The Federal Reserve's Other Consumer Debt Problem?

About three-quarters of the consumer debt in America is mortgage debt. If you have a pulse, you know that there has been a crisis in the mortgage markets, as subprime mortgage defaults have proven much worse than many expected and caused investors to pull back from buying mortgages. That, in turn, has made the mortgage market less liquid. Credit standards have tightened and it's harder for a lot of borrowers to get home loans. Low interest rate mortgages are available only for those that have sterling credit ratings and a 20% downpayment.

The other 25% of consumer debt includes credit cards, department store cards, auto loans and the like. Much of this debt has also been sold by the banks and other creditors that originated it, and packaged by investment banks into CDOs, commercial paper and other asset-backed securities. As the credit crunch in the financial markets has spread, investors have backed away from these securities as well.

One reason why many CDOs have not received cash bids when put up for auction is that they consist of a mixed bag of indebtedness. Mortgages, credit card balances, car loans, and corporate loans have sometimes been thrown together into a Mulligan stew of indebtedness. A trader asked for a cash bid on these instruments has to separately analyze each type of debt in order to come up with a valuation. In today's markets, where 20 seconds is an eternity, potential buyers can't feasibly separate all these disparate strands of debt and then figure out what they are worth. Maybe there was a diversification angle to mix and matching all these different obligations. But, in a credit crunch, they become a witch's brew of toads, frogs, snakes, newts, worms and nightshade that all fear to touch.

As investors step back from non-mortgage debt, banks and other debt originators will find themselves holding the bag . . . uh, we mean risk. That will reduce their enthusiasm for lending to the least creditworthy, and perhaps raise costs for the more creditworthy. While the pullback in non-mortgage debt is likely to be less extreme than, say, the Republican flight from Senator Larry Craig, cutbacks in non-mortgage credit are inevitable when the flow of investors dollars slows.

The ongoing financial crunch is often described in market jargon: it's a repricing of risk, a flight to quality, a loss of liquidity. The use of technocratic terminology sometimes hints at a reluctance to state the obvious. Perhaps we should take a look at the underlying dynamics.

The speech Chairman Bernanke gave on Friday (August 31, 2007) was widely interpreted to mean that the Fed will cut its target for the fed funds rate on September 18, 20o7, and probably at least one more time this fall. Perhaps so. Perhaps not. The amount of pain from the subprime mess is still largely unquantified (at least publicly), but is loudly proclaimed with liberal use of adjectives. It could be pretty bad. On the other hand, the losses, however large, may be mostly confined to wealthy hedge fund investors and financial institutions that will be bailed out by central banks. The economy evidently grew briskly in the 2nd quarter of this year, and inflation continues to be an itch the Fed seems to want to scratch. One strong hurricane that turns north, instead of going west into central Mexico, and inflation could look ugly again. But, as they say, we'll see.

Chairman Bernanke's speech also contained a discussion of the history of credit for home purchases that's worth a look. (Here's a link to the speech. http://www.federalreserve.gov/boarddocs/speeches/2007/20070831/default.htm.) Some 80 or 90 years ago, mortgages were short term (ten years or less) and required 50% downpayments. If those standards were applied today, the qualified borrowers couldn't field a basketball team. Then, with coming of the Depression in the 1930s, mortgage terms were made more liberal. After the Allied victory in WWII, a grateful nation made, among other things, the 30-year mortgage readily available to the returning GIs, and Father-Knows-Best communities sprang up throughout suburbia.

Non-mortgage consumer debt also became more easily obtainable. While store credit was a longstanding feature of agrarian society where farmers could only pay when they harvested their crops and brought livestock into feed stations, the proliferation of credit cards came of age with the television. Minimum payment requirements for the cards have been dropping for decades. Some are now so low that you almost don't have to repay the debt.

Car loans evolved similarly. Thirty years ago, the standard term of a car loan was three years. Today, it's more like six years. As we have discussed before, (http://blogger.uncleleosden.com/2007/05/true-price-of-affordable-loans.html), easy credit terms aren't necessarily good credit terms. In fact, they're often bad credit terms, because you ultimately pay more interest for the loan than you would with a shorter term loan. You have a finite amount of income (everyone does, no matter how much you make). The more of your finite lifetime income you spend on interest, the less money you'll have for personal consumption.

