Can you have Easter without eggs? St. Patrick’s Day without the shamrocks? How can you have a recovery without consumption based on “real” demand? Current demand is driven by increased government spending financed by unsustainable government debt. Though it may have been effective to halt the onset of a systemic economic collapse in late 2008, its continued dependence diminishes its efficacy and distorts the strength of the economy given a consumer base whose wealth has significantly eroded, burdened with debt, and perceives a higher risk of unemployment/decline in income. In May we were excited about the market’s upside, however expressed caution over possible corrections in the August, September, and beginning of the 2010 time periods. It is because of these points that we believe a correction within the stock market could again be foreseeable in the near term. Let us review the three most common consumer demand drivers: wealth, income and credit.
Wealth – An unaccounted for oversupply from “shadow inventories” and strategic defaults from high levels of negative equity and inflated home prices threaten to erode wealth and provide false signals to economic recovery.
As household wealth increases consumers proportionately spend more and save less. When wealth decreases households save a greater portion of their income and spend less. While this is rational for the individual, spending less by the aggregate population negatively impacts economic growth and thus recovery.
A significant portion of household wealth is tied to the home valuations. Homeowner wealth erodes when property prices fall. Decline in property values negatively affect real wealth of those homeowners and their non-delinquent neighbors.
Existing rise in home prices provide a false signal to recovery, as home values, therefore wealth are likely to decline. Downward pressure on home prices exist, due to the potential oversupply from “shadow inventory” and increasing strategic defaults from high levels of negative equity. Additionally, existing price levels are distortions due to easy credit that is based on unsustainable government interventions.
According to the National Realtors Association sales increased, inventories fell, and prices increased in 2009. Despite a dip in sales, without a dip in prices, in December, NAR chief economist, Lawrence Yun, expects sales and prices to surge again by spring and summer of 2010 indicating continued housing recovery. However, this ignores future potential supply created by delinquencies and foreclosures. As of December 31, 2009 total delinquencies (30 day, 60 day, 90+ days) are at 5.49M with those under the foreclosure process an additional 1.75M for a total of 7.24M loans. Both are at their highest levels.
Delinquencies lead to foreclosures as existing efforts for loan modifications do not work. The government has allocated $75B billion to conduct modifications, but so far $15M have been spent and only 7% of modifications completed. One reason they don’t work is most modifications increase debt and monthly payments. Additionally, structural problems still exist in servicing the mortgages that result in prolonged delinquencies and foreclosures.
The rate of conversion from delinquency to foreclosure has significantly lengthened, so the current amount of foreclosed properties on the market do not reflect actual supply. The average days from delinquency to foreclosure increased from 249 to 406 days from January 2008 to December 2009. This is due to government and structural incentives to delay the start of foreclosures, as the rate of seriously (90+ days) delinquent loans escalate to record highs at 3 times that of foreclosure starts.
Residential loans which are 90+ days delinquent combined with those that have started the foreclosure process, but have not entered the market for sale are the “shadow inventory” of housing. This consists of 2.82M seriously delinquent loans and 1.75M in the foreclosure process for a total of 4.58M likely to come to the market.
They are likely to deflate property prices for a while. As of December 2009 there are 3.3M units for sale which is a 7.2 month supply, the lowest since 2006. However, when “shadow inventory” is added, there is a 17 month supply of homes, creating downward pressure on prices. Deutsche Bank expects prices to drop in 2010 by an additional 10-12% with a total accumulated drop from the peak to trough at 40%. Further, in its January 28, 2010 report CIBC echoed Deutsche’s sentiment and expects prices to decrease in the next two years by 5 to 10%.
Oversupply is also being created by a greater portion of homeowners, with high levels of negative equity, choosing strategic default even when they have the means to pay.  They are handing over the keys and simply choosing to walk away. According to First Amercian CoreLogic, ‘[s]trategic default on the part of the owner occupier becomes more likely at such high levels of negative equity.’ As of September 2009 more than 23% or 10.7M residential properties were underwater, which consists of $2.2 trillion of value for $2.9 trillion of debt. An additional 2.3M had less than 5% equity, thereby close to reaching negative equity. First American reports 5.1M or 10% of homeowners will see their property values fall below 75% of their mortgages by June 2010.
