Frank McNamara’s plastic invention – "the epitome of convenience and modern finance" – has slowly ensnared the U.S. consumer. What happens, asks Peter Bennett below, when consumers finally reach "the point of pain"?
Where would Americans be without their credit cards?
As hard as it is to imagine, there was a day not all that long ago when general use credit cards simply did not exist. Before 1950, to be exact.
It was in that year that Frank X. McNamara put his napkin down at a dinner in New York City, only to find to his mortal chagrin that he had no money to pay for his meal. Perhaps it was while an embarrassed McNamara sat waiting for his wife to arrive with cash to rescue him that he dreamed up what eventually became Diners Club…and the world stepped onto the slippery slope of easy money.
Today, of the $2 trillion in total U.S. consumer debt, McNamara’s creation gets credit for about $700 billion, or about $2,400 per every man, woman and child in America. According to CardWeb.com, the average American now carries a total of 7.6 cards, which further breaks down to 2.7 bank credit cards, 3.8 retail credit cards and 1.1 debit cards.
24% of all personal consumption is conveniently made via some combination of bank credit cards, retail cards and debit cards. In the getting-scary category, Visa happily reports that 43% of property rental companies now accept Visa credit and debit cards for rental payments.
Diners Club: Looking Backward
Play your cards right and you can rack up airline reward points to redeem for vacations where you can spend even more…using your cards, of course. The epitome of convenience and modern finance is McNamara’s invention.
Yet the credit card, for all its modernity, predates McNamara’s embarrassment by some 62 years: provenance belongs to Edward Bellamy’s 1888 sci-fi novel "Looking Backward" envisioned a world of the future where cash is replaced by "credit cards" that allow humankind to purchase "whatever he desires, whenever he desires it."
From the looks of things, Bellamy was remarkably farsighted. With one important exception: in Bellamy’s socialist-style utopia, you never had to pay anyone back for your purchases.
Unfortunately, unless you’re willing to go through the ignominy of bankruptcy, that is not the case in current society. As things turned out, credit card issuers very much want to get paid back, though are quite content should you decide to take your time doing so. Provided, of course, you pay them an interest rate on your balance that now averages more than 14.7%. These days, almost half of Americans pay only the minimum due each month on their credit card bills.
Oh, and don’t be late. Miss your due date by even a day and your interest rate instantly vaults over 20%.
How did the formerly virtuous, frugal, fiercely independent, neither-a-lender-nor-borrower-be American corrode into an overburdened debtor? Like human nature itself, the answer is complex and multi-faceted.
Diners Club: Bastardizing Marx
There are, however, a couple of clear culprits, starting with risk-based credit models that have facilitated easy credit to every strata of the American demographic. These models allow today’s banks and mono-line credit card companies to be remarkably adroit at matching the interest rates each consumer is offered to their individual level of default risk, a free market bastardization of Marx’s dictate "From each according to his ability, to each according to their need."
These models, and the underlying business practices, developed in no small part because of Wall Street’s harpish demands for consistent earnings growth and quarterly improvements in loan book size and profitability – demands that have triggered profound, structural changes in the lending markets. The fact is that there are a finite number of consumers in the U.S. to which lenders can offer credit. In order to increase their loan books and keep Wall Street happy, banks and other financial institutions were forced to reduce creditworthiness standards to the point where competitively priced consumer credit is now available to almost all elements of the population.
No matter how low your income, or high your existing debts, there is probably a company willing to offer you a credit card.
Of course, some companies get it wrong. In that category, a relatively recent poster child is the much-heralded and now bankrupt NextCard. Using an avalanche of Internet promotions, that ill-fated company became the darling of the industry by generating over one million credit card accounts in a period of just over 2 years. Unfortunately, their models had grossly underestimated the damage that fraudsters and serial debtors could wreak given loose Internet offers and looser back office procedures. All told, between losses to investors and to the FDIC, which had to take over NextCard, the company vaporized over $400 million.
