The emotional strain of debt is showing up in large numbers:

Source:  MSNBC

I think when we see surveys like this, some will tend to underestimate the amount of debt carried by each household.  For example, not everyone has a mortgage and by far mortgage debt is the largest line item for consumer debt.  We know that in the U.S. 51 million mortgages are outstanding.  The latest Federal Reserve flow of funds shows mortgage debt at over $10.2 trillion.  So run these numbers:

$10.2 trillion / 51 million mortgages = average mortgage debt of $200,000

Now the interesting thing is the median home price across the U.S. is slightly above $170,000.  With that said, recent housing surveys have found that one-third of all these mortgages are attached to homes that are worth less than the actual mortgage.  They are underwater.  It is clear that the average American would feel incredible amounts of stress if they were living in a home that had fallen in value so much, that the attached debt was larger than the market sale price of the home.  And most Americans that have a home have a generally good sense of what their home is worth.  Many of course have their optimistic “dream” price but many deep down have a better sense of the real price.  This is probably derived from recent home sales and other comparable properties in the area.

If we want to break down household debt, this is what we get:

The grand total of mortgage, credit card, student loans, and auto loan debt is a stunning $13.5 trillion.  The tipping point came when total household debt aligned itself with the annual GDP of the United States.  And this number seems to be reflected in the average income data.  The typical household takes in approximately $52,000 per year and this is much lower than the $120,000 of debt each household would be responsible if we were to divide the debt share up today.  What does this number tell us?  We have spent far more than we earn and we earn at a level that is near the top globally.

I was fascinated that the survey was split nearly down the middle in terms of debt related stress.  You have half of U.S. households worried about debt while another half seems to be comfortable with their debt.  There are many households with no mortgage or that rent.  You have others that pay off their credit card balance off each month.  Others have paid off cars and no auto debt.  What appears to happen with some American families is that they have a penchant for taking on inordinate amounts of debt.  Confusing access to debt with wealth was also a large epidemic.

In California during the peak days of the housing bubble, a colleague was talking about how they refinanced out $100,000 from their home.  This money was used for a lavish vacation and other “toys” that filled up their garage.  When we talked, the perception was that the $100,000 home equity loan was actual free money.  They failed to make the connection that the $100,000 would have to be paid off at a certain point.  And many went down this road as evidenced by mortgage equity withdrawals:

Source: Calculated Risk

The great hoax was creating an atmosphere that made people believe that this money was actually free.  I remember seeing many letters that had an actual check attached with the sum of $50,000 or higher as if it were a novelty gag.  All you needed to do was sign and cash the check at a local bank.  It really had the symptoms of a once in a generation mania.  The perspective from Wall Street and banks was that there would always be someone willing to pay a higher more inflated price and willing to take on more debt to make the purchase happen.  Around 2006 many insiders started getting out slowly while talking up to the public that all this wild debt was somehow sustainable.

Now as a county we have always been comfortable with mortgage debt.  In fact, a 30 year fixed mortgage with a decent down payment was the bread and butter of our economy for decades.  Consumer debt on the other hand is really an astonishing concept.  Think of credit cards.  You are allowed to spend money you don’t have.  Would you allow someone, completely unsecured, to spend your money on the promise they will pay you back?  Maybe and this is largely how the system has been built.  Banks have given Americans $850 billion in credit card debt.  Some can pay it back but with the current recession, many cannot.  We can see the purge going on in this sector rather clearly:

Since the peak in 2008 of $975 billion in revolving debt, $123 billion in credit card debt has been purged.  Much of this has come through bankruptcies and write-offs as banks deal with poor performing loans.  Ironically when Wall Street in 2007 and 2008 asked for trillions in U.S. taxpayer dollars, it was under the implicit notion that it was to keep the lending channels alive.  Look at the above chart and you can clearly see that this is not the case.  Credit card offers have dwindled to a trickle and credit lines have been slashed on even good standing customers.

I found this interesting article dated 1986 when interest rates were relatively high:

“(LA Times) Charles Newcomer, spokesman for General Motors Acceptance Corp., General Motors’ auto-finance subsidiary, said, “All the traditional assumptions about the auto-finance market are not necessarily true today.” He noted that just as home buyers are increasingly picking 15-year mortgages over 30-year loans-despite the fact that shorter maturities require larger monthly payments-some customers are also asking for shorter-term auto loans, possibly reversing the trend of recent years toward longer terms.”

It is amazing that today, many dealers offer 72 month financing.  Just like housing, Americans have taken on too much debt to finance auto purchases.  It seems that we reached a point where we simply could not expand terms and pile on more and more debt.  This is a debt purge that is likely to take a decade or even longer.

The current flushing out of debt is coming through many different avenues.  Foreclosures are one large way of flushing out debt.  Bankruptcy is another.  And these have been at elevated levels going on for a few years now.  It is hard to say where the balance will occur.  If the economy picks up and picks up quickly, then many Americans will be able to service their debt again.  Yet all market indicators have shown that a real debt purge is occurring and is likely to continue for years to come.

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“(Prison Planet) A new advisory being sent by America’s third largest bank to its account holders has stoked fears that major financial institutions could be preparing for old fashioned bank runs if the economy takes a turn for the worse.

Originally reported by John Carney over at the Business Insider website, Citigroup is sending the following information to customers along with their bank statements.

“Effective April 1, 2010, we reserve the right to require (7) days advance notice before permitting a withdrawal from all checking accounts. While we do not currently exercise this right and have not exercised it in the past, we are required by law to notify you of this change.”

In other words, let us assume many clients decide to withdraw all their funds in a short period of time because people suddenly realize that $250,000 is actually being supported by pure faith.  In addition, average Americans realize that -$20.8 billion will certainly not cover $5.3 trillion in actual deposits that can be redeemed at any given time!  That is the psychology of our current banking system.  As long as people believe the wizard behind the curtain can back up the deposits then all is fine.  This worked as long as assets actually had values that banks claimed were true.  We know that game is over.  In fact, that is why the entire banking system has received roughly $13 trillion in bailouts and backstops.  It really is this fragile.  This is how the deposit insurance fund looks like:

Source:  FDIC

So you would think that people would at least try to diversify their investments since even a minor bank run would cause major damage.  But instead, people have increased their deposits at these banks at a rapid pace:

And I can’t blame them.  What choice is there?  Gamble in the Wall Street rigged casino or put it in the bank.  If we go back to December of 2007 when the crisis started, DIF-Insured deposits have shot up by $1.1 trillion and the actual fund has gone negative because of all the additional bank failures.  This psychology really does remind me of the mania surrounding the housing bubble boom. What if, hypothetically, people decide that one of the too big to fail is suddenly not that big at all, and Americans start withdrawing funds to some other institution.  Worse yet, they take their funds out and put them in a non-DIF insured institution.  Then what?  Or maybe people want the actual cash.  This is what is so troubling.  Just go to any local store and see how much actual cash is being exchanged.  It is all electronic debits and credits.  Insured to $250,000?  On what?  Clearly the U.S. Treasury would step in at this point and flat out start printing money but what use would that be since the dollars you are being paid with would quickly devalue (even more).