High levels of negative equity have led to strategic defaults and foreclosures. While there is still a stigma attached to walking away, more borrowers are doing so. Walking away gives borrowers a fresh start, where they have no hope of property values increasing to that of the mortgage and where rental payments are less than the mortgage, insurance and taxes. Research from the Oliver Wyman firm showed that 17% (588,000) of defaulting mortgages in 2008 were strategic. CIBC in their January 28, 2010 report indicated 25% of the 2M foreclosures in 2009 occurred for the same reason. CIBC’s figure is an underestimate due to the longer conversion process from delinquency to foreclosures as discussed earlier.
Existing supply does not account for the looming oversupply from “shadow inventory” and an increasing portion of homeowners walking away due to high levels of negative equity. This unaccounted for oversupply threatens to deflate current price levels and lower consumer wealth.
Income – Consumers’ financial health continues to severely deteriorate despite the latest increases in employment, compensation income and government transfers.
Income based demand is one of the most stable forms of demand as it does not come at the expense of future demand as in the case of borrowing to finance consumption or unsustainable government transfers. The current state of consumer demand/spending is weakened through lower availability of income for spending due to protracted high rates and amounts of unemployment and underemployment, and a heavy debt burden.
The shift of personal income and compensation income from decline to steady growth over several months does not necessarily signal recovery as year over year compensation income has decreased, and the personal income growth seen is primarily derived from rental income and government transfers. Personal income has been growing since April 2009 with a .5% year over year increase from December 2008 to December 2009. However, the increase in personal income is mostly due to a 21% and 14% year-over-year increase in rental income and current transfer receipts.  Of the current transfer receipts the largest year over year increase (48%) is derived from government unemployment benefits. 
Compensation income, on the other hand, while growing from March 2009, has declined 1.5% from December 2008 to December 2009. The increase in compensation income since March was primarily due to correcting the austere cost cutting measures instituted in late 2008 and 2009 due to fears of a financial collapse. Moreover, demand based on consumer spending, as discussed later in this paper, did not increase to the levels to justify rise in compensation income. Businesses fearing the potential for the next great depression overshot the number of workers it laid off. Job losses skyrocketed from 100, 000 to 200,000 per month in early 2008 to 380,000 in October; 597,000 in November; and by 741,000 per month in January 2009 according to the President’s Economic Report.
The severity of cost cutting methods through layoffs and the protracted period of high unemployment inhibit recovery, despite some corrections shown in the recent decrease in unemployment levels. January 2010 showed a .3% decrease in the official unemployment rate (U-3) from December 2010 to 9.7%. Further, U-4 (which adds in discouraged workers to the official rate), U-5 (which adds those additional marginally attached to the labor force to U-4), and U-6 (which adds those who are employed part-time for economic reasons to U-5), have each stayed the same or decreased in the last 3 months. They have decreased by .2%, .2% and .8% respectively from December 2009 to January 2010.
Regardless of the recent improvements, the unemployment situation is still bleak as the numbers of both officially and unofficially unemployed are severely high with a greater portion of individuals facing longer periods without jobs. The total official unemployment (U-3) is 14.8M in January 2010. Forty three percent of the unemployed workers have long-term unemployment, as they are jobless for 27 weeks and over and have searched for a job within the last 4 weeks. Long term unemployment numbers increased in January 2010 to 6.3M, a 5M increase from 2007. The official unemployment figure does not include discouraged workers. Discouraged workers are those “persons not currently looking for work because they believe no jobs are available for them”. They include another 1.1M. Further, add in those who are marginally attached to the labor force, who “had not searched for work in the 4 weeks preceding the survey for reasons such as school attendance or family responsibilities” but who “wanted and were available for work, and had looked for a job sometime in the prior 12 months” which is another 1.5M. Therefore, the unemployed (U-5) number is 17.3M. Adding in underemployed workers (7.9M), who are working part-time due to economic reasons, which is 16.5% (U-6) of the civilian workforce, results in 25.2M people who are unemployed and underemployed as of January 2010. Moreover, year over year unemployment conditions are worse as the official and each of the unofficial statistics show increases in unemployment from January 2009 to January 2010: 1.2% increase in U-3; 1.3% increase in U-4; 1.5% increase in U-5; and 1.1% increase in U-6. Despite the recent decreases in unemployment and underemployment, and increase in personal income through rise in compensation income and government transfers, consumers’ financial conditions are deteriorating. They are heavily burdened by debt and use a greater portion of the diminished compensation income to pay off debt instead of consumption.
