Roubini on the Credit Crunch, Global Recession, and Deflation (Part Two)

Part two of Nouriel Rubini's speech at the 2009 CBOE Risk Management Conference. He discusses several topics including: the credit crunch, global recession, and deflation.

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Are Credit Cards the Next Shoe to Drop--Credit Crunch

Without doubt, credit was extended too freely over the past 15 years, and a rationalization of lending is unavoidable. What is avoidable, however, is taking credit away from people who have the ability to pay their bills. If credit is taken away from what otherwise is an able borrower, that borrower's financial position weakens considerably. With two-thirds of the U.S. economy dependent upon consumer spending, we should tread carefully and act collectively.

I am reading stories about consumers complaining that their credit card limits are being reduced. In addition, I wrote recently about consumer complaints about sharp increases in the annual percentage rates they are paying on their credit card. It seems that credit lines are getting cut, and APRs are going up, regardless of the quality of the consumers' credit. It appears credit card companies are using zip codes to determine your credit worthiness. In other words, if the zip code you live in is experience high housing default rates or price deterioration--you are going to pay higher rates regardless of your credit history.

Today, Meredith Whitney is writing about the behavior of credit card companies. She says,

...available (credit) lines were reduced by nearly $500 billion in the fourth quarter of 2008 alone, and she estimates over $2 trillion of credit-card lines will be cut within 2009, and $2.7 trillion by the end of 2010.

When you couple this with the rising savings rate, you could easily conclude that the economy is going to grow slowly for the foreseeable future.

You should read the article below carefully and to the end.

There are going to be investment opportunities based on this trend. For example, is it a good idea to be short the major credit card companies? Are travel companies going to get "killed"? While it is not well known, a large fraction of senior citizens use credit cards to purchase their medication, is this trend going to effect the health of older people and retiring baby boomers? Or, the earnings of pharmaceutical companies?

Are you listening? Your thoughts?

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Credit Cards Are the Next Credit Crunch

Washington shouldn't exacerbate the looming problem in consumer credit lines.

By MEREDITH WHITNEY

Few doubt the importance of consumer spending to the U.S. economy and its multiplier effect on the global economy, but what is underappreciated is the role of credit-card availability in that spending. Currently, there is roughly $5 trillion in credit-card lines outstanding in the U.S., and a little more than $800 billion is currently drawn upon. While those numbers look small relative to total mortgage debt of over $10.5 trillion, credit-card debt is revolving and accordingly being paid off and drawn down over and over, creating a critical role in commerce in America.

Just six months ago, I estimated that at least $2 trillion of available credit-card lines would be expunged from the system by the end of 2010. However, today, that estimate now looks optimistic, as available lines were reduced by nearly $500 billion in the fourth quarter of 2008 alone. My revised estimates are that over $2 trillion of credit-card lines will be cut inside of 2009, and $2.7 trillion by the end of 2010.

Inevitably, credit lines will continue to be reduced across the system, but the velocity at which it is already occurring and will continue to occur will result in unintended consequences for consumer confidence, spending and the overall economy. Lenders, regulators and politicians need to show thoughtful leadership now on this issue in order to derail what I believe will be at least a 57% contraction in credit-card lines.

There are several factors that are playing into this swift contraction in credit well beyond the scope of the current credit market disruption. First, the very foundation of credit-card lending over the past 15 years has been misguided. In order to facilitate national expansion and vast pools of consumer loans, lenders became overly reliant on FICO scores that have borne out to be simply unreliable. Further, the bulk of credit lines were extended during a time when unemployment averaged well below 6%. Overly optimistic underwriting standards made more borrowers appear creditworthy. As we return to more realistic underwriting standards, certain borrowers will no longer appear worth the risk, and therefore lines will continue to be pulled from those borrowers.

Second, home price depreciation has been a more reliable determinant of consumer behavior than FICO scores. Hence, lenders have reduced credit lines based upon "zip codes," or where home price depreciation has been most acute. Such a strategy carries the obvious hazard of putting good customers in more vulnerable liquidity positions simply because they live in a higher risk zip code. With this, frequency of default is increased. In other words, as lines are pulled and borrowing capacity is reduced, paying borrowers are pushed into vulnerable financial positions along with nonpaying borrowers, and therefore a greater number of defaults in fact occur.

Third, credit-card lenders are currently playing a game of "hot potato," in which no one wants to be the last one holding an open credit-card line to an individual or business. While a mortgage loan is largely a "monogamous" relationship between borrower and lender, an individual has multiple relationships with credit-card providers. Thus, as lines are cut, risk exposure increases to the remaining lender with the biggest line outstanding.

Here, such a negative spiral strategy necessitates immediate action. Currently five lenders dominate two thirds of the market. These lenders need to work together to protect one another and preserve credit lines to able paying borrowers by setting consortium guidelines on credit. We, as Americans, are all in the same soup here, and desperate times are requiring of radical and cooperative measures.

And fourth, along with many important and necessary mandates regarding fairness to consumers, impending changes to Unfair and Deceptive Acts or Practices (UDAP) regulations risk the very real unintended consequence of cutting off vast amounts of credit to consumers. Specifically, the new UDAP provisions would restrict repricing of risk, which could in turn restrict the availability of credit. If a lender cannot reprice for changing risk on an unsecured loan, the lender simply will not make the loan. This proposal is set to be effective by mid-2010, but talk now is of accelerating its adoption date. Politicians and regulators need to seriously consider what unintended consequences could occur from the implementation of this proposal in current form. Short of the U.S. government becoming a direct credit-card lender, invariably credit will come out of the system.

