Debt-Fueled Consumer Running on Fumes

Long-term trends may be undermining the consumer's ability to keep on spending.
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Research released this week by the Federal Reserve Bank of New York puts in stark terms just how far consumers extended themselves to keep the American economy afloat over the past few years.

The data, rather than rising energy prices, may help explain why consumer spending has weakened over the past few months.

Wal-Mart

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this week said its August sales would be flat to up 2% from last year, and the trade group International Council of Shopping Centers cut its industrywide forecast for the month to a 2.5% gain from the 3% to 4% rise previously expected.

Some have put the blame on high oil prices, but energy may not be the full story. After all, in the summer, most consumers are buying gasoline, not heating oil. And gas prices are lower than they were in the spring. The average price of a gallon of gas across the U.S. was $1.88 this week, down from over $2 a gallon in May.

The real answer may be in the spending and borrowing reports that the government issues. During the 2001 recession, consumers actually increased spending by 4.2% as businesses cut back by 8.4%. That was in sharp contrast to an average 1% drop in consumer spending during the previous three downturns, according to a

paper by New York Fed economist Charles Steindel.

Consumers kept up the pace in the first year of expansion coming out of the recession by increasing spending another 2.5%, Steindel found. At the same time, the median household income fell over those two years by about 3% after adjusting for inflation, according to the Census Bureau.

So how did Mom and Pop keep buying while big business was going into hibernation? One word: Leverage.

Total consumer indebtedness rose 8% in 2001 to $1.8 trillion, including a 6.6% jump in revolving debt such as credit cards and a 9% increase in nonrevolving debt such as home mortgages, according to earlier reports by the

Fed

. Total consumer debt rose another 4.1% in 2002 and 4.3% in 2003. So far in the first half of 2004, it was up another 2.6% to a record $2.04 trillion.

Historically low interest rates and rising home values helped many Americans generate cash by refinancing mortgages. But many others borrowed against their growing equity nest eggs by either taking out bigger mortgages or using home equity lines of credit. Refinancing activity totaled $1.3 trillion in 2001 and $1.8 trillion in 2002, according to the Mortgage Bankers Association.

To some, all that debt signals trouble ahead for the consumer. "The home equity credit phenomenon is a national bubble and it will hang over many households, adding to their monthly debt payments and hurting retail spending," said Richard Hastings, retail analyst at Bernard Sands LLC in New York. Weakness in the past few months of retail sales is a sign that the housing market as a source of borrowing is "finally returning to earth," he added.

The Mortgage Bankers Association said its index of mortgage loan applications dropped 6.3% this week, including an 8% drop in refinancing applications. The refi index is still 11% above its level of four weeks ago, but it remains 16% below where it stood a year ago.

Chad Hudson at David W. Tice & Associates, managers of the

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Prudent Bear fund, is similarly warning that the trend of rising home values bolstering consumer confidence will eventually peter out -- even if he's not sure when.

"Calling the top of the housing market has been even more dangerous than trying to forecast when consumers will retrench," he wrote in a weekly commentary on Wednesday.

The Commerce Department said this week that the median new-home price in July declined almost 3% from June, although it was still up more than 9% from a year earlier.

As disconcerting as the debt numbers may be, the Fed also publishes measures of consumers' monthly debt payments compared to income, which gives a cheerier picture. Trends in the so-called debt-service ratio can help predict future consumer spending according to research done by Boston College professor Robert Murphy in the 1990s.

By that measure, consumers' monthly payments equaled about 13% of their disposable personal income at the end of the first quarter vs. the 11% from 10 years ago, according to the Fed's most recent report. Even if you include property taxes, homeowners' insurance and car-lease payments -- what the Fed calls the financial obligations ratio, or FOR -- the monthly burden is still only 18.1% of income vs. 16.6% in 1994. (The debt ratio stayed in the 12% range from 1995 through 2000 and then increased as high as 13.3% in the fourth quarter of 2001. The more comprehensive FOR peaked at the same time at 18.7%.)

The current reading gives ammunition for those who say the data show no worries for the housing market. "While there may be some justifiable concerns about the potential for home price declines in certain markets, the Fed data on homeowner FORs does not indicate an affordability problem in the aggregate,"

Fannie Mae

(FNM)

chief economist David Berson commented this week.

Another factor influencing current weakness in consumer spending could be the one-time cash advance for tax credits that the Bush administration sent out last summer.

After Congress enacted an increase in the child tax credit to $1,000 per kid from $600, the Treasury mailed out checks of up to $400 per child. Without a similar windfall arriving in their mailboxes this year, consumers may have spent less for back-to-school gear, leading to Wal-Mart's shortfall.

Granted, some retailers seem to be doing fine.

Williams-Sonoma

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said sales increased 19% last quarter. The company increased its revenue estimate for this quarter to as much $735 million, which would represent a 27% gain from last year.

But with the Fed taking away the punch bowl at a measured pace and interest rates rising, the party has to end some time.

In keeping with TSC's editorial policy, Pressman doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send

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