Sep 5, 2006

...How can a consumer economy keep consuming when the consumers have no more money? Or, is there a source of revenue we have overlooked?...

Today is a day of rest in the US. Here at the Daily Reckoning's roving headquarters, on the other hand, we labour as usual.

We labour, mind you, not only to keep up with what's happening. But also to follow what's not happening. So much is not happening these days that we wonder if we might actually be missing something. Reading the news, it seems as if you could rapidly come to any conclusion you wanted. The economy could look terrible to you, or great, or middling. True, US housing is in trouble, but the Dow is going up and unemployment is near a 5-year low; oil has sunk back under $70, the dollar is holding steady and gold seems trapped in the $630 range.

The lumpenhouseholder ought to be nearing the end of his spending spree. He ought to be running out of money and running out of time. But you wouldn't know it from the headlines. It is as if investors hadn't noticed. Or had noticed and yawned. Are they blind, we wonder, or are we? In the past several years, the consumer has been taking money out of his house just to keep going. Fistfuls of money. Truckloads of it. Over the last two years alone, $1.352 trillion of equity has been extracted - an amount equal to about 10% of annual GDP. But now, with US housing prices levelling off, the river of ready cash is drying up. Is there some other source of easy money that will save him? If anyone knows what it is, he doesn't work here at the Daily Reckoning.

The consumer has squeezed himself into a tight spot, but what got him there was the grease of phenomenally low interest rates. And now that the inverted yield curve is normalizing and borrowing for three months is actually becoming cheaper than borrowing for ten, the grease is getting a little stiff and gritty. US housing prices aren't rising like they used to, while unsold houses are stacking up like empty shipping containers at Long Beach. Existing house inventories are 40% above those a year ago.

And stuck in his tight spot, the US consumer looks up into the mirror and sees a sucker in it.

Business Week describes the trap in greater detail:

"The option adjustable rate mortgage (ARM) might be the riskiest and most complicated home loan product ever created. With its temptingly low minimum payments, the option ARM brought a whole new group of buyers into the housing market, extending the boom longer than it could have otherwise lasted, especially in the hottest markets. Suddenly, almost anyone could afford a home - or so they thought. The option ARM's low payments are only temporary. And the less a borrower chooses to pay now, the more is tacked onto the balance.

"The bill is coming due. Many of the option ARMs taken out in 2004 and 2005 are resetting at much higher payment schedules - often to the astonishment of people who thought the low instalments were fixed for at least five years. And because home prices have levelled off, borrowers can't count on rising equity to bail them out. What's more, steep penalties prevent them from refinancing. The most diligent home buyers asked enough questions to know that option ARMs can be fraught with risk. But others, caught up in real estate mania, ignored or failed to appreciate the risk.

"There was plenty more going on behind the scenes they didn't know about, either: that their broker was paid more to sell option ARMs than other mortgages; that their lender is allowed to claim the full monthly payment as revenue on its books even when borrowers choose to pay much less; that the loan's interest rates and up-front fees might not have been set by their bank but rather by a hedge fund; and that they'll soon be confronted with the choice of coughing up higher payments or coughing up their home. The option ARM is "like the neutron bomb," says George McCarthy, a housing economist at New York's Ford Foundation. "It's going to kill all the people but leave the houses standing."

What are we missing? We squint. We look around. We scratch our heads. And then we look under the cushions and behind the chairs. How can a consumer economy keep consuming when the consumers have no more money? Or, is there a source of revenue we have overlooked?

"With soaring stock portfolios now ancient history and leaping house prices about to be," writes Gary Shilling, "no other sources, such as inheritance or pension fund withdrawals, are likely to fill the gap between robust consumer spending and weak income growth. Consumer retrenchment and the saving spree I've been expecting may finally be about to commence. And the effects on consumer behaviour, especially on borrowing and discretionary spending, will be broad and deep."

Shilling expects house prices to drop by at least 20%, which will cause a 'major recession.'