Diners Club: Clifford Gets a Credit Card
It’s also worth pointing to the recent tale of Steve Borba’s dog, "Clifford," who received one of those ubiquitous pre-approved credit card offers. That a dog could be sent a pre-approved credit card offer is funny enough, but funnier still was that when Steve returned the application as a joke, the company went ahead and issued Clifford a credit card with a limit of $1,500. Every dog has its day and, it now appears, its credit card, too.
On the whole, however, modern credit card companies are properly motivated to get things right: offering credit and collecting interest can be a stunningly profitable enterprise. It is for that reason that the sum of all the credit card and finance companies and banks and department stores and countless other institutions involved in offering credit equals one of the largest industries in America, employing hundreds of thousands of employees and generating billions in revenues.
But the recent explosion in the sheer quantity of debt can be laid squarely at the downtrend in interest rates and the massive refinancing boom. People don’t pay nearly as much attention to the amount they owe as they do to the amount they spend on the amount they owe – otherwise known as the ratio between debt service and disposable income. According to the Bureau of Labor Statistics, this ratio is now at an all-time high of over 19%.
When an individual’s personal debt service ratio reaches the point of pain, and 19% of disposable income is on the line, he has two choices: Cut back on spending, or keep spending until the phone starts ringing at dinner with hard-sounding creditors on the other end.
Which brings us to the topic of charge-offs. Or, to paraphrase one of the old Beach Boys’ lyrics, "fun, fun, fun ’til your daddy takes your credit card away."
In recent years the number of individuals pulled underwater by the siren of easy credit has been growing steadily. Personal and business bankruptcies grew from 837,797 in fiscal year 1994 to 1,661,996 in fiscal year 2003 – a staggering 98% increase. Of the 2003 total, about 1,600,000 were personal bankruptcies, representing about 1.5% of the 104 million total households in America.
Another indication of the current state of things – in our opinion, maybe the best – are the data on late fees charged by credit card companies. These fees have risen from an already high $1.7 billion in 1996 to a positively painful $7.3 billion by 2002. With regulations limiting the amount of fees that can be charged, there is only one way to interpret those numbers: people who had previously built good, long-term credit histories are now also falling behind on payments, or stopping payments altogether. Currently, about 6% of credit card debt is ultimately charged off by card issuers as uncollectible – definitely not a magnetic swipe in the right direction.
When it comes to seeing into the economic future, the only thing that is predictable is its unpredictability. However, with debt service at 19% of disposable income, bankruptcies on the rise, and late fees on credit card bills reaching truly scary levels, we believe consumers are reaching the point of pain.
Over 70% of the economy is driven by consumer spending. Should consumers decide to cut back, the U.S. economy will not necessarily hit a brick wall…but it will clearly be in for a slowdown in GDP growth.
for The Daily Reckoning
February 17, 2004
P.S. As investors concerned with generating absolute (versus relative) portfolio returns, it is time to look for ways to profit from the mountain of debt, and its eventual unwinding. And unwind it will: despite their prolificacy of recent decades, most Americans hate being in debt and we are optimistic that most – certainly those who had previously established good credit – will eventually come to their senses and want to cut back and clean up. Unfortunately for our consumption-based economy, the stock and bond markets will almost certainly follow the GDP down.
What investments will do best as the mountain of consumer debt starts to erode? In addition to gold and similar wealth-preservation alternatives, which will benefit as global markets throw in the towel on the U.S. dollar due to the government’s own mountain of debt, we think that businesses that serve the tail end of the credit industry will do well. As consumers return to personal fiscal sanity, these businesses, operating on a model that calls for buying debt for pennies on the dollar, and then collecting nickels, dimes and quarters – helping clients clean up their credit records in the process – should have their day in the sun.
Editor’s Note: Peter Bennett is the Managing Director of Applied Income Sciences, LLC, a San Francisco-based investment management firm specializing in charged-off debt portfolios. He is the recipient of several Best Performing Fund manager awards in various categories from Standard & Poor’s Micropal as well as Lipper.
