Thursday, August 23, 2007

Cascading Credit Failures

The recent NY Times story on the IRS data that shows the average income tax return filing American is still earning less real dollars in 2005 than they did in 2000 is just another piece of evidence confirming the thesis that things have been tight and probably still are tight for most people in this country. The past couple of years have seen mediocre at best real wage growth, although mediocre is significantly better than absymal, none or negative real wage growth that we had seen for most of this decade.

US savings rates have been hovering at or below zero for the past couple of years as personal consumption expenditures have been increasing at a rate significantly faster than current income has been increasing. People are spending more money without making the same or greater amount of money.

This is not always a horrendous thing in the aggregate if the drawdown in assets or increases in debt are used to buy higher yielding opportunities, or if the society as a whole is paying for retirement based on previous savings. However this has not been the case for the American economy. Instead we have collectively been using the wealth effects of our home equity mark to model price appreciation to cash out money at multi-generationally low interest rates in order to maintain and expand our lifestyles.

This is not a problem as long as credit standards are ultra-loose, interest rates are low, risk premiums are low, and a greater fool is still willing to part with their money.

It is a problem today. Credit standards have tightened up, interest rates for most people are increasing as underwriters are actually being told to do their job for the first time in years, risk premiums have rebounded, and the supply of greater fools has peaked and depletion of the global fool reserve is happening at a rapid rate.

CNN Money is reporting the obvious --- American consumers are stretched tight and the tightening of credit standards means cascading future credit problems:

Fallout from the mortgage mess and lower home prices may have started to creep into the credit card arena, judging from July payments and some initial moves by issuers to tighten the screws on cardholders.

After falling for three consecutive months, delinquent payments on credit cards -- defined as more than 30 days late - increased slightly in July, to 4.64 percent from 4.62 percent in June, according to A year ago, the delinquency rate was 4.18 percent..... CEO Robert McKinley suspects delinquencies may increase in the fourth quarter because of the credit crunch. Mortgages and home equity loans are harder to come by, home prices have fallen and more than 2 million subprime adjustable rate mortgages (ARMs) are beginning to reset to much higher rates.

"As an adjustable mortgage payment rises it may limit the ability to service other debt, and lower home prices may limit the ability to do a cash-out refi," McKinley said.

If the basic thesis of "American consumers are stretched and their financial situation is fairly brittle" is reasonably accurate, then we should start expecting to see some serious problems in the next three to six months. Remember the year over year 11% increase in credit card defaults reported in this story was for July 2007 when risk was still priced very low. I am betting the August and September numbers will be much worse as risk has been repriced at a much higher rate, and the ability of the marginal borrower to refinance themselves into a managable situation has been dramatically reduced.

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