Sunday, September 7, 2008

Newsweek: Get Ready for the Pain of Paying

This is an interesting opinion piece by Daniel Gross of Newsweek and part of the reason I decided to pull the plug on Mastercard (MA) Friday. As the U.S. "delevers" and the "credit contraction" spreads from Wall Street to Main Street it could have some serious implications (deflationary) on the country. We are seeing some hints of this from the surge in debit cards in the US versus credit cards (this was in reverse order for many years) Deflation was the scourge of the Great Depression ... it can be best explained by "why should I buy something now when I can get it cheaper later?" This especially applies to big ticket items - the obvious example is homes. But homes go up and down over time in a cycle. More disconcerting are automobiles. New cars usually do not go down in price. But we're starting to see signs of it.
  • New vehicle prices are falling at the fastest rate ever recorded, a team of analysts said Thursday, squeezing automakers' profit margins at a time of slumping sales but setting the stage for a sales rebound once the economy improves.
  • JPMorgan auto analyst Himanshu Patel and economic analyst Marc Levinson said in a research report that the average price of a new vehicle in the second quarter fell 2.3 percent from a year earlier to $25,632, citing government data. That's the steepest drop recorded in the bank's 41-year-old survey, the analysts said.
  • The analysts attributed the decline in average price to two factors. First, demand among consumers has shifted from trucks to less-expensive cars due to the run-up in gas prices, they said. Truck-based vehicles like pickups, minivans and SUVs accounted for less than half of all sales in the second quarter for the first time since 2001, they said.
  • Second, consumers are trading down within both the car and light truck categories to cheaper, more fuel-efficient models overall, they said.
  • The result is that the average new vehicle now costs less than 40 percent of an average household's median annual income, the analysts said, whereas from 1991 to 2007, it would cost more than half of the median income.
So the open question now, is this a cyclical situation which is relatively benign? (weak economy leads to temporary price decreases in big ticket items) or is this the next step of a deflationary crisis? Or is this just a shift in product mix from trucks/SUVs (more expensive) to cars? Too soon to tell but wanted to get this data in front of you. What will be of importance to me is consumer behavior as gasoline trails back towards $3. If this is just a temporary shift, then "bad behavior" will ensue again and SUVs/trucks will become favored again. If people are either scared "straight" or truly weakening economically - then I'd expect current trends of trading down to cheaper product to persist.

Frankly, deflation is the worst case scenario and something that I gave, in my sprinkling of potential outcomes a year ago, as something with a chance of happening but not a good chance. But til now we've had inflation in things we need (food/energy), and deflation in things we want. I am not sure where autos and homes fall in the continuum of things we need versus want but...