I’ve seen a few people dismiss the current negative DIF fund by saying “the FDIC is flush with cash.”  Really?  Let us examine that part of the equation.  From the latest FDIC quarterly bank report:

“In June 2008, before the number of bank and thrift failures began to rise significantly, total assets held by the DIF were approximately $56 billion and consisted almost entirely of cash and marketable securities (i.e. liquid assets). As the crisis has unfolded, liquid assets of the DIF have been to protect depositors of failed institutions and were exchanged for less liquid claims against assets of failed institutions. As of September 30, 2009, although total assets had increased to almost $63 billion, cash and marketable securities had fallen to approximately $23 billion.”

Did you get that?  The FDIC “cash” went from roughly $56 billion in June of 2008 to $23 billion in September of 2009.  And supposedly, they now have “assets” of $63 billion but how much of this is crap mortgages from failed banks like WaMu and IndyMac?  In reality, the FDIC at this point only had $23 billion to back up $5.3 trillion.  But in December of 2009 the FDIC took the radical step to front-load prepaid assessments:

“To provide the FDIC with the funds needed to carry on with the task of resolving failed institutions in 2010 and beyond, but without accelerating the impact of assessments on the industry’s earnings and capital, the FDIC approved a measure to require insured institutions to prepay 13 quarters worth of deposit insurance premiums. These prepayments—about $46 billion—were collected on December 30, 2009. Cash and marketable securities stood at $66 billion on December 31, 2009.”

Now don’t you feel better?  The FDIC took in 13 quarters of prepaid deposit insurance premiums and we now have a combined total of cash and marketable securities of $66 billion.  In other words, one too big to fail going down and good luck with that $250,000 backup really being worth what you would actually think.  This is what surprises me here.  We all know things are actually getting worse with the banking system yet we keep piling on the risk.  In fact, the FDIC has even upped the number of troubled banks on their list:

You know if the FDIC is saying 702 we know it is much higher.  I still stand by my prediction that this crisis will bring down at least 1,000 banks when all is said and done.  I love how the FDIC lists “assisted institutions” as 8 with total assets of nearly $2 trillion.  I wonder who those could be?

The bottom line is, we are playing a very big game of confidence here.  Gallup just ran a poll showing that 19.9 percent of Americans are underemployed.  That number is getting really close to the 25 percent rate of the Great Depression but with part-time employment.  That does a number on the psyche of average Americans.

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I think most Americans have noticed new methods of austerity all around them.  For example, I’m sure many of you have seen the Wal-Mart ad that talks about taking lunch to work.  They even break down the numbers to show you how much your budget will save by doing this.  Contrast that ad with this one below talking about taking a home equity loan while having a couple in a speed boat cruising in the background:

Source:  YouTube uploaded on June, 2007

When you contrast the two messages, one of easy money and endless excess and the new ads talking about brown bagging your lunch to work, we realize that average Americans are finding it much harder to saddle on more debt.  Some might try to recall the last decade as a wonderful time but the economic data shows otherwise.  Much of the spending and consumerism was built around easy access to debt.  People weren’t buying new automobiles with cash, they were financing it with 5 or even 7 year loans.  Want a new surround sound system but are low on cash?  No problem, just take on an extra credit card and charge it up.  Now, the ads highlight a very different economic climate.

I stopped by a local dollar store to pick up some items for the house and noticed that first, the parking lot was full.  A few years ago the parking lot was two-thirds empty.  This trend has been going on for about two years since the recession hit.  After entering the store I noticed that people for the most part were buying groceries.  Now this area is one that I wouldn’t consider poor but more along the lines of middle class.  Yet this is the new reality for the middle class.  There is no sharper contrast than seeing a women load her leased Mercedes full of dollar store groceries.  Austerity doesn’t happen overnight.

On Monday we received news that some of the most egregious practices from credit card companies will need to change now that legislation is in effect.  Yet credit card companies have already adapted by hiking up rates, charging annual fees on good customers, and other methods of front loading earning before the law came into effect.  So Americans who have relied so heavily on credit cards will now have to be extremely cautious when using these items of consumption.  Even the tried rule of paying off your balance every month may not save you from the annual fee that some companies are now imposing.

Casinos Lose Money for Second Time in History

In another clear example of changing habits of the American middle class, Casinos in Nevada lost money last year for only the second time in history:

“(Las Vegas Sun) CARSON CITY – For only the second time, Nevada casinos posted a loss – but this time it was the biggest.

The state Gaming Control Board today released its “Gaming Abstract” for fiscal year 2009, which ended June 30, showing a net loss of $6.7 billion among the 260 major casinos in Nevada.

Clubs along the Las Vegas Strip, which makes up 53 percent of the gambling revenue in Nevada, registered a $4.1 billion loss. The only bright spot, from a financial standpoint, was that people drank more. Sales of booze rose by 2.5 percent while revenue tied to casinos, rooms and food dropped. But 36 percent were recorded as “comp” drinks.

“It was a horrendous year,” said Bill Bible, president of the Nevada Resort Association, which represents several casinos on the Strip. He said many of the casinos had three and four waves of layoffs to cut cost during this national recession.”

I find it really telling that the only “bright spot” was that people drank more booze.  Self medication for the realities of the new economy.  Gambling whether it is in Las Vegas or through lottery tickets is a form of escapism.  I think many people in places like Las Vegas go to strike it big.  The irony of how the city has morphed is a large part of their revenues now come from other sources outside of gaming.  These include boutique stores and high end restaurants.  I was in Vegas only a few months ago and strolled down some of the shops and the higher end stores were very empty.  A few years back, these places were bustling with people.  It is a microcosm of the new austerity in our country.  Contrast the $100 t-shirts versus the Wal-Mart ad highlighting the benefits of taking your lunch to work at the cost of a few dollars per day.  Things are shifting out of a practical necessity.

