The Math: Economy Less Consumer Equals Recession

Without a doubt, investors will remember 2007 as the year that the housing market collapsed and triggered a credit crunch. The earnings of just about any company that was involved in homebuilding or lending were crushed, and resulting economic worries triggered stock declines for many consumer goods companies. Simultaneously, U.S. exports boomed, reaching an all-time high of 12.1% of GDP. Not surprisingly, companies with significant foreign-based earnings did well. Overseas stocks also delivered great returns, and as these economies continued to grow so did their demand for energy and raw materials commodities from China and other high-growth developing countries.
The last four months have been difficult for stocks as prices have declined substantially from their highs in October 2007. The markets have broken through many technical support levels -- this is true for every major index (Dow Jones, Russell, Nasdaq and S&P), which means that technical damage has been done.
The good news is that the Federal Reserve has finally woken up to the severity of the situation and is working diligently to respond to escalating economic concerns. On January 22, 2008, the Fed unexpectedly cut the fed funds rate by 75 basis points (0.75%) from 4.25% to 3.50% in advance of its policy meeting. The Fed has not cut rates in one stroke by such a large amount since 1982. In making the cut, the Fed cited the “weakening of the economic outlook and increasing downside risks to growth.” This move was desperately needed to ensure market stability and sooth investor fears. Sinc then, the Fed has continued to cut rates and has stated its willingness to cut rates further to shore up the markets.
It appears that the combined impact of the housing implosion and the fallout from the structured finance debacle has pushed the U.S. into recession - or at least whole sectors of the economy are now in recession. How protracted the economic weakness will be and what its full impact on the markets are the new questions to be answered.
The key to an economic turnaround is consumer spending because it accounts for 70% of our economy (Gross Domestic Product—GDP). The falling housing market and the resulting tightening of mortgage lending have hit consumers hard, causing them to spend significantly less. Consumers who are more and more worried about the overall economy have triggered stock declines for many consumer goods companies.
A volatile stock market does not help consumer sentiment either. When you add rising unemployment to the mix, it is obvious that the U.S. consumer isn’t going to go on a spending spree anytime soon. It will be tough to entice the consumer to start spending when it is difficult to borrow, and many are already heavily in debt. Until credit markets are repaired, the consumer won’t start spending enough to cause a recovery, and businesses will curtail spending. If consumers and businesses aren’t spending, that only leaves the federal government, a scary thought. Even the proposed fiscal stimulus plan by the President won’t be enough to turn the tide. When credit becomes this tight, a recession is almost inevitable.
How did credit get so tight? Why are funds more scarce and underwriting criteria toughening? It all started with the mortgage-backed securities and how they are packaged and sold through our unregulated shadow banking system.

How Bad is the Housing Market? Pretty Bad

The pizza guy delivers a pizza to your door. He wants to be paid in cash right now. He doesn’t care how much equity you have built up in your house. You look in your wallet and it is empty. This scene is playing out for many home owners. They can’t make their mortgage payments and the bank is knocking on their door demanding payment. These resetting mortgages payments have ballooned to a level that borrowers aren’t able to pay.
Why did the banks and secondary lending institutions make these loans to people they knew would never be able to repay? Greed! Wall Street was clamoring for these riskier mortgages because they were looking for bonds that generated a higher yield (higher interest rates) and to heck with the risk. In particular, hedge funds had an insatiable appetite for these riskier asset-backed consumer loans. Here is the bad news: the worst is yet to come. The most egregious of these risky loans (with high escalating payments at reset) were 2 year Adjustable Rate Mortgages made in 2006 and early 2007. As the above graph shows there is a massive wave of these loans that will reset in 2008. The default rate will be significant. This is like watching a train wreck in slow motion.
Unfortunately, when excesses end, things don’t just return to normal. The pendulum frequently swings far in the other direction. This quick swing sparked a liquidity crisis on Wall Street. The mortgage defaults triggered an extreme lack of interest in holding consumer-backed debt, and an inclination on the part of most institutions not to lend to each other. This cascaded into broader risk avoidance on the part of investors, hedge funds, and other financial market players who have played an important role in expanding the amount of available credit. This was greatly exacerbated by large amounts of leverage (debt) held by many of the non-bank credit providers (e.g., hedge funds). The result was that credit, which as noted is crucial to the economy, was sharply restricted for a few weeks during the quarter.
With the Fed’s decisive action in September to cut the federal funds rate by 50 basis points, things have settled down, but they have not returned to normal. Capital will no longer be available to certain groups of borrowers and it will be costlier to other groups. This is somewhat good because excess liquidity was leading many investors to make imprudent investment decisions. On the flip side, the seizing up of the credit markets in a credit-dependent economy has a ripple effect which will hurt consumer spending.

With consumers unable to use their homes as an ATM machine (consumers extracting capital from their homes largely shut down and housing prices have fallen) and home sales severely slumping, the economy is faced with the possibility of a material cutback in consumer spending. The primary driver of economic growth is consumer spending, which accounts for approximately two thirds of the US economy. Some industries are already slumping since consumers have less cash available to spend on their homes and lifestyle. For instance, the furniture, home improvement and auto industries are already feeling the pain. The homebuilders and mortgage lending industries have also begun to retrench. All this has a negative multiplier effect on the economy. It seems highly probable that the economy will, at the very least, experience slower growth.