Where's the Consumer Money Coming From?

In this article Justice Litle provides some insight on how consumers are actually getting money to spend.  This spending has been propping up sales figures for the past several months and with unemployment numbers not getting any better, how can this be happening?  The answer:  Strategic Defaults.  Read on for some interesting commentary.


A4 Driver

Taipan Daily: Did the Housing Bust Fuel the Consumer Spending Binge?
by Justice Litle, Editorial Director, Taipan Publishing Group

Today I had planned to write to you about how to protect against currency collapse. That's still a worthy topic, and one that will be delivered on shortly.

But something else grabbed hold of my brain between here and there, so much so that I simply HAD to get the thoughts down.

It has to do with a question that had been driving me nuts... a question regarding the U.S. consumer.

But let me back up for a second. Have you ever puzzled over a result or an outcome that seemed bizarrely out of whack? Maybe a set of numbers that simply didn't add up, no matter how many times you ran through them... with no clear explanation as to why... making you want to scratch your head and say, "What in the world - that just can't be right."

It's not about uncertainty or unexpected result. That kind of thing is a common feature of markets and shows up all the time.

No, it's more about a result that seems, well, off somehow... in violation of the laws of physics, let alone basic logic.

As Morpheus said to Neo in the Matrix: "You don't know what it is, but it's there, like a splinter in your mind, driving you mad."

A Mysterious Strength

For a little while now, the "splinter in my mind" had been the mysterious strength of the U.S. consumer.

Part of the reason retail stocks saw such a mind-blowing, epic rise in the early months of 2010 is because the strength and vitality of the U.S. consumer was almost wholly unexpected.

Based on the earnings reports of various consumer retail companies, not even the optimists could have expected such a full-blown "re-opening of the wallet" like the one we just witnessed.

The bulls, of course, saw no need to look a gift horse in the mouth. "Hooray! The consumer is back!," they chirped, without bothering to ask how this result was even possible.

Your humble editor, on the other hand, could not get past the "how" of the whole business - as in "How the %@#%?" Remember all that's happened up til now:

• An epic housing bubble and bust
• Widespread pain and foreclosure threat
• Bankruptcies surging
• Roughly 1 homeowner out of 4 in trouble
• 20% combined unemployment and underemployment
• Small business in turmoil, big business in deep cost-cutting mode
• Lines of personal credit getting slashed (or yanked completely)
• Savings rates trudging along near zero

Against all that, the consumer simply "bounces back" like a superball? Again, how? It is not a question of doubting the data points, but finding the missing puzzle piece.

It's not a function of rising employment, we know that much. "As of February," the WSJ recently reported, "6.1 million Americans had been out of work for 27 weeks or more."

Nor is it a function of rising income, nor an improvement in the housing market. "The supply of foreclosed homes that banks need to sell is rising again," the WSJ intoned some weeks ago, "signaling further downward pressure on home prices in some parts of the U.S."

So what gives?

The Thelma & Louise Theory

Last month, your editor shared his "Thelma & Louise" theory with Macro Trader subscribers. It went like this:

"Thelma & Louise" is thought of as a 1980s movie, but it actually came out in 1991. It stars Susan Sarandon and Geena Davis as two suburban women - an Arkansas waitress and a housewife - who go on a wild road trip after fleeing from a crime. The movie's tagline: "Somebody said get a life... so they did."

At the end of the movie, Thelma and Louise have to decide whether or not to turn themselves in. They look at each other in the front seat of their convertible Thunderbird as an army of police cruisers closes in on them.

Rather than surrendering to the police, Thelma and Louise make a suicide pact. They decide to "go all the way"... and drive the Thunderbird over the edge of a cliff.

The "Thelma & Louise" theory argues that this is what the U.S. consumer is doing: If it's all hopeless anyway, why not "go all the way" and drive over a financial cliff. "Shop til you drop," long an American art form, is being turned into a literal plan.

A psychology of relentless optimism, bordering on delusion, acts as partial explanation. But a nagging question still remained. Where did the money come from?

Or, in keeping with the analogy, how did Thelma & Louise (aka U.S. consumers) actually fund their road trip? From whence came the cash?

Voila - Strategic Defaults

The answer, surprisingly enough, may have to do with "strategic defaults" - a new phenomena rising up from the smoking rubble of the housing bust.

I am indebted to a post on the financial blog Credit Writedowns for helping me solve this puzzle. The post, titled Three potential explanations for the continued fall in US savings rate, included this response to the author:

The recent boost to retail sales could have come from a surge in Strategic Defaults. A recent article by [a Seeking Alpha contributor] documented that for every foreclosed house on the market another 5-6 houses are in strategic default.