And this isn’t simply a function of discretionary spending like trips and gambling.  Even in more practical aspects of daily life this is changing and evolving.

Fast-food Breakfast Slumps with Fewer Workers

You know things are tough when even low cost fast food is taking a hit:

“(WaPo) The nation’s high unemployment rate has thrown millions of people out of work, scared shoppers away from stores and threatened the economic recovery. Now it’s taking a bite out of breakfast.

Breakfast sales had grown at a ravenous pace during the boom years as busy workers scarfed down sausage biscuits on the way to the office, fueling a $57 billion business and accounting for as much as a quarter of sales at some fast-food chains. Chains opened earlier and expanded their morning menus to accommodate the traffic as lunch and dinner sales flatlined.

But as the jobless rate hit 26-year highs fewer people headed to work, and even those who did worried about their spending. So they poured bowls of cereal at home or simply slept in, putting breakfast on the back burner.

“Typically, if you’re unemployed, you’re not getting up at six and not going through the drive-thru,” said Jeffrey Bernstein, an analyst at Barclays Capital. “There is a direct correlation between unemployment and breakfast sales.”

It is hard to even comprehend that breakfast sales accounted for $57 billion in revenue.  However, with more people out of work many are skipping breakfast or eating at home.  On my early morning drives I will always see cars pulling up to McDonalds or Starbucks for that early morning purchase.  The lines seemed a lot shorter and looking at the data it is part of the new frugality that Americans are having to deal with:

Source:  Washington Post

And this recession is shaping how people view their future and what they expect out of it:

“(New York Times) See that,” she said, spotting a man dressed as the Statue of Liberty. Standing on a sidewalk, he waved at passing cars with a sign advertising a tax preparation business. “That will be me next week. Do you think this guy ever thought he’d be doing this?”

And yet, she would gladly do this. She would do nearly anything.

“There are no bad jobs now,” she says. “Any job is a good job.”

That person dressed up as the Statue of Liberty is a very common vision especially with tax season here.  2010 is a very different world from 2007.  I wonder what lady liberty would think about how we are spending our tax dollars in bailing out banks while average Americans are forced to tighten their belts?

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Many Americans are still struggling at the depths of this recession.  We have 37 million Americans on food stamps and many wait until midnight of the last day of the month so checks can clear to buy food at Wal-Mart.  Do you think these people are starring at the stock market?  The overall data is much worse:

Source:  William Domhoff

If we break the data down further we will find that 93 percent of all financial wealth is controlled by the top 10 percent of the country.  That is why these people are cheering their one cent share increase while layoffs keep on improving the bottom line.  But what bottom line are we talking about here?  The Wall Street crowd would like you to believe that all is now good that the stock market has rallied 60+ percent.  Of course they are happy because they control most of this wealth.  Yet the typical American still has negative views on the economy because they actually have to work to earn a living:

The above daily poll asks Americans about their view on the health of the economy.  Only 13 percent believe the economy is good or excellent.  Funny how that correlates with the top 10 percent who control 93 percent of wealth.  Many Americans were sold the illusion of the bubble.  They were sold on the idea that their homes were worth so much more than they really were.  And many used this phony wealth effect to go out and spend beyond their means.  They started spending as if they were part of this elite 10 percent crowd.  But once the tide rolled out, it was clear they were not.  And the horribly built bailouts demonstrate who is controlling our political system.  This was not the rule of a capitalist system but a corporate run government.

Just think about the bailouts and which companies were saved.  We ended up bailing out the worst performing and troubled companies thus keeping alive companies that should have completely failed.  Did we bail out Google?  Proctor and Gamble?  Of course not.  These companies actually produce something that people want.  Banks and especially the Wall Street kind merely keep that 42 percent happy by making sure their stock values stay high so they can keep on making money while the average Americans is sold up the river.

Yet many were brought into the easy money fold by going into massive amounts of debt.  And who has most of the debt?  That is right, the average American:

The bottom 90 percent have been saddled with 73 percent of all debt.  In other words much of their so-called wealth is connected to debt.  Debt is slavery for many especially with egregious credit card companies taking people out with absurd credit card tricks and scams.  Yet the corporate propaganda machine is strong and mighty.  Have you ever received an inheritance?  A large one?  Probably not because only 1.6% of all Americans receive an inheritance larger than $100,000.  If this is the case, why in the world do politicians worry so much about the tax impacts of this?  Because they want to keep the corporatocracy alive and well so their spawn can get a piece of their pie.  They give the illusion to average Americans that if you only work hard enough you too can join this elusive club of cronies.  The data shows otherwise.

But if we start looking at investment assets, the true wealth in the country, we start realizing why Wall Street is all giddy about the recent stock market government induced rally:

Of investment assets 90 percent of Americans own 12.2 percent.  The rest goes to the top 10 percent.  Welcome to the new serfdom.  The bailouts that went out to the filthy rich were more about protecting their tiny corner of the world than actually making the economy better.  That is why it is interesting to see companies fire people and Wall Street cheer for the increase in earnings per share.  Good for the few at the expense of the many.  Yet the propaganda out of Wall Street and our government is what is good for Wall Street is good for you.  Just like that 1.6% inheritance issue, the vast majority of Americans won’t deal with that and their primary concern is simply a job.  A job that has provided stagnant wages for a decade while the ultra wealth get richer and richer in a phony form of corporate socialism.

If you break down the data you realize that most Americans don’t have time to speculate in stock markets:

Only 34% of U.S. households make more than $65,000 per year.  What is that after taxes?  Let us use a state like California for example:

Now if we breakdown this data further you will realize that most of the money is consumed by cost of living necessities, not Wall Street speculation.  Just to show this example let us look at a family budget for someone in California making $100,000:

Notice after running the budget we are in the hole for $1,000?  That is because of many costs that typical families have.  We can debate the merits of where they are spending money but the point is this; are these people really making beaucoup money from the stock market?  They are putting away $12,000 a year into their 401k.  As we have now found out, 8 percent a year is never guaranteed in the stock market although the corporate powers would like you to believe that so they can have other suckers to unload stocks onto.

