Street Capitalist: Event Driven Value Investments

One of my fundamental beliefs is that consumer spending drives our economy, this is a lasting lesson from Joseph H. Ellis’ wonderful book Ahead of the Curve. With the current turmoil of the housing and credit markets, I have become extremely interested in determining what sort of effect we may see in real consumer spending (PCE).

Today I stumbled across Housing, Credit and Consumer Expenditure, John N. Muellbauer from the Jackson Hole 2007 Symposium on the Calculated Risk blog. Muellbauer’s study analyzes data over the last few decades to see how the development of credit markets affect consumer expenditures.

The findings were mostly in line with my expectations. Nations with less developed credit markets tended to have “high aggregate household saving rates” (Muellbauer, 8 ) because of a low quantity of loans offered to first-time home buyers. When real estate markets appreciated in these countries, those aspiring to own homes were forced to save more of their income, resulting in a consumer spending decline. This kind of situation changed in the 1990s “largely due to a shift in the mortgage credit supply to first time buyers,” (Muellbauer, 30) leading to the ability to take out risky home equity loans and increase consumer spending. First-time home owners did not need to ssave as much, and existing home owners were able to take out more debt at rates which appeared more attractive, contributing to a rise in consumption.In the US, policy makers created a situation where there was incentive to engage in this reckless behavior.

Muellbauer breaks down and gives us three main factors which allowed for the liberalization of credit markets to be more expansive than those of other western nations.

1. “Mortgage interest, even on second homes, is fully tax deductible in the US”
2. “The fixed rate mortgage system is highly effective in protecting US households from interest rate risk”
3. “In many US states there is a ‘walk away’ option for households with negative housing equity: they can simply hand in the keys to their home to the mortgage lender and be free of further debt service obligations”

These three factors did an excellent job of understating the riskiness of sub-prime loans and helped increase our consumer spending over the last few years. The propensity for Americans to consume out of household wealth (housing + liquid assets – debt) is between 6-7% which is double the 3% that’s seen in the UK. This wide discrepancy is mainly due to our lax regulatory environment compared to the British and other European countries where credit markets developed over the last 20 years.

A decline in consumer spending is on the horizon as many sub-prime homeowners will soon have to deal with their variable rate mortgages being reset. These borrowers were instilled with the idea that real estate is supposed to appreciate year after year so that they would be able to refinance their homes and keep rates from climbing too high during the resets. Now we know that this is not the case when looking at markets like California and Florida. What previous helped increase our ability to spend in the past now poses a threat to our financial system. Central bankers will need to focus on a solution that alleviates the problem but does not promote the moral hazard which brought us here in the first place.

Tradeable ideas:

Some of the industries most likely to experience defaults are listed in the picture above, but the ones that are most important to me are, “consumer products and retail/restaurants are vulnerable because of their exposure to consumer spending, which investors believe will be negatively impacted by the housing slowdown; finance companies are being pummeled by the subprime meltdown and widening credit spreads;” (Lewitt, Vectors of Credit) both of these areas have been hit quite hard recently, with many investment banks trading at their lowest levels in years.

If you have stocks in these sectors within your portfolio, you should be conscious of the current economic environment and brace yourself for any negative movements in share prices.

Some light?

We’re seeing a downtrend in the cost of gasoline from where it was last year. If this can hold up it’s certain that some savings will be passed on to the consumer which can help offset the portion of the population most affected by sub-prime loans.