Here on the Pacific Coast of Latin America at 6am, the appropriate response might be, "who cares?"
Here, it is the works of nature that impress us…not those of her most conceited creation.
Last night, we looked up and saw more stars than we thought existed. There were so many…so bright…where did they all come from, we wondered?
But this morning, we put our head back down…and wonder what the brightest star in the economic firmament – our own Mr. Alan Greenspan – must have been thinking. He spoke to Congress and told the assembled that consumer debt was nothing to worry about. Yes, Americans had borrowed a lot of money, he explained, but they had used it wisely.
What they actually did with the money is a bit of a mystery. All that we know for sure is that they did not put it in savings accounts and have not, as yet, paid it back.
Aside from a few old fogeys, almost all Americans assume that they will never have to pay it back. They are counting on inflation to wipe out the principal faster than their monthly payments pay it down. And they’re betting that their financial assets will rise in price so quickly, they will never have to settle up on their financing.
Eventually, they will be wrong. Maybe now.
American borrowers have reached ‘The Point of No Return,’ thinks Richard Benson. They’ve borrowed so much, they could not pay it back even if they wanted to.
"Last year, personal income increased about 2%. Individual debt increased about 10%," he writes. "Personal debt for autos, credit cards, etc., topped $2 trillion – up about $120 billion despite massive debt consolidation and mortgage refinancing. Mortgage debt rose about $800 billion, and total individual debt rose over $925 billion, while wages and salaries rose only $190 billion. Retirees and savers saw their interest income shrink, as interest paid on savings dropped by $30 billion. Indeed, given the Fed’s low interest rate policies, it doesn’t pay to save.
"In December, the savings rate dropped to a new low of 1.5% and in the 3rd quarter of 2003, the only reason financial assets were acquired is because they were bought with borrowed money. The low savings rate is even more astounding when you consider the increase in disposable personal income of around $200 Billion from the tax cut. The economy needs $500 billion in government stimulus from tax cuts and increased spending just to keep employment from falling and to help consumers roll over their credit cards for another month."
Benson points out that the savings rate – as low as it is – is nevertheless overstated. The official number includes a fraud…reasoning that when your house goes up in price, you have received ‘imputed income’ from it. If only you use it to repay real debts! Alas, that will take real income…from cash flow.
We return to this sorry subject, below…but first…a news update from our correspondent in New York…
Eric Fry in the City of Dreams…
– The U.S. stock market hung out the "CLOSED" sign yesterday, denying millions of investors the opportunity to add to their holdings of overvalued American stocks. So optimistic has the lumpeninvestoriat become that it buys stocks every time the market dips…And if the market doesn’t dip, the lumps buy stocks anyway. Why do the lumps do what they do? Do they even know? Is stock-buying just another bad habit, like eating two desserts?
– Your New York editor’s 5-year old used to wander around the house sometimes, singing a nonsensical song: "We have to work, because we have to work. That’s why we work…Hi work!" None of us could figure out how he happened to create these lyrics, nor why he sang the song.
– Last week, your editor recalled his son’s bizarre little ditty, as he watched the stock market march to new highs. He imagined millions of investors singing to themselves, "We have to buy stocks, because we have to buy stocks. That’s why we buy stocks…Hi stocks!"
– No one knows exactly why the lumps buy, but no one would deny that they do. Goaded into action by Alan Greenspan, Wall Street strategists, and a vague sense that buying stocks is prudent, no matter the price, the lumps buy and buy and buy…until, eventually, something bubble-like appears.
– Something bubble-like seems to be appearing in Lower Manhattan, in the vicinity of Wall Street. And something bubble-like is hanging in the air over Shanghai. A kind of Sino-bubble is in progress – the sort of bubble that features red-hot IPOs and rampant speculation.
– Is Greenspan to blame (or to credit) for both bubbles? Both the long-running American one and the Sino-bubble? The thought has crossed our mind.
