Tapping Equity

I never would have pictured Alan Greenspan with a 0%- financed-Ford Explorer in the front yard and a home-equity- loan-funded-Jacuzzi in the back. But he sure sounds like the typical American consumer. After all, in his February testimony to Congress, the Fed Chairman told us to forget about the loan balance; it was the monthly payment that mattered. The finance man at the dealership couldn’t have said it better himself.

Here are the facts: by the Fed’s measure of mortgage and consumer credit, household debt-to-income has reached a record high. Typically, consumers pare down debt in an economic slowdown. In 1991, for example, Americans cut non- mortgage debt by $11 billion. But last year, consumer installment borrowing increased a whopping $110 billion. With three quarters of data in, consumers are on a pace to have borrowed $70 billion in 2002.

In his February testimony, Chairman Greenspan admitted that consumer debt relative to income was high. However, he chose to focus on the cost of servicing that debt, noting that debt service costs as a percent of income “do not appear to be a significant cause for concern at this time.”

Borrowing Against Equity: Skyrocketing Bankruptcies Are a Swell thing

We would not be concerned either, if we thought the skyrocketing bankruptcies of the late 1980s were a swell thing. But the ’80s were hardly a frugal period. By the Fed’s own measure, the consumer’s debt-servicing burden is bumping against records set in the mid-to-late 1980s. That’s despite ultra-low interest rates and five mortgage refinance booms in eight years.

Certainly, lower interest rates have enabled consumers to maintain higher debt burdens. But the consumer has also extended maturities. This combination has allowed the consumer debt-service burden to “only” reach levels of the late ’80s without surpassing them.

In our view, the consumer’s debt situation will crimp spending even under a “best-case scenario” – an environment with no crash in home prices and no spike in interest rates. Why? Consumers are stretched.

At least, that’s what a loan officer would infer, given the consumer’s willingness to take out six-year car loans. According to Dealer Magazine, six-year car loans account for 21% of new car and truck financing.

A closer look at the variables behind new car loans illustrates how monthly payments stayed down while borrowing skyrocketed: according to the Fed’s numbers, auto finance companies now loan an average 96.71% of the cost of a new car. The average maturity is now 57.51 months. That compares to 91% and 51.3 months in 1985. Thanks to lower interest rates, the monthly payments work out to be slightly lower on the average loan today. But because the amount financed has jumped to $26,647 from $9,965, the average car loan as a percent of per capita income has jumped from 77% to 96%. The result is a higher debt burden without higher monthly payments.

Borrowing Against Equity: Loans in Excess of Value

As you might expect, with more consumers opting for longer maturities, more are “upside down” on their trade-in. A car dealer in the Dallas area estimated that 75% of his applicants for new car loans are upside down. So far, the financial engineers are keeping consumers in the game by making loans in excess of the value of their new car!

But unless lenders start giving away principal, consumers eventually will be forced either to trade cars less or cut back elsewhere.

Home equity loans, mortgage refinancing and equity lines of credit have made it easy for consumers to swap home equity for cash. According to a study by CIBC World Markets, home equity withdrawals accounted for almost one-third of the increase in consumer spending last year. Although real estate bulls argue that rising home prices will continue to bail out borrowers (by giving them more and more to borrow against), we would argue that even real estate prices can’t go up forever. Again, according to CIBC World Markets, home prices rose 32% in real terms since 1995. That’s about twice the gain in prior housing booms. Past performance may not be an indicator of future results.

For an idea of how enthusiastically homeowners have chosen cash over equity, consider that home equity as a percent of market value stayed in the 65-70% range from the mid-1960s to the mid-1980s. That ratio is closer to 56% today. How low can it go?

Borrowing againat Equity: Fewer New Kitchens

Even if interest rates stay low and home prices stay flat, new rules from Fannie Mae and Freddie Mac could cut down on the number of cash-out financings. Borrowers could soon be paying an extra one-eighth of a percent for the privilege of taking cash out in a refinancing. Fewer cash-out refinancings means fewer new decks, new cars, and new kitchens.

From October 2001 through year-end, consumers have driven the savings rate up from 0.3% to 4.1% of disposable income. During this period, consumer spending as measured by real personal expenditures has advanced at a below-average rate. This was also the case in the last two periods of rising savings rates. If this newfound frugality continues as we expect, we would also expect below-average spending to continue for some time.

Despite last year’s refinance boom, personal bankruptcy filings hit a record last year, up 6% from 2001. The American Bankruptcy Institute expects a repeat performance in 2003. So far, they are on the mark. Weekly bankruptcy filings jumped to 32,223, up 9% for the week ending Feb. 7. That’s the highest level since early November.

While bankruptcies are rising, spending is already slowing. Retail sales rose just 3.4% last year, the smallest gain since 1993. And consumer borrowing is dropping. Consumer credit outstanding fell in December on the heels of a decline in November that was the first since January 1998. For all of last year, non-mortgage consumer credit grew just over 3.2% ($55 billion), less than the increase in income. But because mortgage growth continues to surge, we can’t really make the case that consumers have stopped borrowing. We can venture, however, that the refinance boom won’t last forever, and that mortgage purchases will wane. Already, the number of mortgage purchase applications appears to have peaked and is rolling over.