Over the past 20 years, Americans have also grown to use their credit card as a cash-flow management tool. For example, 90% of credit-card users revolve a balance (i.e., don't pay it off in full) at least once a year, and over 45% of credit-card users revolve every month. Undeniably, consumers look at their unused credit balances as a "what if" reserve. "What if" my kid needs braces? "What if" my dog gets sick? "What if" I lose one of my jobs? This unused credit portion has grown to be relied on as a source of liquidity and a liquidity management tool for many U.S. consumers. In fact, a relatively small portion of U.S. consumers have actually maxed out their credit cards, and most currently have ample room to spare on their unused credit lines. For example, the industry credit line utilization rate (or percentage of total credit lines outstanding drawn upon) was just 17% at the end of 2008. However, this is in the process of changing dramatically.

Without doubt, credit was extended too freely over the past 15 years, and a rationalization of lending is unavoidable. What is avoidable, however, is taking credit away from people who have the ability to pay their bills. If credit is taken away from what otherwise is an able borrower, that borrower's financial position weakens considerably. With two-thirds of the U.S. economy dependent upon consumer spending, we should tread carefully and act collectively.

Ms. Whitney is CEO of Meredith Whitney Advisory Group, LLC.

Bob DeMarco is a citizen journalist, blogger, and Caregiver. Bob has written more than 500 articles with more than 11,000 links to his work on the Internet. His content has been syndicated on Reuters, the Wall Street Journal, Fox News, Pluck, Blog Critics, and a growing list of newspaper websites (15). Bob is actively seeking syndication and writing assignments.

Bold Endeavors: How Our Government Built America, and Why It Must Rebuild Now

Debt Binge--The Perfect Financial Storm

When historians look back they will be writing about the Debt Binge.

A binge is any behavior indulged to excess.

In America, we now have a series of binges coming together to form the perfect financial storm. The components of the perfect storm include:

• excessive governement borrowing from foreigners to finance enormous debt in the public sector,
• excessive borrowing by consumers in the form of mortgages, mortgage refinancings, and credit cards,
• and, the enormous borrowing by investment banks and bank banks to leverage up their balance sheets with credit default swaps.

The most recent of the borrowing binges--the stimulus package. Or should I say--packages.

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If you saw the movie the Perfect Storm you might remember at one point in the movie it appeared that the fishermen on the Andrea Gail had ridden out the perfect storm. For a brief moment, a hole appeared in the sky and the sun peaked through. The fishermen in an almost euphoric moment thought they had ridden out the monster storm. But, as quickly as the sky opened it closed. Soon the ship was being battered with a series of monster waves that kept getting bigger and bigger. In spite of efforts of the fisherman the Andrea Gail was consumed by a giant wave that consumed the boat and sent it to the bottom of the sea. This where we are today in the financial markets.

I am a proponent of the stimulus package. It is better than nothing (nothing equals depression). Nevertheless, the stimulus package is a continuation of the same binge pattern--

curing a debt problem with more debt.

Soon we will be calling on the world to lend us enormous amounts of money. Treasury debt offerings will come to the market in bigger and bigger waves--a key component of the perfect storm. Corporation will be crowded out of the market and unable to borrow more in an attempt to pay for their past sins. Consumers, leveraged to the hilt, will begin to default on their debt in greater and greater numbers as unemployment marches higher and higher. Hedge funds will be the next to follow the trend. In case you haven't noticed investment banks are now extinct. Not only did Bear Stearns and Lehman Brothers implode; but, the venerable Goldman Sachs is now a bank bank. Weak hedge funds now hanging by a thread will join the party during the next downside in the market. As hedge funds near extinction, they will be selling assets as fast as they can--the equivalent of a fire sale. Prices of stocks will get very cheap (a good thing if you were a squirrel during this period).

It seems like much of this is happening unnoticed as history unfolds right before our eyes.

The best way out of this trap is a massive inflation that bastardizes the U.S. currency and lessens the debt burden by cheapening it. Of course, there is the Argentinian solution--default.

We should be looking around and noticing that every major economy in the world is wounded. The situation came about because of excessive debt and leveraging--the World Debt Binge.

The cure to excessive debt is savings. The only good thing I hear out there is talk about wringing out the excesses in our government to bring about costs savings and lessen the need for future borrowing. What is the likelihood of that happening soon? In case you haven't noticed over the last 25 years the quickest way to cut costs is to "fire" people. Instead, we are trying to put more people on the government payroll by creating projects funded with government dollars via the stimulus package.

Something has to give. The massive leveraging of the U.S. economy leaves us in debt to the tune of three and a half times times the output of our economy. The big credit card in the sky is being leveraged to the max. What if the lenders pull the plug? The likely result is higher and higher interest rates to finance the borrowing--or worse.

We have not learned our lesson--excessive leverage via borrowing is not a good thing. There are only two possible solutions to this problem: inflation or default. Both are ugly but the only way out of the trap.

Coming soon: Tsunami.

Original content:

Debt Binge--The Perfect Financial Storm