Consumer debt appears to enhance our lifestyles, because we don't have to save in order to buy things. We buy them now and pay later. That enhancement, however, is an illusion. Consumer credit frontloads consumption. You can consume now. But credit doesn't increase your lifetime income. If you consume now, you have to devote some of your future income to interest payments. That reduces your future consumption. The more you consume today on credit, the less you'll consume later in life. It's a zero-sum game because you will make only so much money during your life and no more. Credit simply changes the timing of your consumption, and it reduces the amount you have to spend, because some of your money will go to enriching banks. People who pay cash end up with more wealth and can afford more lifestyle. (Paying cash also makes you a smarter consumer because you weigh your nickels and dimes more carefully.) The timing of a cash-payer's consumption is different, but it beats eating dog food in your old age.

However, lest we sound like we've read too much Cotton Mather, let's return to macroeconomics. The securitization of debt--including mortgage and non-mortgage debt--brought a lot of investor money into the credit markets, and made easy credit much easier. As credit terms eased, more consumption was frontloaded. And the more that consumption was frontloaded, the more easy--and easier--credit was needed to continue the trend of rosy economic growth. For a while, the credit markets responded with adjustable rate mortgages, interest only mortgages, teaser rates, home equity loans, and credit cards with low introductory rates, low balance transfer rates, rebates, points and Lilliputian minimum monthly payments. In turn, the economy kept growing, all the while robbing the future of more consumption.

This is the other consumer debt problem confronting the Fed. Consumption is 70% of the U.S. economy. With the subprime goblin scaring investors away from all asset-backed securities, consumer credit will be less able to play its historic role of frontloading consumption and boosting economic growth. There is no ready replacement. People can't easily turn from credit-based consumption to cash-based consumption. Such a transition, although possible, takes a major adjustment (called "saving") and a lot of time. But household savings have been going more negative than campaigning politicians. And household income and wages have risen like a failed souffle.

A fed funds rate cut will probably have little impact on credit card interest rates. Credit cards are cash cows for banks, and people who carry a balance from month-to-month are more dependent on their credit cards than the United States is dependent on gasoline-driven automobiles. These people would have great difficulty walking away from credit cards no matter how high rates become. Credit card rates were high and higher during the early 2000s, when the fed funds rates was 1%. There's no reason to think that the Fed lowering fed funds from 5.25% to 5% or 4.75% will reduce credit card rates one whit.

There's nothing the Fed can feasibly do to maintain the frontloading of consumption, and it would probably do more damage than good if it tried. Perhaps a change of the nation's economic focus would be in order. Maybe the Fed should try to stimulate growth by promoting conditions that favor investment. An environment where inflation is kept under control, the financial markets function reasonably well, the dollar maintains relatively predictable value and a pool of savings is built to provide home-based capital (i.e., less susceptible to capital flight) would encourage greater business investment. America is not made wealthier by corporate spending devoted to share buybacks. America is made wealthier by the manufacture of superb commercial aircraft (our largest export), entertainment (yes, Hollywood is our second largest export, even though one might not have suspected that foreigners would have tastes as lowbrow as ours), and sophisticated computer hardware and software.

The credit-based consumption-frontloading model for our economy exists only at the sufferance of our creditors--and they're suffering so much now they've been rethinking things. The fastest-growing economies in the world today are those that favor investment and production. We may be forced by the pullback from the securitization of assets to reduce our dependency on credit-based consumption. That's a market trend that the Fed shouldn't fight. Ultimately, no one--not even the Fed--can successfully fight the market. (Whenever it's tried, it's caused price or asset inflation and misallocated resources.) We can't borrow and spend our way to economic health. Without the narcotic effects of easy credit, we'll be in for some pain. But that's preferable to more narcotics. Britain borrowed a lot to win World War II. The United States manufactured a lot to win World War II. Who was better off in the end?

Animal News: Chupacabra sighting. http://www.wtop.com/?nid=456&sid=1236802.