Record high debt to income ratios have been steadily declining to reach pre-crisis levels. Total household debt to income ratios, which include mortgages and consumer debt, have steadily decreased during the 4th quarter of 2008 (13.57%) through the 3rd quarter of 2009 (12.85%), their lowest since 3rd quarter of 2001 (12.75%). The highest recorded level was 13.91% in 3rd quarter of 2007 and again in the 1st quarter 2008. Similarly, the financial obligations ratio which adds “automobile lease payments, rental payments on tenant-occupied property, and homeowner’s insurance and property tax payments to the debt service ratio”, have been declining for renters and homeowners: for renters, the decline started in the 1st quarter of 2009 (18.44%) to reach 17.76% by the 3rd quarter of 2009, the lowest since the 1st quarter of 2001 at 17.72%; and for homeowners the decline started in 4th quarter of 2008 (17.20%) to reach 16.36% by the 3rd quarter of 2009, the lowest since 2nd of 2004 at 16.29%. The highest recorded level of financial obligations ratio is 18.86% for renters and 17.58% homeowners, both in the 1st quarter 2008.
Recent drops in both debt ratios could signal potential for rebound of consumer financial strength as they deleverage. However, consumers are substituting current consumption with reducing outstanding debt. Consumer debt is declining. Outstanding consumer debt, which includes revolving loans (mainly credit card) and non-revolving loans (such as auto loans and student loans), have decreased by $102B from the 4th quarter of 2008 to the 4th quarter of 2009. The decline was mostly due to the fall in revolving loan debt by $91.3B, with the remainder of $10.9B in non-revolving debt. There were successive declines for both revolving and non-revolving loans for each quarter of 2009.  However, preliminary results show an increase in non-revolving loans by $6.8B (.4%) from November 2009 to December 2009.  This is unlikely to be indicative of a shift toward a recovery as the outstanding non-revolving loans show a pattern of alternating between increasing and decreasing for each month from October 2009 to December 2009. One reason for the greater proportion of decrease in revolving loan debt without a similar effect for non-revolving loans is consumers’ effort to cut expenses from the spike in interest rates and fees charged by commercial banks for credit cards. Interest rates for revolving loans generally increased in each of the quarters in 2009, while interest rates decreased in each quarter of 2009 for non-revolving loans. The November to December increase in outstanding debt for non-revolving loans can be attributed to the precipitous fall in the interest rate for car loans to 3.26% in December 2009 to 3.73% in November 2009, the highest since the 1st quarter.
Consumer debt reduction is not a positive sign of consumer financial health in the context of lower compensation income from a year ago, protracted periods of high unemployment and underemployment numbers, and wealth erosion. Instead, consumer debt reduction is an effort to cut expenses driven by fear of the deterioration of existing and future income.
