The Uppers

Doug Noland, The Credit Bubble Bulletin, www.prudentbear.com  08/01/08

       ...[I]t is my view that the greatest – as well as least appreciated – Bubble Economy Excesses were at The “Upper-middle” to “Upper-end.” It is in The Upper-ends where years of Credit excess had the most pronounced effects on incomes, household net-worth, spending, and government revenues.
 

The U.S. Bubble Economy has burst. I sympathize with those who would argue this is old news. But the probabilities are now high that GDP turns decisively negative during the second half – if it hasn’t already. Instead of the year-long Credit crisis showing signs of improvement or even stabilization, a further tightening of Credit Availability is taking hold broadly throughout the economy.

The so-called “subprime” crisis has, of late, invaded “prime” and “conventional” mortgages. This is a major additional blow for home prices and the economic support provided from built-up home equity. The securitization markets remain in shambles. Even corporate debt issuance dropped to a 5-year low in July. Meanwhile, the increasingly impaired banking system has sharply curtailed lending virtually across the board – to households; to students; and to businesses both small and large. Bank Credit is basically unchanged over the past nine weeks. And without sufficient Credit creation, the finance-driven U.S. “services” economy is an unmitigated bust. It is my view that this bust has over the past few weeks gained critical – and self-reinforcing – mass.

The subprime mortgage fiasco provides a convenient poster child for this boom’s egregious excesses. I would argue, however, that its role in fueling the boom was much less than presumed. It actually wasn’t a critical source of finance for the overall Bubble Economy. Or, stated differently, the relative brief period of subprime excess was not a major factor in the protracted period of financial excess that spurred imbalances and deep structural economic impairment. Likewise, last year’s subprime bust wasn’t a decisive development for the Bubble Economy generally. Its overall impact on system employment and incomes was not great – its effect on tax receipts only marginal.

I tend to view subprime as chiefly a “lower end” issue with respect to the real economy. And it is my view that the greatest – as well as least appreciated – Bubble Economy Excesses were at The “Upper-middle” to “Upper-end.” It is in The Upper-ends where years of Credit excess had the most pronounced effects on incomes, household net-worth, spending, and government revenues.

It was the at The “Uppers” where loose finance encouraged many to stretch to buy the expensive home, to lease the luxury vehicle, and to finance the upscale lifestyle – Credit creation that then further stoked the overall economy and asset markets. And it was the Uppers that enjoyed spectacular gains in income and financial wealth. It was the momentous changes in Uppers’ spending patterns that spurred enormous real economy investments in a multitude of new businesses and services – a great deal of this spending of the discretionary and luxury variety. It was the Uppers’ windfalls that encouraged state, local and federal governments to rapidly boost spending. These were the inflationary distortions that had a profound impact on the underlying economic structure – over years spurring the transformation to a “services”-based Bubble Economy.

It is my view that The Uppers are now in the process of being hit with rapidly tightening Financial Conditions. This year will see a historic decline in financial sector compensation, led by collapsing Wall Street bonuses and unprecedented layoffs throughout the financial services industry. This week also saw the announcement of major “white collar” job losses at General Motors, an employment trend that I expect to spread throughout the real economy. Many companies and industries must today respond to collapsing profitability (as Financial Conditions tighten and spending patterns and levels adjust), and there will be no alternative than to shrink “Upper-end” employment and compensation.

This week also saw evidence of a significant tightening of Credit Availability for the Uppers. BMW, GM, Ford and Chrysler all announced that major changes in vehicle leasing terms are in the offing – especially for SUVs. BMW apparently has recognized that it is problematic that 60% of its U.S. unit sales have been leases. Surging gas prices and other economic worries have hit used vehicle residual values hard, turning the leasing business into a losing proposition. Leasing terms are now being tightened significantly – a dynamic that will further depress used vehicle prices. It is worth noting that July new vehicle sales were reported at the lowest level since 1992. They will most certainly go lower.

This week also saw higher rates and additional withdrawal from the Jumbo mortgage marketplace. At 7.56%, 30-year fixed jumbo borrowing rates this week were almost 100 bps higher than a year ago. And one can assume that lending standards continue to tighten, with downpayment requirements putting many buyers out of the market for “Upper-end” homes in neighborhoods throughout the country. And keep in mind that, to this point, home prices have actually held up reasonably well in many locations, a dynamic that will likely not withstand a further tightening of Credit in prime jumbo and conventional mortgages. A more broad-based downturn in housing prices will spur a more broad-based decline in spending – especially for discretionary purchases by The Uppers.

This week was also notable for bankruptcy announcements from a few national restaurant and retail chains. Increasingly, the post-boom adjustment in spending patterns is challenging the profitability of scores of businesses. This dynamic is poised to feed on itself, as more business closures and layoffs severely impinge incomes. And what I expect to be rapidly deteriorating business Credit conditions will surely worsen the financial crisis.

For years now, the leveraged speculating community has profited handsomely from taking leveraged positions in higher-yielding business loans. Borrowing from Wall Street was easy, and it was just as easy during the boom to extend Credit to profitable (or at least cash flow positive) businesses. But this dynamic is changing profoundly. With business and economic prospects now deteriorating rapidly, I would expect significant tumult to unfold in the corporate Credit market. And a reversal of speculative flows away from leveraged business lending would be a major blow to both corporate Credit Availability and the vulnerable leveraged speculating community, a dynamic with negative ramifications for the Uppers.

And when it comes to states with huge exposure to Uppers, California and New York sit at the top of the list. Not surprisingly, both states are today in the grips of intense fiscal pressure. And with my expectation that economic prospects are now worsening by the week, it is not at all clear how California, New York and other states will deal with ballooning deficits. Drastic spending cuts and tax increases are inevitable to get budgets back somewhat in line with post-boom receipts. And this will prove one more problematic dynamic for the bursting U.S. Bubble Economy.