– "The Fed’s commitment to keeping interest rates low for a considerable period of time fueled speculation in high-risk assets," says Andy Xie, Hong Kong-based chief economist at Morgan Stanley Asia Ltd. "The byproducts of this speculation," Xie explains, "are the wealth effect on consumption in the U.S. and the cheap capital-fueled investment boom in China – the twin engines or bubbles, depending on your perspective, for the global economy today.
– "History [will] not be kind to the Fed," Xie says. "Its accommodation and even encouragement of speculative excesses [will] be viewed as the primary cause of the massive bubble in the global economy today, the consequences of which are yet to show."
– "What happens when two bubbles collide?" the Asia Times wonders. "Do they both burst, or do they coalesce and become an even bigger bubble – which will eventually burst even more spectacularly?" That is the question posed by the growth figures from both the U.S. and China, whose growth rates are tied in ways that neither seems to want to admit too loudly.
– "The same money managers who poured funds into AOL, MCI, Enron and Tyco – all with problems, to say the least – are now pouring millions into Chinese IPOs with the same enthusiasm. It is difficult to see any more economic rationale in the 1,600-times oversubscribed China Green Holdings than the Internet Bubble of the last decade.
– "But along with this week’s figures on economic growth came another ominous big number. From once being nearly self-sufficient in oil, China is now the second biggest oil importer in the world – and is on the verge of needing massive coal imports as well. The China Bubble has expanded to a point where it will soon reach the sharp edges of infrastructural capacity and reckless over-investment to the point of over-production. That is when bubbles burst."
"China is touted everywhere as the investment destination of the century," Karim Rahemtulla remarked in this space last week. "Don’t believe it. My experience tells me that the only people who can really make money in China are the Chinese…"
– Note to Mr. Market and his Chinese counterparts: Avoid sharp objects.
[Ed note: "Something bubble-like" is indeed hanging over China and the U.S. stock market…but as investment director for The Supper Club, an exclusive venture capital group, Karim Rahemtulla has uncovered several investment opportunities still well worth looking into.
And now, back to Bill Bonner in Nicaragua…and Americans’ debt…
*** "What is perfectly clear from simple arithmetic," Benson concludes, "is that without a sudden increase in the number of jobs and the wages they pay, individual debt can not be serviced by personal income….Income and job growth are so low that we have certainly passed ‘The Point of No Return.’"
[What happens when we pass ‘The Point of No Return’? Paul Bennett searches for an answer in today’s DR guest essay, below…]
Benson notes that the Fed’s low rates and tax cuts can create a spending boom – putting Americans further in debt. But they cannot create a hiring boom. When Americans spend money, the hiring is done in China, not in the U.S.. No hiring boom…no growth in wages…no way to pay back debt.
"So, where are Americans and their mountain of debt headed?" Benson asks. "If the days of borrowing more – courtesy of both the Federal Reserve and Asia’s central banks – are winding down later this year when Asia revalues its currency, it looks like there will only be two ways out: increased inflation and debt default. Both are likely.
"When those Chinese goods at Wal-Mart go up 30% in price, Americans will see inflation. The Fed will accommodate most of the inflation, but there will be a rise in interest rates. Inflation, if allowed and encouraged, will save the wage earner so he can continue to service his consumer debts. Rising interest rates will smash into housing prices like a tornado in Kansas. Homeowners who have a 30-year fixed rate mortgage will come out in the end, if they don’t have to sell their home for at least 10 years. Anyone who wants to sell their home will see some ‘asset deflation,’ and financial institutions will experience substantial ‘debt default.’ The Federal Reserve will ‘print money like crazy’ to fight asset deflation and encourage inflation. Sometime before or after the Presidential election, the financial markets will be interesting, but painful to many."
A modest prediction from your modest editor: sometime between now and the crack of doom, Americans will turn their heads towards the stars…and wonder what they were thinking.