Evidence of worsening consumer financial health which threatens recovery is in the highest recorded level of credit card delinquencies and chargeoffs within the last three quarters of 2009. Rising credit card chargeoffs are ‘the canary in the consumer credit mineshaft’ and “can signal that credit problems may be looming” . Further, ‘[a]n all-time high for credit card chargeoffs could indicate that the U.S. economy has not yet bottomed out, and may worsen before it rebounds.’ Delinquencies and chargeoffs to credit cards/revolving debt are one of the best early signs of consumer distress as they are not secured. Charge offs are attributable due to bankruptcy or seriously missed payments. Charge offs are written off after 180 days of default or 60 days after receipt of notification of filing at bankruptcy court. Chargeoffs spiked the second and third quarters of 2009 and continued in 4th quarter. The FDIC data show chargeoffs for the 3rd quarter of 2009 are the highest at a little under 10%, almost double the average in the last 20 years. The Federal Reserve similarly shows consumer credit card chargeoffs at 10.24%, the highest on its record from 1985. This rate is almost double that of the rate from a year ago. In its January 20, 2010 report, Fitch Ratings also indicated that chargeoffs and 60+day delinquencies were at record levels in 2009 and continue to remain high. It reported 4th quarter 2009 chargeoffs at above 10% and expects chargeoffs in 2010 to be about 12%. Fitch data supplements the federal data as they include off-balance sheet loans which account for a greater portion of credit card loans. Delinquencies on credit cards were 6.58% in the 3rd quarter of 2009 which were slightly lower than 6.59% from the previous quarter. The two quarters had the highest delinquencies since 1985, the length of Federal Reserve data. Fitch Ratings, the most recent data, also showed a dip in 3rd quarter 2009, however the 4th quarter showed an increase in delinquencies. Further, personal bankruptcies have also increased precipitously signaling continued consumer financial deterioration.
As a result of mounting financial difficulty as evidenced by the recent record levels of chargeoffs and delinquencies despite economists’ and government’s proclamations of recovery, consumers are still wary about their own financial situation even while believing the worst is over. This continuing belief curbs consumer spending and demand. Generally, both the Surveys of Consumers by the University of Michigan and the Consumer Confidence Survey by the Conference Board indicate weak consumer confidence, with moderate improvements as of their latest releases in January. According to Richard Curtin, chief economist of the Surveys of Consumers, continuing levels of high unemployment, stagnating incomes, “burden of their debts, especially those underwater on their mortgages, the negative impact of foreclosures and bankruptcies on their communities, and the impact of continued credit constraints that limit their flexibility” will inhibit spending and increase savings. “Consumers’ short-term outlook, while moderately more positive, does not suggest any significant pickup in activity in the coming months,” according to Lynn Franco Director of the Conference Board Consumer Research Center in its January 26, 2010 release. The Conference Board release showed improvement in consumer confidence, which is evidenced by a greater portion of consumers believing income and jobs will not worsen in the next few months. However, more had a negative view towards improvement in business conditions, believe conditions will worsen, and fewer believe jobs will increase.
The moderate improvements have deteriorated and consumer confidence has worsened since the early January data from the latest releases of the Conference Board and University of Michigan. Gallup, provides weekly not monthly, and thus reflects the most recent consumer sentiment. Consumer confidence has worsened. The declines occurred despite the Super Bowl parties and president’s positive job outlook reflected in the State of the Union Address. According to Gallup “[a]fter a year of hoping and then experiencing repeated disappointments, many Americans may need to see a real upturn in their local economies before they buy into the idea that things are actually getting better.” Gallup’s recent data support Lawrence Summer’s, the director the National Economic Council, view that consumer confidence will continue to weaken if job prospects don’t improve.
Besides the recent increase to record high chargeoffs and delinquencies and weak consumer confidence, depressed personal consumption levels to the “new normal” and the maintenance of high savings rate provide further evidence of consumers’ continuing concern over their income and wealth prospects.
Personal consumption continues to remain severely depressed. After consecutive decreases in each of four quarters of 2008, a pattern of increases and decreases across each of the 2009 quarters combined with a 1.1% ($103B of chained 2005 dollars) year over year increase in personal consumption from 4th quarter of 2008 to 4th quarter of 2009 may indicate improvement. However, the improvement was primarily driven by government programs, which distorted consumption based on income. Two of the largest year over year increases were in the non-durable goods categories of motor vehicles and parts and recreational goods and vehicles, which accounts for $44B (chained 2005 dollars) of the increase in personal consumption. The improvement is thus likely tied to the government cash for clunkers program (discussed below) and less from the sustainable income driven consumer demand. Consumers have remained thrifty during the month of January 2010 by continuing to spend in what is described as the “new normal” at an average of $62/day.  During the same period in 2009 consumers spent $64/day, significantly lower than the $104/day spent January 2008.