“Yet the median household income in the U.S. is $50,000 and not $100,000.  They have even less to invest.”

They are more concerned on working to have a paycheck to pay for necessities.  They are more concerned about paying their house off by the time they retire and hopefully, have a little bit of retirement funds coming in.  The sad fact is most Americans rely on Social Security when they retire.  All those ads of unlimited golf and daily trips to Tahiti are propaganda of how Wall Street lives and they want to sell you the sizzle, and clearly not the steak.  They live their lives paper pushing and sucking the life out of the productive part of our economy.  The average American should now realize this since this financial crisis was primarily caused by them.  They are now on a massive campaign to blame Americans for this.  This is hypocrisy to the next level.  Many Americans have paid for their mistake by losing their home through foreclosure.  We have 300,000 foreclosure filings a month.  Many have taken a hit to their overall stock portfolio (if they have one).  Yet the corporate cronies have protected their horrible economy crushing debts at the taxpayer expense.  Unlike you, many hold bonds on the companies and not common stock like many Americans.  Bondholders have been protected at all costs during this crisis.  Goldman Sachs through AIG received 100 cents on the dollar for their horrible bets.  The banks have unlimited back stops thanks to taxpayers.  This is how the top 1 percent rule the new feudal state.

Welcome to the 2010 serfdom.  Time to wake up and restructure the system.  Many people are starting to wake up to this massive scam.

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A strategic default occurs when a homeowner stops paying their mortgage even though they are still financially able to do so.  A recent study shows why this problem will impact mega-housing bubble states like California more than other states.  You will also find that many people that walkaway from these products have stellar credit scores.  So why would someone strategically decide to leave their mortgage?  The reasons are many but first let us look at the distribution of late Alt-A loans in the country:

Now why focus on Alt-A loans?  Under this category of loans we will find most Interest Only and option ARM products.  These are loans most at risk for a strategic default.  In many cases for example option ARM loans were given to people with good credit but simply did not have the income to back up the purchase of a home.  In these situations you would see a family with good credit and a household income of $100,000 taking on a $700,000 mortgage in California.  With a teaser payment, the family could pull this off.  But when the recast of the payment occurs the family will default especially given the crash in housing values in California.

Let us examine a few reasons why and how people strategically default.  A recent study may surprise you.  This study examined 24 million credit files and gives us a good view of the overall situation:

“The number of strategic defaults is far beyond most industry estimates — 588,000 nationwide during 2008, more than double the total in 2007. They represented 18% of all serious delinquencies that extended for more than 60 days in last year’s fourth quarter.”

This number is enormous and we can expect this number to rise.  Why?  Many of the interest only and option ARM products will start hitting recast dates in 2010 to 2012 that will severely impact borrower’s monthly payment.  Many of these loans are far below the current loan modification program caps of being underwater at a ratio of 125 percent or higher.  In some case, some of these loans have 150 to 200 percent LTV ratios.  That is, someone might have a $600,000 mortgage on a home worth $300,000.

“Strategic defaulters often go straight from perfect payment histories to no mortgage payments at all. This is in stark contrast with most financially distressed borrowers, who try to keep paying on their mortgage even after they’ve fallen behind on other accounts.”

This is probably one of those shocking statistics.  How can someone with a perfect credit history go from on time borrower to a strategic default?  The answer is simple.  For the average American their housing payment, either rent or mortgage, is the biggest line item on their budget.  Increase that payment by 50, 60, or even 70 percent and you have a default waiting to happen.  Housing makes up 34 percent of consumer expenditures:

In areas like California however, this category is much bigger.  That is why this issue of strategic defaults is more concentrated to states like California and Florida that have the bulk of these Alt-A loans.  588,000 may sound high but it will only get higher in the next few years.

“Strategic defaults are heavily concentrated in negative-equity markets where home values zoomed during the boom and have cratered since 2006. In California last year, the number of strategic defaults was 68 times higher than it was in 2005. In Florida it was 46 times higher. In most other parts of the country, defaults were about nine times higher in 2008 than in 2005.”

It is rather clear how unequal this will impact the U.S.  The strategic default seems to be an issue of housing bubble states.  And you can put yourself in the shoes of someone who bought a home at the peak.  Say you and your spouse bought a home in a bubble market for $500,000.  Deep down, both of you felt that housing would never go down.  This view was widespread.  You saw for nearly 5 years homes appreciate by 10, 15, and 20 percent per year.  At the very worst, you would be able to sell your home for $600,000 or $700,000 in a few years when your loan recast.  Well your home is now worth $250,000.  It may never regain that peak value.  Your payment will jump from $1,500 to $3,000.  You can rent a similar place for $1,300.  What do you do?  Many are simply electing to walkaway.  In a state like California with 12.2 percent unemployment this decision might be made also by necessity.  Sure, they can make the payment but how much of their budget is it eating up?

“Homeowners with large mortgage balances generally are more likely to pull the plug than those with lower balances. Similarly, people with credit ratings in the two highest categories measured by VantageScore — a joint scoring venture created by Experian and the two other national credit bureaus, Equifax and TransUnion — are far more likely to default strategically than people in lower score categories.”

Now this is simply more fuel to believe that those who strategically default will occur unequally in states like California and Florida.  These states saw the biggest housing bubbles and also took on most of these exotic mortgages.  If you don’t believe this?  Just take a look at this article:

$30 billion home loan time bomb set for 2010
“(SF Chronicle) Thousands of Bay Area homes have a ticking time bomb embedded in their mortgage. The homes were purchased with loans known as option ARMs, short for adjustable rate mortgages.

Next year, many option ARM payments will begin to readjust, slamming borrowers with dramatically higher monthly mortgage bills. Analysts say that could unleash the next big wave of foreclosures – and home-loan data show that the risky loans were heavily used in the Bay Area.

From 2004 to 2008, “one in five people who took out a mortgage loan (for both purchases and refinancing) in the San Francisco metropolitan region (San Francisco, Alameda, Contra Costa, Marin and San Mateo counties) got an option ARM,” said Bob Visini, senior director of marketing in San Francisco at First American CoreLogic, a mortgage research firm. “That’s more than twice the national average.

“People think option ARMs (will be) a national crisis,” he said. “That’s not really true. It’s just in higher-cost areas like California where you see their prevalence.”

