The U.S. Gross Domestic Product (GDP) performance in the second half of 2003 and first quarter of 2004, along with the recently announced creation of 308,000 jobs, has many toasting an expanding economy. The cheering is perhaps loudest in the White House as a growing economy gives the Administration momentum going into the height of the campaign season. The jobs number appears to vindicate President Bush, for now.
In the president's State of the Union Speech of January 2002, he declared the antidote to the then struggling economy was "jobs, jobs, jobs." At the same time, Mr. Bush implored the American consumer to do what he/she does best-consume. Still in the shadow of the Sept. 11 tragedy, the president knew that the key to the economy was (and always will be) the willingness of the consumer to spend. Since consumer spending is historically two thirds of the economy and having been challenged by the terrorists to stay home, the president saw the opportunity to make spending almost a patriotic duty.
Encouraged by 50-year lows in financing costs, the American consumer went out and did battle in the shopping malls, car dealers, restaurants, and housing markets. We eventually rang up an 8.3% GDP in the third quarter of last year fueled by a record refinancing wave and the tax cuts. It's my belief that since 2001 the economy is enjoying its finest moment from July 1, 2003 to June 30, 2004. While the Fed may indeed feel the need to raise Fed Funds in August or September, by the beginning of 2005 we may see a marked slowdown in the domestic economy again. Here's why.
Jobs, Jobs, Jobs
Are companies really hiring on a sustained basis to re-employ the 3.5 million people who lost jobs since the fall of 2001? We are too early in the game to call this a job adding (not jobless) recovery. We will need to see months of sustained job growth like we saw in March to believe the employment picture is better. Also, and unfortunately, there is growing evidence that the people who are finding employment are earning wages significantly less than their previous job. We may hear more about this new calamity of the middle class called underemployed.
American corporations are reluctant to add back to payrolls for some very logical reasons. Foremost is that with all the improvement to productivity, they simply don't need as many employees as before to deliver the same amount of goods or services. Since employee costs (including medical coverage) are the highest expense a company has, a company will naturally be slow to add back. This is especially true since most industries are still highly competitive leaving companies with little pricing power.
Why do you think there is still so much consolidation going on in industries such as banking, credit unions, and department stores? The best example may be the mortgage lending business, where, due in part to technology advances, the Top 100 mortgage originators now underwrite 83% of all mortgages in America.
Some will argue that if spending by the consumer continues at it's pace since last July, companies will be forced to add employees. Perhaps, but the American consumer has been spending and borrowing at break-neck pace since December of 2001 and may be running out of gas (credit).
Consumer Debt
Loan growth in the credit union movement has been above 13% since 1999 making me wonder why anyone would think there is pent-up demand among consumers (for comparison, coming out of the recession of the late 80s and early 90s, loan growth was 4.9% to 9%). Indeed, the consumer has been spending. Unlike previous refinancing booms, the homeowner has been adding debt, not paying down debt. Since 1996, home equity lines of credit (HELOCS) have more than tripled at banks and more than doubled at credit unions. At the same time, consumer credit in total has doubled since 1994 (source is Bloomberg and call reports from FDIC and NCUA).
The result is that, according to the Bureau of Labor Statistics the average household in America today has expenditures and debt equal to 101.5% of disposable income.
The scary aspect of this record run-up of debt isn't just the resulting level of debt. It's that the acceleration of debt has occurred when corporations have been downsizing 3.5-million people out of jobs and the sheer scale of the escalation in a relatively short time frame. Worth repeating, total consumer debt has doubled in the last 10 years.
We've become a finance-based economy.
Trouble Brewing?
An economy based on debt could run into trouble sustaining itself when rates go up because a lot of the debt is adjustable. Most HELOC borrowings are adjustable, for example. In fact, 29% of the mortgages written in 2003 were adjustable. Rising rates will take the consumer out of the game, hinder corporate hiring and borrowing, and send the stock market back into a bearish posture. Of course, if the quality of the debt is sound, not to worry.
Therein, lies the problem.
A new study by J.D. Power & Associates says that 38% of new car buyers are upside down on their trade-ins, up from 25% in 2001. The average buyer with an upside down loan was $3,763 in the red. The new purchase financing rolls in the balance owed. This, along with no interest loans for mortgages, makes me wonder what the quality of the debt is like in America today.
According to CNW Marketing Research, lenders have been lowering their credit scoring requirements. A decade ago, captive and independent lenders required FICO scores of 743 for new car buyers. Today, Art Spinella president of CNW says the independents require 735 and the captives require 698. "If people had to have the same credit rating today as in 1985, we'd lose 2.5 million buyers." The underwriting standard of a mortgage not exceeding 28% of your monthly gross income and total expenses plus mortgage payment not exceeding 38% of your monthly gross income is no longer the standard, but rather 35% and 45%, respectively. This new underwriting standard has enabled consumers, in a lower rate environment, to borrow more money on a highly valued housing market.
Accordingly, the borrower who may not qualify for a conventional fixed rate loan with the newer underwriting standard are being offered and vying for adjustable rate mortgages in order to get into a home. The inherent dangers in this scenario are twofold, one is the ability of the borrower to service debt in a rising interest rate environment and secondarily, the ability of the borrower, if necessary, to find gainful employment in a jobless recovery (additional credit risk).
The Next Six To Eight Months
The next six to eight months should prove interesting to all of us. In the meantime, CU's are advised to carefully monitor credit scoring and particularly scoring related to all the indirect lending that is being conducted. A lender doesn't want to get stuck with an inordinate amount of debt calculated using lower standards, in a time when higher standards might be more appropriate.
From a marketing perspective, sales and advertising campaigns with CU's should emphasize the culture of caring for the member and fiscal responsibility, which we believe could resonate quite well with the public. Given the backdrop of the go-go 90s and the mountain of debt generated in the last 10 years, we believe CU culture can be leveraged as a beacon to the millions of potential members who still don't know what a credit union is.
Peter Duffy is senior vice president with Keefe, Bruyette & Woods, Inc., New York.The comments and opinions expressed here are those of Mr. Duffy, and may or may not represent those of KBW as a whole. Mr. Duffy can be contacted at pduffy