Consumers are still concerned about their financial health as they maintain a relatively high savings rate which has remained on average at 4.58% in 2009. The year over year savings rate from December 2008 and December 2009 remains fairly unchanged at 4.7% and 4.8% respectively.
Despite some improvements in income and employment, consumer financial health is deteriorating and less income is available for a consumption based recovery. The spikes to record levels of chargeoffs and delinquencies during the recent improvements evidence consumer financial health is deteriorating precipitously. Heavy debt burden in the context of the severity and protracted periods of unemployment, continue to depress consumption levels as consumers use a greater portion of existing income to pay off debt. Further, recent improvements in personal income is not sustainable as they occurred from distortions created by government transfers, and corrections from overshooting austere cost cutting measures by businesses. The deterioration of consumption/consumer demand is evidenced by diminished personal consumption absent government support and at the significantly lower “new normal” levels, falling consumer confidence levels, and maintenance of a high savings rate.
Credit – Current unsustainable government incentives limit and distort access to credit.
Though not as stable as income driven demand, access to credit increases current spending (at the expense of future spending). Access to consumer credit has declined precipitously. Banks continue to decrease lending. Bank holding companies which have received government aid, through TARP funds, lower borrowing costs and guarantees from the Federal Reserve and FDIC are not lending. Instead, they are borrowing from the Federal Reserve at near zero rates, and lending funds to the Treasury, through the purchase of bonds. As a result, they have recorded profits in 2009 primarily derived from interest income, instead of lending to consumers and businesses.
The most significant area of diminished access to credit is in the area of revolving consumer credit (credit cards) as consumers face increases in fees and penalties and reduction in credit lines, balance transfers and originations. A total of $1 trillion in unused credit card lines were reduced from 3rd quarter of 2008 to 3rd quarter of 2009. The private sector provides nearly all consumer debt and its contraction was not subsequently buoyed by the government with the exception of “cash for clunkers” program.
The government was the primary source of mitigating wealth erosion and personal income growth, through its mortgage and “cash for clunkers” programs. The government distorts consumer demand and wealth through propping up housing prices through tax incentives and the purchase of mortgage securities to keep interest rates down. The improvements in housing starts, sales and prices by the end of 2009 should not be looked to as evidence of recovery. The private market for housing loans is virtually gone, with almost all net new residential mortgages being backed by the federal government or its sponsored entities. According to the Jan 30, 2010 report of the Office of the Special Inspector General for TARP “the Government has done more than simply support the mortgage market, in many ways it has become the mortgage market, with the taxpayer shouldering the risk that had once been borne by the private investor.” The Federal Reserve spent $1.25 trillion to keep mortgage rates down. Rates were lowered 100bps from the peak of the financial crisis due to the Fed’s purchases of MBS, which were about 50% of all MBS issued last year. The program is set to be completed by March 2010. This will lead to increase in interest rates, depress demand and further lower home prices. 
Additionally, the homeowner tax credit boosted housing sales by 15% in 2009 When the tax credit was expected to expire, housing sales plummeted in December.  However, this was extended to April 2010 and includes existing homeowners, promoting higher sales when it takes effect.
Besides boosting consumer wealth through buoying home prices through cheaper mortgage rates, and tax credits to increase sales, the government has also boosted demand through consumer expenditures through its “cash for clunkers” program. Two of the highest year over year increases in personal consumption expenditure was seen in motor vehicles and parts and in recreational goods and vehicles at 2.8 and 9%, respectively. Consumption expenditures increased in motor vehicles and parts 9.5% in 3rd quarter of 2009 from the 2nd quarter 2009.  Upon the expiration of program, consumption dropped from the 3rd to the 4th quarter 2009by 6%. Recreational goods and vehicle expenditures continued in both 3rd and 4th quarters at about 4% increase each quarter from the previous quarters. 
Conclusion – 110 footnotes of “fine print” indicate the economic recovery bandwagon could be derailed.