And here is an example of an area that depended on decent credit scores to dish out toxic mortgages like option ARMs.  Now you might be asking why are so many loans gathered in certain areas?  Well these areas had a collective bubble psychology where people had very little qualms taking out $500,000 or $600,000 mortgages:

“First American shows more than 54,000 option ARMs issued here with a value of about $30.9 billion. Fitch shows more than 47,000 option ARMs here with a value of about $28 billion. Both say their data underestimate the totals.

Why are so many option ARMs clustered here?

“In markets where home prices were going up rapidly, more and more borrowers needed a product like this to afford something,” said Alla Sirotic, senior director at Fitch Ratings. Option ARMs were designed for savvy real estate investors and people whose income fluctuates, such as those paid on commission. Instead, the loans became a tool for regular people to “stretch” to buy homes that were beyond their means.”

I tend to disagree that borrowers “needed” a special mortgage to afford housing.  This is like saying people needed cows during tulip mania to buy tulips.  These products were merely creations of the housing bubble.  They only serve a purpose in a rapid rising housing market.  They gave the biggest incentives to mortgage brokers and Wall Street.  These loans are a mess.  Take a look at an example that highlights all of the above:

“Joey Amacker of Newark, who works as an account manager for a catering company, refinanced his home with an option ARM for $624,000 so he could pull out money to build an addition. The friend who sold him the loan assured him that an option ARM was a safe and affordable product, he said.

Amacker said he initially made only the minimum monthly payment of $1,800, which covered part of his interest and none of the principal. The amount he owed grew to $660,000 by November 2008, according to loan documents…

Between the negative amortization and his missed payment and penalties, Amacker’s total debt has ballooned to $725,000, while the house is probably worth about $500,000, he said.

“I feel so ashamed of how I could have gotten myself in such a bad situation,” he said.

Like Amacker, most option ARM borrowers owe much more than their homes are worth, so they cannot refinance their way out of trouble.”

This is a perfect example of the environment for strategic defaults.  The borrower took out a $624,000 mortgage that had a minimum payment of $1,800.  The payment reflects a mortgage of $200,000 and not $624,000.  However, with negative amortization the loan is now at $725,000 on a home that is probably worth $500,000.  The payment will likely be higher than $4,000 once recast hits.  Take a wild guess what will happen then?

Strategic defaults will be a major problem in 2010 but only for states in major bubbles.  California and Florida need to gear up for this because it will be happening.

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In a recent survey by Gallup, they found that 48 percent of Americans making $60,000 or less would be unable to make a big purchase if they had to:

Why this is important is that 50 percent of our U.S households make $50,000 or less.  When you see data like this you can understand the motivation for massive incentives like cash for clunkers.  But interestingly enough, many when asked if they have enough money to buy the things they need many stated that they did:

This data somewhat goes in the face of the other chart but part of this is due to the new austerity.  In times like this, a want and a need are very different things.  I am sure that many Americans are finding a new found respect for their jobs in light of the 26 million unemployed and underemployed Americans.  Many now realizing they have to depend on their own savings and not credit, are starting to sock some money away:

The simplicity here is that with more saving, Americans are also spending less which the above graph highlights.  Retail sales have fallen off a cliff.  Although things might be stabilizing, the halcyon days of the bubble are long gone.  There must be a new normal.  And those who are out of work are finding it harder to land a new job:

This is one of the more difficult things of this recession.  Companies are not hiring in large numbers.  Even as the amount of layoffs tapers, company hiring remains at record lows.  The long-term unemployed are a significant part of the population.  Many of these people are doing very little consumption.  And personal income has fallen at the fast pace in record keeping history:

When we look at data like this, it is easy to understand why Americans depended so much on the credit bubble to make things appear as they once did.  It was only a matter of time before the piper would be paid.  With that, personal consumption expenditures have declined drastically:

Even with all the bailouts, the average American employee is finding it harder and harder to go back to how things were.  And that is probably one problem with our current lull.  The assumption is that it is only a matter of months before we are back to “normal” spending.  If you look at the above charts, those days are long gone.  Many baby boomers are entering retirement and they are trading security over spending.  Given the wild casino like movements in the S&P 500, stability might be a sought after commodity.  The American consumer is altered for a generation thanks to a decade of easy money and debt induced spending.  Many are realizing that 1 plasma TV is just as good as 3.  A new normal will emerge from this crisis.

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First, let us look at this insanity on a chart:

Source:  Chart of the Day

I think when people see charts like this they start doubting the source.  This unfortunately is accurate.  Even during the Great Depression, when the market plunged to the depths, the PE ratio never even touched 20 and some of the many mini-rallies after the crash of 1929 involved legitimate looks at low PE ratios.  A PE ratio is important because it factors in the price of a stock to the actual earnings.  This matters.  Even right before the tech bubble burst in 2000 the S&P 500 had a PE ratio over 40 and this was extremely expensive.  In this case, we have 26,000,000 Americans unemployed or underemployed and earnings are simply not there with consumers pulling back.  So what is causing this massive rally if not earnings?  This recent rally is being driven by the “getting less worse” mentality.  Sure, we lost 247,000 official jobs last month but sure beats 700,000!  Okay, earnings are way low but it beats actually losing money!  This kind of thinking is leading many sheep to the slaughter again.

Take a look at some of the official data from S&P itself:

Source:  S&P

At the end of last month, only three weeks ago the S&P 500 data had the PE ratio at 143.  So to currently have it at 129 is a slight improvement.  But with only 3 percent of companies reporting to close out the quarter, we are massively over priced.  We have never seen the entire index suffer a negative earnings quarter that is until recently.  So the crash wasn’t a panic but actually based on declining earnings.  That quarter saw $202 billion in negative earnings (losses) from S&P 500 companies reporting.  Q1 of 2009 saw reported earnings come in at $7.52 per share.  So right now, everything looks good when looking from the ground up.