The ability of consumers to service their debt as “easily” as they did in the mid-’80s is hardly a bullish prospect. Going forward, it’s difficult to see how the construction, remodeling, and auto industries can reproduce the results of the last few years.

Typically, these areas are engines of growth in a recovery, but they are quickly running out of gas. Given that last year’s weak performance was fueled by a refinance boom, we wonder what consumer spending will look like without such a boost. In our view, it is just such a level of post-bubble spending that truly will be “cause for concern”.

Warm regards,

David Tice,
for The Daily Reckoning
March 20, 2003


The bombs have begun falling over Baghdad and the whole world holds its breath.

Will the war be short and sweet, as people believe? Reports from Iraq tell of surprisingly little preparation for war. Did they not believe it? Did they not care? The Iraqis went about their business like a man whose wife was sitting down with lawyers to write up the divorce papers. A new stage of their national life is coming, they must think to themselves…but not necessarily a worse one.

Who knows, maybe the fix is in. Maybe the Iraqi leadership has decided to take a dive early in the fight. Maybe they’ve made a secret deal with the CIA and loaded up on call options and dollar futures. We don’t know. Anything could happen.

Investors pushed stocks up yesterday in a pre-war rally; they think the conflict will be followed by a boom, as was the last war with Iraq. Will it? We don’t know. Anything could happen.

But some things are more likely than others. The U.S. military has such an overwhelming, butt-kicking superiority advantage…and such a good idea of what to expect from the one-legged Iraqi forces…it is unlikely that they will not be able to flatten their adversaries easily. The question marks pop up later. What will happen after the war is over? Will the world be a safer place…or a more dangerous one? What will the U.S. do with Iraq once it is conquered? How much will the war cost? Where will the money come from? How will U.S. markets…and the U.S. economy react? We don’t know. And neither does anyone else.

All we know, and even we are getting tired of hearing us say so, is that stocks are still very expensive. Most likely, they’re going to get less expensive. But a post-war rally could drive them up long enough and far enough to make people forget the major trend.

We also know that history is not made by individuals going about their business, making reasonable decisions on the basis of what they actually know. It’s made by groups of people caught up in absurd episodes of madness, which are rarely evident to those in the middle of them. A tech-stock buyer in ’99 could no more see he was acting madly than a piece of pork fat can see it is part of a sausage. But both are devoured in subsequent events.

After the fall of the Berlin Wall and the end of the ‘Cold War’, Francis Fukuyama worried that history might have come to an end. But here we are, only a dozen years later, and not only is history back in business, but her stock is rising. America is making history with the most ambitious foreign policy program since the end of WWII (The war against Iraq alone is estimated to cost somewhere between $27 billion and $1.92 trillion!!). She is also making history with the most fantastic program of debt financing ever…with public deficits “as far as the eye can see”, record house refinancings, and record current account deficits.

Never before has so much paper money been taken up by so many people with so few doubts about it. And never before has a nation that owed so much to so many been able to go so long without settling up.

We don’t know where any of this leads…but we continue to give you our annoying thoughts…below…



Eric Fry in New York…

– U.S. troops have their toes to the Iraqi border like homesteaders waiting to jump the Oklahoma line, moments before the Cherokee Strip Land Run of 1893. And whenever George W. fires off the starter’s pistol, U.S. forces will charge across the “prairies” of Iraq to claim their prize.

– Investors are giddy with anticipation. If the Pre- invasion Rally can add 700 points to the Dow Jones Industrial Average, just imagine what the Invasion Rally will do! The lumpeninvestoriat have so thoroughly convinced themselves that war is bullish – and that the one-sided war they anticipate is particularly bullish – that they continue bidding up share prices. Yesterday, the Dow gained 71 points to 8,265, while the Nasdaq slipped 3 points to 1,397. The greenback, which is also enjoying a brisk pre- invasion rally, gained ground for the sixth straight session and now stands at $1.0560 per euro.

– Meanwhile, investors cannot seem to imagine any reason whatsoever to buy oil. Crude futures dropped $1.79 to $29.88 a barrel – the lowest close for oil since early January. For a while there, we thought the gooey, black stuff might be in short supply. But soon we will control Iraq, and that place has got plenty of oil to keep our SUVs flying down the road. Besides, it’s so much more environmentally friendly – for us – to yank oil out of the Iraqi dessert than to drill it out of the pristine Alaskan wilderness. Perhaps it is no coincidence that the US Senate voted yesterday to reject oil drilling in the Alaska wildlife refuge.

– But even if Iraq and all of its oil were to become the 51st state, our economic difficulties would continue to mount. That’s because America, “land of the free and home of the brave”, has become the “land of underfunded pension plans and home of soaring government deficits”. The net effect of these two trends is to impede capitalism and encourage a de-facto socialism.

– One consequence of America’s three-year bear market is a soaring national pension liability – both in the private sector and in the public sector. Because of this increasing liability, we must devote an ever-growing share of corporate cash flows to pay pensioners rather than reward workers and investors (shareholders). That’s not a healthy combination. Nothing against pensioners; it’s just that this “closet socialism” discourages investment and hinders productivity. We doubt that this trend is bullish for stocks. All else being equal, large pension obligations cut into corporate profits and drain cash flow away from productive endeavors.