There is marked economic improvement from 2008 to 2009. Not being on the brink of a complete meltdown, however, does not mean one should jump on the economic recovery bandwagon. While increase in home prices, increase in personal income, increase in personal consumption expenditure, decline in unemployment rates and underemployment, and decline in outstanding consumer debt may each be indicators of a recovery, they must be taken in context, as consumer demand drivers of wealth, income and credit show otherwise.
Consumer wealth based on price levels is inflated, since it does not take into account the oversupply looming by “shadow inventory” and strategic defaults and government support through lower mortgage rates and tax incentives. Existing income is subsidized by government transfers. Less income is used for consumption, given an environment of the large numbers of unemployed over a lengthy period and the heavy consumer debt burden.
Further, consumer financial health has severely deteriorated as evidenced by recent record levels of credit card chargeoffs and delinquencies. Access to credit is virtually nonexistent without the government support of mortgages and cash for clunker’s programs. Current profit making structures based on government aid, warps private market incentives against lending to consumers and business. Unless this is corrected, the private market cannot replace the unsustainable government programs for credit. Consumer demand continues to be damp as evidenced by the “new normal” levels of spending, lower consumer confidence and extended periods of high savings. Therefore, recovery based on unsustainable government propped up demand, without addressing the underlying factors which drive consumer wealth, income, and access to credit, is not a feasible recovery.
 The Budget and Economic Outlook: Fiscal years 2010 to 2020: Summary, THE CONGRESSIONAL BUDGET OFFICE, January 2010. http://www.cbo.gov/ftpdocs/108xx/doc10871/Summary.shtml. Budget deficit for 2010 ($1.3 trillion) is expected to be $65 billion less than that of 2009 ($1.4 trillion). It would be 9.2% of the GDP compared to 9.9% in 2009. However, CBO warns if legislation boosts spending or reduces revenues, then 2010 deficit will exceed last year’s the highest since the end of WWII. Further accumulated debt held by the public as of 2009 is $7.5 trillion or 53% of the GDP. The CBO expects the debt to rise o $15 trillion by 2020. Therefore, the CBO warns that with such a large debt combined with rising interest rates upon economic recovery, the “government’s annual net interest will more than triple between 2010 and 2020 in nominal terms from $207 billion to $723 billion, and will more than double s a share of GDP, from 1.4% to 3.2%.
real-time-center/survey-of-professionalforecasters/2009/survq409.cfm. The survey of economists by the Philadelphia Federal Reserve indicates job growth of 150,000 per month by the second half of 2010.
 LPS Mortgage Monitor Mortgage Performance Observation, LENDER PROCESSING SERVICES (LPS.) January 2010, p. 5. www.lpsvcs.com/…2010%20Mortgage%20Monitor/LPSMortgageMonitorDec09.pdf.
 Daniel Wagner and Alan Zibel, Watchdog: Bailouts created more risk in system, ASSOCIATED PRESS, January 31, 2010. http://finance.yahoo.com/news/Watchdog-Bailouts-created-apf-64186480.html/print?x=0.
 Federal Reserve Board Household Debt Service and Financial Obligations Ratios, FEDERAL RESERVE BOARD, December 18, 2009. http://www.federalreserve.gov/releases/housedebt/default.htm.
http://www.federalreserve.gov/releases/housedebt/default.htm. Data goes back to 1st quarter 1980
 Mark Furletti, Measuring Credit Card Industry Chargeoffs:A Review of Sources and Methods, THE FEDERAL RESERVE BANK OF PHILADELPHIA, PAYMENT CARDS CENTER, September 2003. p. 1
 QPB Graph Book, FDIC, September 30, 2009. Graph: Credit Card Loss Rates and Personal Bankruptcy Filings. September 2009 is the latest data available as of publication of this paper.
 Surveys of Consumers: Consumer confidence slowly improves, THOMAS REUTERS UNIVERSITY OF MICHIGAN, January 29, 2010.
 QPB Graph Book, FDIC, September 30, 2009. Graph: Expansion of Commercial Bank Credit Card Lines
 Benjamin Tal and Meny Grauman, Economic Insights: US Housing –A Double Dip, CIBC WORLD MARKETS, INC., January 28, 2010, p. 2.
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