Yet to show you how off predictions have been and how wrong analyst can have earnings, let us look at the Q3 2009 estimates and how they have evolved over one year:

Now this chart is something.  Back in June of last year, the Q3 2009 estimate was coming in at $27.68.  Keep in mind we were already in recession at that point.  In September of 2008, the EPS didn’t change much for analysts.  After the market crashed and the U.S. Treasury and Federal Reserve had to step in to save the financial world supposedly, they finally revised earnings lower.  The market went lower and lower and now, the latest estimate for Q3 of 2009 earnings is $14.57.  This new revised estimate is a drop of 47 percent from the June 2008 estimate.  Sounds about right with the market.  Yet the market is up 50 percent while earnings estimates are down by 50 percent.  Any value investor will tell you that looking at PE ratios is absolutely crucial.  Some of the top experts avoided the tech stock mania because they were seeing stocks with PE ratios of 100 or even 200 on the prospect of making it big.  Some did survive but the vast majority didn’t.  Even a high flying stock like Google has a PE slightly above 30.

Now assuming the $14.57 EPS for Q3 of 2009.  Is this necessarily good?

1026 (current S&P level) / ($14.57 estimated EPS) = 70 PE ratio

Even with this estimate, the PE ratio would still be at 70!  At record levels.  And keep in mind, a big jump of earnings in these last few quarters involved massive infusions of free money into the banking sector.  Do they not realize that there are still some $3 trillion in toxic commercial real estate debt left?  Of course on the estimates, you can see that the financial sector is having the best expectations.  The industry that brought us the credit and housing bubble is now going to lead us out of this massive recession.  We are in good hands.

Many now agree that this is the worst recession since the Great Depression.  Yet many think things will turn around in a few months.  These kind of market dislocations last years and impact generational thinking.  There is a new austerity out in the market.  In fact, this new spending habit is taking hold so deeply that the government had to entice people to trash their working vehicle for a new car.  People are surprised that the cash for clunkers program worked.  How are they shocked?  Free money for your bucket and a new car?  Who could have ever seen that coming!

Yet even the analyst estimates put the S&P 500 at a PE ratio of 70 for Q3 of 2009.  A more normal average PE ratio even at the high end would be 20.  From the mid-1930s to the 1980s the PE range would peak out in the low 20s.  But then, the technology bubble and housing bubble gave us two decades of wild valuations.  But let us assume a high 20 PE ratio.  What should the stock market be valued at?

(X/ $14.57 Q3 2009 estimate) = 20 PE ratio

291.40

This is the insanity of the current market.  For the PE ratio to come in at 20 for Q3 of 2009 and with estimated earnings of $14.57 per share, the S&P should have a value of 291.40.  This is even less than that the 666 low reached in March.  So why the rally?  Because people believe we’ll be back to peak earnings again.  And insiders seem to have a different opinion.  Last week, insiders had 18 buys for $30 million while on the sell side some 131 sold for over $889 million.  Maybe the insiders know something that the public doesn’t regarding the S&P casino?

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We recently discussed the rise in bankruptcies which comes even with the stricter guidelines put in place in 2005.  A recent Freddie Mac report found that 17 percent of the mortgages in their portfolio had negative equity while another 11 percent had equity of 10 percent or less.  Now if you think about it, selling costs can be 6 percent so even those with 10 percent or less equity stand to lose money in a home sale.  If we put this together, some 28 percent of Freddie Mac loans if they were sold today may yield the borrower zero or will cost them thousands.  This is a recipe for disaster.

First let us take a look at the Freddie Mac world:

At the end of 2008 some $11.9 trillion in mortgage debt was outstanding.  Between Fannie Mae and Freddie Mac, a total of $5.3 trillion was in their portfolios.  The massive rise in debt followed in line with the multi-decade long housing bubble.  Now Freddie Mac and Fannie Mae serve virtually the same role in the mortgage market.  They provide so-called liquidity in the secondary arena.  What this means is no one else would buy these mortgages now that they know Wall Street virtually turned many loans into casino like instruments.  Now, the two giant government agencies are virtually the only game in town.  But what is in the report should be of concern.  Let us pull out the Freddie Mac data by itself:

Freddie Mac has a mortgage portfolio worth $1.96 trillion.  Of this portfolio 13 percent is made up of option ARMs, ARMs, and interest only products.  These are toxic loans.  This may not seem like much but this is equivalent to $254 billion in toxic loans.  Keep in mind those 30-year fixed mortgage are also seeing rises in defaults.  Assuming 17 percent of the borrowers are underwater, some $333 billion in mortgages are severely at risk.

Yet the risk is much deeper since the unemployment situation is causing even those with 30-year fixed mortgages to default.  The problem with being underwater is that the owner has little motivation to keep paying the mortgage.  For most people, they buy homes to live in but also to build up a steady stream of equity.  Yet in this decade, we have seen something that hasn’t occurred since the Great Depression.  We have seen a nationwide housing market decline.  And now, with websites like Zillow and also, local county assessors offices going online many people can check the “value” of their property with very little hassle.  So what this creates is an obsessive real estate culture.  Let us take a look at what occurred in this decade:

Since the 1980s for nearly 30 years housing prices have been on a tear.  Now that the bubble has burst equity levels are now back to 2001.  The peak was reached with zany valuation while the debt still exists.  That is why on the chart above you’ll notice housing prices declining while mortgage debt levels are still near their peak.  It is interesting to note that Freddie Mac assumes booming mortgage debt again:

Yet the losses are going to continue mounting as home prices continue to decline.  Freddie Mac figures some 1 out of 5 homeowners with mortgages are underwater.  Yet we know that there are still many more Alt-A loans that will have much higher default rates.  Freddie Mac is probably as conservative of a portfolio as we will get.

Here is some of the data on walking away:

“(WSJ) The researchers found that homeowners start to default once their negative equity passes 10% of the home’s value. After that, they “walk away massively” after decreases of 15%. About 17% of households would default – even if they could pay the mortgage – when the equity shortfall hits 50% of the house’s value, they found.
…
“Our research showed there is a multiplication effect, where the social pressure not to default is weakened when homeowners live in areas of high frequency of foreclosures or know others who defaulted strategically,” Zingales said. “The predisposition to default increases with the number of foreclosures in the same ZIP code.”

And here is another point.  If you live in area with high defaults the stigma may not be there for a strategic default.  Take a look at the rising losses in certain states:

In California the negative equity rate is much higher.  So losses are starting to mount and virtually all Alt-A and option ARM holders in the state are underwater.  This is going to increase the walking away phenomenon.  Even a map of the U.S. will tell us where most of the foreclosures will occur:

With 1 out of 5 homeowners with negative equity, we have a fleet of 10 million Americans being tempted to walk away from their mortgage.  With unemployment rising, the default may occur because of necessity.  Keep in mind these are people who are still current on their mortgages and not in a stage of default.  Unfortunately housing prices still have a way to go on the downside thus pushing more homeowners underwater.