On to the opinion piece - again a lot of reading I am doing is the cutback in credit, both from banks and primary credit card companies. For example in credit card company, we're seeing companies cut back credit limits as consumers pay off debts. For example, instead of keeping a $10K credit limit for a customer who paid down their credit debt from $8K to $6K, the companies are immediately dropping the credit limit to $6500. In a country which has become dependent on credit and with a 0% savings rate, this could pose some major implications in the years ahead.
  • The most revolutionary notion in commerce today is one of the oldest. If you want to buy something, you may actually have to pay for it. We are quickly reverting from a borrow-and-buy model to the old school cash-and-carry model our grandparents and great grandparents knew. It may seem passing strange now, but paying hard currency for goods and services has been part of our consuming DNA pretty much from the beginning of time.
  • But widespread consumer credit is really a 20th-century phenomenon. It got started in the 1920s, when expensive consumer durables like cars and refrigerators were first produced in mass quantities. It wasn't until Bank of America began carpet-bombing California with credit-card applications in the 1960s that the debt wave started in earnest.
  • In the decades since, consumer credit became so pervasive that paying cash became passé. Want a new $32,530 Dodge Ram Crew pickup? Take a lease. Sick of your old house? Get a 100 percent mortgage and trade up. Face-lift? Round-the-world cruise? New PC? A $300 sushi dinner? Whip out that plastic. It was this behavior—the endless willingness of lenders to lend and borrowers to borrow—that kept the consumer economy humming uninterrupted from the early 1990s, straight through the brief recession of 2001, until the credit meltdown of 2007.
  • But many of those who extended credit recklessly are now acting like a single twentysomething who, after having a few bad affairs, takes a vow of celibacy. Students are returning to campus this fall to find that lenders have graduated. Retailers who freely extended credit to any customer with a pulse are deploying bean counters armed with sophisticated software to sniff out potential liabilities. When higher rates and fees don't deter their borrowers, credit-card companies resort to slashing credit lines. "We predicted there would be some degree of spillover from mortgage meltdown," says Curtis Arnold, founder of "But the credit line reductions by big credit-card companies in the last six months has been fairly unprecedented."
  • And make no mistake, deducting the price of a pair of shoes directly from your bank account packs a much more potent emotional punch than charging the pair of Allen- Edmonds loafers on your American Express platinum card. Chalk it up to a concept called "the pain of paying," says Dan Ariely, the author of Predictably Irrational.
  • The availability of credit also changes the calculus people make about what they can afford. Blowing $6,000 on a week in Tuscany might be tough to swing if you have to pay for it all next month. Convince yourself it's a once-in-a-lifetime experience that you can pay for over three years, and it becomes a bargain.
  • The tightening of credit is forcing more people to confront these uncomfortable choices. In the second quarter, credit giant Mastercard reported that the gross dollar volume (GDV) of credit charges processed in the U.S. rose just 0.7 percent from 2007, while the GDV of debit charges rose 15.8 percent.
  • The retailer Target said that in the second quarter, for the first time in memory, the percentage of sales charged to credit cards fell, while the proportion of purchases made with debit cards rose. That's partially by design, since the company has undertaken an "aggressive reduction of credit lines and significant tightening of all aspects of our underwriting." (Translation: No Credit for You!!) Target's same-store sales fell 0.4 percent in the second quarter.
  • Leverage is an appropriate synonym for credit because it allows you to lift more than you could with simply your own financial muscle. Take away the leverage, and the power spender becomes a 98-pound weakling.
  • In 2007, according to the National Association of Realtors, 45 percent of first-time home buyers put no money down, and the median first-time homebuyer financed a massive 98 percent of the purchase. (that means the median put down 2% - what happens if we return to an era where lenders demand if not 20%, maybe 10%? Who is out there with savings to afford such things?)
  • In effect, the lack of credit makes things seem more expensive to consumers, even if prices are holding steady.
Some more anecdotal stories that are building this case - banks (in this case National City - one of those very troubled regional banks) PAYING customers to close out their home equity lines of credit
  • National City, the US bank that has been among the hardest hit by the subprime crisis, is trying to reduce its exposure to the riskiest category of home loans by offering customers cash to close their untapped home equity lines.
  • If the scheme is successful, analysts say other banks could follow suit, choosing to spend money now to avoid taking on more exposure to the US housing slump.
  • Lenders such as National City have tightened their lending standards and reduced lending volumes sharply, but portfolio exposures could still grow as a result of so-called “open-ended” home equity lines that are committed but as yet undrawn. The bank’s initiative, which was launched at the end of July, encourages National City customers to surrender their unused home equity lines by waiving fees it would normally charge for closing the line and by writing customers a $200 cheque. The bank’s customers are normally charged up to $350 to close a home equity line.
  • Some banks, such as Bank of America, Wachovia and Chase, have frozen borrowers’ access to home equity lines or changed the terms to reduce their potential home equity exposure.
  • National City’s scheme in essence buys back the borrower’s right to access the line, and reduces the bank’s exposure to lending money against houses that have fallen in value.
So in effect, instead of assessing a punitive damage to close a line (i.e. an attitude of "we want you to use it") we are moving to a beneficial result to close the line (i.e. an attitude of "please don't use it") Note - I actually think this is a positive move (in the short term) for banks trying to survive, while a negative for those who expect "growth" from banks in the long run.

Interesting times. The question is on duration and magnitude of these changes. Are these economically sensitive short term maneuvers or sea changes that could carry us into the beginning of the next decade and cause a country wide retrenchment? These are the type of things I am mulling as we watch the retailers scream higher on "everything will be fine in 6 months, thank you" thinking.

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