As usual, we don't presume to know what will happen and we're not going to sweat too hard to try to figure it out. We suspect that there will soon be more than enough sweating going on.

*** First, our friend Byron King reports from the confluence of the Monongahela and Allegheny rivers in the US.

"True story from a lunch time conversation today (9/1):

"A Pittsburgh real estate attorney (not me, by the way) is currently in the process of losing his Brooks Brothers shirt because he bought into a group of condos and houses in Florida. 'I was expecting to flip them, just a lay up shot,' he told me.

"Now, all of his properties are under-secured, and cash- flow negative. One of his lenders is asking for copies of recent balance sheets and cash flow statements. They are sending out the appraisers to do new appraisals. Whoops. This guy is now in the process of cashing out a lifetime worth of whole life insurance policies to get the funds to stay afloat. Here is his summary:

'It seemed like a no-brainer. Florida real estate looked bulletproof. The Baby Boomers are going to retire, move to Florida and live in their condos overlooking the beach. You could get a bankable appraisal on buildings that had not even been constructed. Just buy, hold, sell and pocket the difference. Now I am taking a haircut down to my scalp. I am cashing out all of the whole life policies that I accumulated over my entire career. This was the kids' college money, if not my retirement nest egg. What in the hell was I ever thinking? My wife is furious, my kids don't know about this but they are going to hate me, and my dad is just shaking his head, like 'I thought I raised you better than that'. I am probably going to have to work until the day I die, and then my family will not have any life insurance on me. Man, did I ever screw myself.'

"Note the last line. At this point, he is blaming himself. Just wait. Eventually he, and others like him, will probably figure out that they have been victimized. We will all figure out some way to blame other people, and then sue the class-action crap out of them. Or bomb them back to the stone age."

*** And our old friend Francois told us another interesting story over dinner last night.

"My father-in-law was an executive for one of the big steel companies in France. This was back in the 1950s and '60s. Even then, there was talk of Asian competition. But I remember he told me that the steel industry had nothing to worry about because steel-making involved too much capital and too much technological expertise. The French steel-makers thought they were protected. They thought they had a permanent advantage.

"Well, he died several years ago but he must be turning over in his grave. Acelor Steel, the successor to the business he worked for and one of the prizes of French business, was just acquired by an Indian steel magnate, Lakshmi Mittal. He's also the richest man in Britain."

*** Francois had a look at our gypsy wagon:

"I guess you didn't have enough to do. You had to dream up a new project. Well, this should keep you busy."

We don't seem to have much success explaining to people why we are building a gypsy wagon. They find it odd; they wonder what the point is.

"Are you going to change your career? Hitch up a horse and become a vagabond?" they ask, laughing.

What is it for, they want to know.

"Nothing practical," we explain, lamely. "We just thought it would look nice out in the garden, like a piece of sculpture. Each summer, we will roll it out. It will sit there and occasionally, we will wander out and have tea in it. Or, maybe some young guests will want to sleep in it. Look, it even has a little gas stove, so we can heat up water for tea.

"Besides, it's been the perfect project for summer. The boys helped with it a lot. In fact, Henry and Jules did most of the work."

"Well, in that case, it was a good idea," conceded Francois. "You need to keep the boys working. Otherwise, who knows what they'll get up to, but I think it will be nice down by the pond, especially if you hire a gypsy to live in it, you know, like they used to do. In England, in the 19th century, they would build rustic cabins - or even grottos - in a grand garden, and they'd hire one of their farm-hands to live in them and dress in a costume. It made a delightful spectacle."

"Well, we can't afford to hire a gypsy full time - not at French labour rates. But Maria said she'd play the part anytime we wanted. You know she's had a lot of practice from when she played the lead in Carmen. Yes - that's the opera with the bull-fights. But luckily, we're not planning to stage one of those. At least, not yet."

Sep 4, 2006
-Bill Bonner
email: DR@dailyreckoning.com
website: The Daily Reckoning

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