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Monday February 9, 2009 - 15:57:32 GMT
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Market Directions   February 09, 2008

In the past year leverage has been one of the most overused terms in explaining the causes and ramifications of the economic crisis. It has been applied specially to the gearing of investment banks and hedge funds, now supposedly cured of their addiction to leverage.  Excessive leverage has also been blamed for the inhibition of commercial     bank lending by the billions of dollars of devalued asset-backed securities on their balance sheets.   Less attention has been paid to the equally important consumer side of the leverage leger.

It has been a general presumption that the blame and the cure for restricted lending lies with the banks. Once the impaired securities are removed from their books banks will be able to resume their normal business role, lending to consumers and businesses, creating money through their loans and letting the populace regain its debt fueled purchasing habits. 

Purged of bad assets banks could again extend credit to businesses and consumers who would invest and spend and return the economy to robust growth.  The essential credit function of banks is unchanged though perhaps subject to stricter standards than in the bubble years.  The real question is not whether the banks will lend when their books are clear, they will, but will Americans borrow?  Are the consumers’ free spending ways just waiting for the resumption of credit?

Has the economic crisis wrought a permanent change in consumer attitudes?  Will the old consumer complacency towards consumption and debt resume when the Federal stimulus check start arriving or job creation begins again? Or has this crisis changed the US economy by changing the outlook of the US consumer?

Long term changes to consumer attitudes are difficult to track but there is some indication in retail sales and in consumer credit that this crisis has had an earlier and deeper effect on spending and consumer outlook than usually realized.

Consumer credit has been contracting since mid last year.  Consumers have been deleveraging, paying down credit lines instead of spending.  In December consumer credit fell $6.6 billion.  The majority of that reduction, $6.3 billon, was to revolving credit, essentially credit cards and lines of credit that can be utilized at the discretion of the borrower or consumer. 

Nominal retail sales have been negative only since July last year, except for February they were positive in the first half of 2008. It seemed that consumers had continued to spend freely despite the long running housing crisis and the steep fall in job creation almost until the banking crisis struck in September and October. Such apparent resilience in the face of an economy that had worsened steadily throughout the year might bode well for a return to normal spending once the extraordinary restraints of the credit crisis are removed.

However if one examines real retail sales, corrected for the effect of rising and falling prices they tell a much less optimistic story.  Real sales were static in the first half of 2008; the three monthly rises of 0.2% in March, April and May were negated by contractions of 0.5% in February and 0.8% in June when the current string of negative months began.  In fact the negative monthly numbers are unbroken from August 2007 with the three exceptions above and a flat January 2008.  This is a much more cautious consumer than generally depicted. Bank credit has not been restricted since the late summer of 2007, that crunch started in earnest last fall, but the fall in real retail sales began a year earlier.

If and when bank lending is no longer contained by balance sheet problems and credit begins to flow again, then those people who can afford new cars and homes but have been unable to find credit will purchase.  These borrowers will have to meet the new stricter standards that banks have instituted.  These standards must necessarily reduce the number of eligible borrowers for all types of credit.

The lax mortgage standards of the housing boom contributed much to the housing bubble by granting mortgage credit to folks who had little or no real chance of honoring the terms of the contract. That group of purchasers is now shut out of the market.   The pool of potential home buyers, to take just one market, has been substantially reduced.  What percentage this group was of the total pool of potential home buyers is difficult to tell.  But what is certain is that all types of consumer credit now have much stricter standards.  Consumer credit cannot return to pre-crash levels because the pool of eligible borrowers is now smaller.  If consumer credit is now permanently tighter, consumer spending will be lower for the foreseeable future. 

But the reduction in eligible borrowers is not the main factor depressing consumer spending. 

Fear of unemployment is a much heavier burden for consumers. But even the stunning job losses in the fourth quarter are not the whole story for consumer planning. The unusual and desperate circumstances of the credit freeze last fall, the failure of Lehman and disappearance of every major US investment bank, the national election, the gargantuan fiscal stimulus and President Obama’s apocalyptic rhetoric make for an uneasy future even for the most determined optimists.

The recovery scenario for the US economy has consumer spending in its primary and profligate place. That reliably cheerful consumer is likely to have disappeared in the financial crisis as surely as Lehman Brothers and Bear Stearns.

Joseph Trevisani
FX Solutions, LLC
Chief Market Analyst

[email protected]

2008 - FX Solutions, LLC

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