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California has drastically changed in the past century.  Before 1912 California would pull 70 percent of its revenue from property taxes.  In most cases property taxes are a better and steadier revenue stream because they tend to fluctuate the least in challenging economic times (assuming we don’t have mega once in a century national real estate bubbles like we just did).  Even with recessions, property taxes are a good revenue stream because people for the most part will cut back on virtually every other line item before losing a home.  Yet that is now not the case.  Now, the primary sources of income for the state are personal income taxes, sales and use taxes, bank and corporation taxes, and a variety of excise taxes.  This is how it breaks down:

It is rather apparent how a recession this deep will plunge the state to near economic collapse.  First, personal income taxes take major hits during a crisis like this.  If the state is drawing nearly half of its revenue from a volatile stream, you will get volatile tax collections.  Plus, with an 11.5 percent unemployment rate meaning over 2,100,000 people are “officially” unemployed there is no income tax being paid in the first place by a large contingent.  Sales and use taxes make up nearly 35 percent.  Well of course during a crisis, people are going to pull back and not buy items like cars, big televisions, and therefore sales taxes will be hit as well.  The California revenue system is a boom and bust system.  Take a look at revenue streams for the past few years:

Capital gains income highlights this boom and bust cycle perfectly.  In 2000 with the technology bubble California residents took in $117.56 billion in capital gains which the state received a nice chunk of $10.6 billion.  Yet after the bust, in 2001 only $50.7 billion was made and only $35.5 billion in 2002.  So of course, this revenue stream was chopped each year.  Then with the real estate bubble, we see that 2005, 2006, and 2007 actually brought in more money than the tech bubble.  The state of course collected nice sums of money from this bubble.  Yet now, this has busted and capital gains income has fallen off a cliff.  Interestingly enough, property taxes actually increased from 2000 to 2001 at a modest rate even while cap gains split in half.

Now we are seeing drops in property tax collections given the epic California housing bubble that was built over the decade.  Property taxes for the most part are viewed as local revenue streams and impact cities, counties, and schools more directly.  The breakdown for example is roughly 17 percent counties, 11 for cities, 53 percent to schools, and 19 percent to special districts.  Here is the breakdown:

Now keep in mind, this is for 2006-07 which was a banner year.   During the 2006-07 fiscal year property tax revenues came in at $43.16 billion.  According to data provided by the Board of Equalization property assessed values during this time reached $4.28 trillion in the state.  Now this was at the peak.  By most estimates, the bubble has popped and California as whole has seen the median price drop by 50 percent.  So it is safe to say that the values are now at $2.1 trillion.  No wonder why revenue is drying up from every possible angle.

A big shift in revenue streams came on June 6, 1978 when voters overwhelmingly approved Proposition 13.  The reason this was passed is dramatic rises in property taxes during that time and also, a growing state surplus of $5 billion.  Proposition 13 rolled most local property taxes back to 1975 assessments and limited property tax rate increases to 1 percent plus the rate of local voter approved bond measures.  It was a limit to future property taxes.

After this measure passed, property taxes collapsed from $10.8 billion in 1977-78 to $5.4 billion in 1978-79.  So people tend to forget that once this happened local governments went into fiscal haywire.  For the first two years after Proposition 13 passed the legislature had to bailout local governments.  The first year a stop-gap measure costing $4.17 billion was used from the state surplus.  A second year bailout cost the state $4.85 billion.

But many properties have traded hands in recent years given the California housing bubble.  With this, many properties are now sitting on overpriced assessments.  Proposition 13 allows for reassessment when properties exchange hands.  So now after the drastic collapse in prices, you can rest assured that taxes may be too high on some properties ironically.  It is pure insanity how California does its taxes.  How so?  Well if you assessed property at bubble level prices on a yearly basis, the overall cost of owning a home would be more accurately reflected.  We now have people who bought at the peak with overpriced homes and over assessed properties.  It just doesn’t give an accurate reflection of true cost.  Also, you have corporations who use Proposition 13 as a shell to keep paying commercial rates dating back to the 1970s since they don’t need to exchange property as often as say a residential homeowner.

Yet that is one side of the story.  The bigger drain is the personal income tax stream plus the sales tax.  Let us see how this plays out for someone making $100,000 a year:

Let us assume you are a young working professional making $100,000 a year.  The above chart shows you how much money you are left with once all taxes are taken.  After all is said and done, nearly 40 percent of your income is gone (most of it going to the federal government).  So after that, you can feel good right?  No.  Because the state will then tax you like crazy with sales tax.  Here in California many counties now have 9 to 10 percent sales tax rates!  So after your $8,333 a month gross goes to $5,267 net, you now have to go out and buy things.  But when you buy an item, you are going to pay an additional tax.  The true tax burden for Californians is near 50 percent when all is said and done.  It would be one thing to pay for effective government but can you call what we have effective?

What many people don’t realize is that 15 percent of California taxpayers, those that make over $100,000 pay 84 percent of all the personal income tax revenue.  And those that make over $480,940 which are the top 1 percent pay 48 percent of all state personal income taxes:

The problem with this system especially when you had many in the technology industry making tons of bubble money during the bubble is once it bursts, you will lose your primary source of income.  More recently, you had a double revenue bubble since property taxes soared because of the massive housing bubble but you also had tons of people working in the finance, real estate, and other related industries making these high incomes which are now gone.  So you lose the income and the property tax streams.  Systemically our system is broken.  Proposition 13 is only one piece of the puzzle.  The problem is we depend on revenue sources that are not stable.  Unfortunately a better source of revenue is property taxes just like many other states have.  Yet to raise property taxes without adjusting state personal income taxes is insanity.