– “We’re talking to companies about cutting capital expenditures and hiring in order to have sufficient cash to fund pension deficits,” says Kevin Wagner, retirement practice director for Watson Wyatt Worldwide, a pension consulting firm. “These cuts will cause a definite ding in the U.S. economy.” And it’s a fair bet that owners of certain high-profile American stocks will feel like ding- dongs for ignoring these massive pension liabilities.

– Meanwhile, government borrowing is soaring. The two trends may not be unrelated. “Four states are considering the unusual step of borrowing money to meet their obligations to future retirees,” the Mobile Register reported recently. “Among the worst off is Illinois, where Gov. Rod Blagojevich wants to float a $10 billion bond issue to help cover a massive pension shortfall. More than half of state pension systems are underfunded, according to a study by Wilshire Associates Inc. The study also pointed out that in Nevada, West Virginia, Oklahoma and Oregon, the dollar amount of long-term pension liabilities exceeded the entire state budget.”

– In a healthy economy, private companies and private citizens do most of the borrowing and investing, while the government feeds itself like a tickbird in the mouth of a rhinoceros. In a sickly economy, the government is the rhino. “The state and local government sector’s 11.4% increase in debt [last year] was the first double-digit growth since 1987,” observes the Prudent Bear’s Doug Noland. “At the same time, last year’s 1.3% expansion in Corporate borrowings was the weakest performance since 1992.”

– These are not healthy trends.

– [Editor’s note: Working in tandem with Apogee Research, Eric Fry has conducted some groundbreaking research into the pension crisis, subsequently picked up by Barron’s and Washington Insight. For ideas on protecting your own retirement, why not check out Apogee yourself? Click here:Apogee Research]


Back in Paris…

*** “Your editors at The Daily Reckoning, observers of the Old School,” began James Davidson’s essay, which appeared in this space the day before yesterday, “think the prospects of economic expansion are negligible because of heavy debt and a moral requirement that investors be punished for the ‘excess returns’ of the 1990s by a ‘regression towards the mean’.

“In other words, they think it is impossible for the returns on investment to increase substantially over time. In effect, they posit a kind of ‘steady state’ of economic potential, as if some law of physics with the potency of gravity ordained that profits wear lead boots. But I know of no such law of physics. To the contrary. The possible rate of return on investment is clearly variable. It is a function of the rate of economic growth…”

We do not usually comment on the other opinions in the Daily Reckoning. But this one seemed to crack a dam in our thinking…we found ourselves flooded with thoughts.

Paul Krugman, writing in the New York Times, made a similar attack on the Daily Reckoning – even before it came into existence. In the early ’90s, he ridiculed what he called the ‘hangover’ school of economics…the Old School in which economists believed investors really were punished for their mistakes.

Of course, we have no idea what rate of return investors might get. But by the late ’90s, it became obvious to us that they weren’t getting it. Investors were paying high prices for companies that not only were not producing extraordinarily high profits, but were actually not producing profits at all. They weren’t producing profits because the source of their supposed profitability – information technology – was a sham.

Information doesn’t make people rich. In fact, it is worthless…or worse than worthless…outside of the refined, nuanced and evolved system that gives it value.

Information’s value depends upon what is done with it. And that depends not on digits, but on wisdom, rules, and principles. These things take more than information to produce. They take time and experience. What makes them valuable is that they are the lessons of many generations…many years spent in the Old School…through bull markets and bear markets…and many passes through the sausage grinder of history.

What do the Old School rules tell us? They tell us to buy low/sell high, for example. If the tech stocks of the bubble years really had been able to produce higher rates of profit, we would have been delighted. But it still wouldn’t have made sense to pay more for them than they were worth – 8 to 15 times real earnings. Those who made more were punished. As Emerson put it, ‘all the world is moral’ after all.

*** “What really gets the public,” says Old School crank capitalist, Warren Buffett, “are CEOs that get very rich and stay very rich [while shareholders] get very poor.” But there are few real capitalists like Buffett left. In our modern consumer capitalist system, the lumpeninvestoriat may be annoyed by corporate parasites, but what can it do about them? Like lumpenvoters, the small investors take their lumps and say ‘thank you’.

*** People were not particularly unhappy under the Roman Empire…nor the Ottoman Empire…nor the Austro-Hungarian Empire…nor the British Empire. In almost every case, they were wealthier and healthier than they were under the regimes that followed. Empires tends to be civilized and peaceful. Arguably, independent states with populist leanings, by contrast, tend to raise taxes and fight with one another.

For the benefit of new readers, here at the Daily Reckoning, we see nothing wrong with empire. We neither support it nor oppose it. We merely wonder how we will afford it…and write about it to prepare you for the next stage in world history. Whether it wants to or not, we think America is headed towards an imperial role. Will it be a good thing? A bad thing? Will it be a new form of empire all together, maybe a sort of Empire Lite? We cannot say. But we aim to enjoy it.

The Daily Reckoning