Assuming their mortgage was the single largest expense in their budget, they suddenly have a lot more spendable money. That additional spending money could account for both the recent drop in credit card delinquencies as well as a recent uptick in retail sales.

All of a sudden, the picture becomes much more clear. Strategic default 'mad money' could well be the fuel consumers relied on to power their 'recovery.'

Dumping the Mortgage Nut

We have seen plenty of strange phenomena in these bizarre upside down times. One of the strangest bits was a sudden surge of mortgage default and delinquency rates above and beyond credit card rates.

In a normal (i.e. sane) world, you always pay the mortgage before you pay the credit card bill. Being hopelessly late on a credit card bill leads to nasty consequences. But those consequences are a mosquito bite compared to putting ownership of one's home in jeopardy. The mortgage bill ALWAYS gets precedence.

At least, that's the way it used to be. Here's how it is now:

• In this massively screwed up environment, where housing prices zoomed to the sky then crashed through the floor, many homeowners realized their homes had become giant millstones around their slender financial necks.
• These same homeowners also saw, with quickly opening eyes, that the rotten banks were too mired in their own troubles to initiate on foreclosures. Homeowners who chose the 'strategic default' option were allowed to stay in their homes, because the banks could not (or would not) take back the house and thus recognize the loss.
• So what did these millions of debt-besieged homeowners do? They chose the strategic default option, putting credit cards over mortgages... and suddenly had much more money to spend, being free of the odious monthly mortgage nut.
  
  
  

Government Folly

In response to last week's piece on the baby boomer retirement debacle, a number of you wrote in to argue that an "eat, drink and be merry" response was perhaps justified. If you're going down, why not go down in style, and so forth.

In regard to the 'Strategic Default' dynamic, we can see this logic writ large. To let go of one's home is to be resigned to a grim financial fate no matter what... even as the monthly cash flow suddenly takes a sharp turn northward.

Financial doom plus temporary cash flow respite, mixed with an already pronounced taste for shopping, can only lead to one conclusion, suitable for reading in full-throated Dick Vitale voice: "Why not spend, baby!"

As usual, the government plays a large role in this tragicomic farce. Consider the following:

• The housing bubble came about from "easy money" Fed policies and criminally lax (nonexistent) Wall Street regulation. (Circa 2006, a golden retriever could have qualified for a subprime loan. A few probably did.)
• Having crashed and burned, upside down homeowners looked on in disgust as the megabanks all got bailed out, to the tune of trillions in largesse and guarantees. (This spectacle of gross indecency utterly destroyed any last remaining shreds of fiscal responsibility or obligation on the part of hurting homeowners.)
• The government's helping hand enabled banks to keep their real estate losses hidden on the books - where they largely remain to this day - thus enabling the whole 'strategic default' phenomenon in the first place. (Banks aren't kicking defaulted homeowners out because they are already choked to the gills on 'shadow inventory.')
• The government continues to prop up an ailing housing market, making things worse with taxpayer funded distortions that only encourage financially destructive decisions... while allowing the defaulters to stay in their technically foreclosed homes.

In this perverse manner, the housing bust wound up acting as fuel for the latest consumer spending binge. In attempting to repeal all consequences of indebtedness and fiscal irresponsibility via massive bailouts, the government has encouraged more of the behavior that put America in dire straits in the first place.

Rather than embark on the necessary, and ultimately inevitable, process of deleveraging, we have elected to apply the "martingale system" to our losses and double, triple, or even quadruple down one last time.

The long run effects of this decision will be dire. We are digging an even larger hole for ourselves than before. Even as you read this, business decisions are being made all over the country, and the world, based on the faulty assumption that the U.S. consumer is in genuine recovery. Inventories are being restocked... expansion plans are being reconsidered... and, of course, stock market euphoria is approaching levels of "extreme optimism" (according to Ned Davis research). And it's all based on a mirage.

Eventually, though, the truth will out. The laws of financial physics have not been repealed. They only appear to have been repealed, or temporarily suspended rather, through a bizarre backlash effect of the unprecedented government bailout.

Via a tangled string of crushing setbacks and perverse financial incentives, U.S. consumers have been given the motive, and the fuel, for one last "Thelma & Louise" road trip.

In the movie, there is a reason the convertible went over a cliff. There was no longer an option of truly going home.

Warm Regards,

JL