Also, going back to the $100,000 worker, housing prices are still much too high.  For example, let us now assume this person wants to buy a modest home in a decent area.  Let us look at some L.A. areas for an example.  Let us assume this person wants to buy a starter home in Eagle Rock.  The median price for Eagle Rock is $475,000 and that is with the current reality that L.A. County as a region has seen the median price drop by 50 percent (of course much of this is because of the lower end distress market making up over half of sales).  So this person decides to buy this home with 10 percent down:

Down payment:                               $47,500

Mortgage:                           $427,500 (30 year fixed at 5.5 percent)

PITI:                                       $2,921

Net Income:                       $5,267

Disposable income after house payment:            $2,346

Now many would say big deal here.  But you need to remember we have done no contribution to a 401k or we haven’t even factored in healthcare costs.  Food?  Car?  You can see that a $100,000 in California does not go a long way and only 15 percent of taxpayers fall in this bracket.  Just imagine for the median income earner which is approximately $50,000.  So you say what about 2 income households?  That puts us up to 26 percent of the population that makes over $100,000 but this is from 2007 data.  With unemployment skyrocketing since then that figure is surely lower.  It’ll be fascinating to see the data figures once we have our next big census in 2010.  We may see a lost decade of income for many Californians.

If it isn’t obvious to you already, we need a massive overhaul of the system.  The current solutions of pure cuts or pure tax hikes are piecemeal solutions because as you can see, we’ll be back at this again next year.  We need to reform the system to include more stable revenue streams and link up state government to these streams so they don’t go into feast and famine mode every few years.  For the past 20 years, we jumped from one bubble to the next.  Unfortunately, there is no other bubble in the short-term and the reality of the mess is being exposed.  Because if $100,000 a year is not enough for someone to live on here in the state and have a middle class lifestyle, then we have some serious issues.

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The Census Bureau reported on Wednesday that for the month of April retail sales came in at $337 billion, a decrease of 0.4 percent from the month before.  The market reacted to this news and headed lower.  If we pry into the data beyond the headline number, we will see that retail sales are actually down by 10.1 percent from April of 2008.  Now why the market is stunned by this news should be the bigger headline since 24,700,000 Americans are unemployed or underemployed, it would logically follow that more and more Americans are having to tighten up their budgets.  Many Americans are quickly realizing that austerity is now the way of life.

Let us take a look at the retail figures chart since two-thirds of our economy depends on retail sales:

What is interesting for the month is auto sales slightly increased.  Normally, the Census Bureau reports retail sales with and without auto figures.  For April, auto sales actually helped the overall figure.  Let us look at how retail sales measure up to April of 2008:

Taking a look over one year gives us a better sense of the overall trend.  What you will see is that over one year, auto sales are down over 20 percent while retail sales are down by approximately 10 percent.  These are gigantic numbers when you think about it.  If our GDP is slightly over $14 trillion a year, and consumption makes up nearly 70 percent of this, a 10 and 20 percent decline is significant.

A large part of this is many Americans are finding out that their access to credit is being limited.  Over the past few months credit card companies have yanked over 8 million in credit cards from the market.  What is problematic about this is Americans supplemented a decade of stagnant wages with more and more consumer debt.  In fact, the massive rise in debt has occurred for over 3 decades.

I compiled a chart that highlights this new austerity showing personal income and household debt:

This is an incredibly important chart because it strikes at the heart of the matter.  If you look at the 1980s, you’ll see a big explosion in household debt; but when personal income went lower, so did the increase in debt.  Over 40 years, the growth of household debt and personal income flowed in synchronization.  That is, until the year 2000.  At this point it is abundantly clear what occurs.  While personal income started to fall on a year over year basis debt explodes.  This goes on from 2000 to 2005.  After muddling through, both personal income and debt are contracting at the fastest pace in over 40 years.  What this tells us is the perceived health of the economy for the past decade was largely all built on a foundation of debt with no real gains for households.

The recent run up in the stock market is now hitting a wall.  This market volatility that produced a near 40 percent gain in the S&P 500 over 2 months is a sign of an unstable economy, not a healthy one.  What occurred is first, we had manufactured one time profits for banks because of massive bailouts and the market was starting to price in a second half recovery.  After hearing that foreclosures are at all time highs and Americans aren’t spending like they once did, that second half recovery is coming into question.  July 1^st isn’t far away and it is hard to see what is going to occur over the next month that is going to set the American spending machine back on track.

Let us examine where Americans are pulling back:

For the most part, Americans are cutting back on nearly every segment of retail goods.  The only 2 areas that seem to be neutral or slightly positive are food purchases and health spending, which shouldn’t be surprising.  Americans are cutting back to the necessities.  One of the biggest hits is in auto sales which are down 25 percent on a year over year basis.  This is a primary reason why one of the three large U.S. automakers has filed for bankruptcy and another, GM is on the verge.  The disconcerting part about the U.S. automakers is that they were failing in large part to the high cost of energy.  Remember that oil bubble?  Well as you can see above, gasoline stations have seen a drop in retail sales by 35 percent over the year largely to the oil bubble popping.  Yet you would logically think that with cheaper fuel, Americans would be back to buying big cars.  That is not the case.  It isn’t that people don’t want new cars, its just that they can’t afford them without easy access to credit.

Going back to the chart above, we see that electronic spending is down by 6.9 percent.  That is why electronic giant Circuit City went under.  People are pulling back on discretionary spending.  Building material and home spending is down as well by 11.2 percent.  People are finding it hard to adorn their home in HGTV fashion when money is tight.  Clothing spending is down by 6.1 percent over the year.  You will also see sporting goods, hobby, and book spending down.  The bottom line is most Americans are shifting their spending priorities to things they need and away from things they want.

This decade saw something that we haven’t seen in nearly 100 years.  Americans even with declining personal incomes were given unlimited access to credit to continue to spend.  That is unheard of.  The chart above demonstrates this.  Right now we are facing the brunt of spending more than we were earning as a country.  The chart showing personal income and household debt should tell you a lot about what occurred over the past 40 years.  Debt would always increase but was closely aligned to growth or declines in personal income.  This decade saw a large disconnect.  We are now dealing with the recalibration of this poor alignment.

The Federal Reserve and U.S. Treasury would like to go back to the debt spending ways of the past but that isn’t in the cards.  Currently, they are trying to sacrifice the U.S. dollar to get Americans back on their spending treadmills.  They have done this through a variety of ways including, making it extremely unattractive to save.  With the Fed rate touching zero, many people see bank savings rates of 0.2 to 1.2 percent and wonder why should they even save a penny?  Yet with the markets off their peaks by 40 percent, many people don’t mind saving their money in a secure vehicle instead of it losing value.  Plus, with the employment situation so fragile, people are saving because they have too.  The new austerity is on us and people need to adjust to the new reality because we are not going back to the way things were in 2000 through 2005.

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