-->McNamara's Embarrassment

The Daily Reckoning

Managua, Nicaragua

Tuesday 17 February 2004


---------------------

*** What's new? Who cares?

*** Stock-buying - just another bad habit? Something
bubble-like in the air...

*** History will not be kind to the Fed... no way to pay
back debt..."The Point of No Return" meets"The Point of
Pain"... and more!

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What's new?

Here on the Pacific Coast of Latin America at 6am, the
appropriate response might be,"who cares?"

Here, it is the works of nature that impress us... not those
of her most conceited creation.

Last night, we looked up and saw more stars than we thought
existed. There were so many... so bright... where did they
all come from, we wondered?

But this morning, we put our head back down... and wonder
what the brightest star in the economic firmament - our own
Mr. Alan Greenspan - must have been thinking. He spoke to
Congress and told the assembled that consumer debt was
nothing to worry about. Yes, Americans had borrowed a lot
of money, he explained, but they had used it wisely.

What they actually did with the money is a bit of a
mystery. All that we know for sure is that they did not put
it in savings accounts and have not, as yet, paid it back.

Aside from a few old fogeys, almost all Americans assume
that they will never have to pay it back. They are counting
on inflation to wipe out the principal faster than their
monthly payments pay it down. And they're betting that
their financial assets will rise in price so quickly, they
will never have to settle up on their financing.

Eventually, they will be wrong. Maybe now.

American borrowers have reached 'The Point of No Return,'
thinks Richard Benson. They've borrowed so much, they could
not pay it back even if they wanted to.

"Last year, personal income increased about 2%. Individual
debt increased about 10%," he writes."Personal debt for
autos, credit cards, etc., topped $2 trillion - up about
$120 billion despite massive debt consolidation and
mortgage refinancing. Mortgage debt rose about $800
billion, and total individual debt rose over $925 billion,
while wages and salaries rose only $190 billion. Retirees
and savers saw their interest income shrink, as interest
paid on savings dropped by $30 billion. Indeed, given the
Fed's low interest rate policies, it doesn't pay to save.

"In December, the savings rate dropped to a new low of 1.5%
and in the 3rd quarter of 2003, the only reason financial
assets were acquired is because they were bought with
borrowed money. The low savings rate is even more
astounding when you consider the increase in disposable
personal income of around $200 Billion from the tax cut.
The economy needs $500 billion in government stimulus from
tax cuts and increased spending just to keep employment
from falling and to help consumers roll over their credit
cards for another month."

Benson points out that the savings rate - as low as it is -
is nevertheless overstated. The official number includes a
fraud... reasoning that when your house goes up in price,
you have received 'imputed income' from it. If only you use
it to repay real debts! Alas, that will take real
income... from cash flow.

We return to this sorry subject, below... but first... a news
update from our correspondent in New York...

------------

Eric Fry in the City of Dreams...

- The U.S. stock market hung out the"CLOSED" sign
yesterday, denying millions of investors the opportunity to
add to their holdings of overvalued American stocks. So
optimistic has the lumpeninvestoriat become that it buys
stocks every time the market dips... And if the market
doesn't dip, the lumps buy stocks anyway. Why do the lumps
do what they do? Do they even know? Is stock-buying just
another bad habit, like eating two desserts?

- Your New York editor's 5-year old used to wander around
the house sometimes, singing a nonsensical song:"We have
to work, because we have to work. That's why we work... Hi
work!" None of us could figure out how he happened to
create these lyrics, nor why he sang the song.

- Last week, your editor recalled his son's bizarre little
ditty, as he watched the stock market march to new highs.
He imagined millions of investors singing to themselves,
"We have to buy stocks, because we have to buy stocks.
That's why we buy stocks... Hi stocks!"

- No one knows exactly why the lumps buy, but no one would
deny that they do. Goaded into action by Alan Greenspan,
Wall Street strategists, and a vague sense that buying
stocks is prudent, no matter the price, the lumps buy and
buy and buy... until, eventually, something bubble-like
appears.

- Something bubble-like seems to be appearing in Lower
Manhattan, in the vicinity of Wall Street. And something
bubble-like is hanging in the air over Shanghai. A kind of
Sino-bubble is in progress - the sort of bubble that
features red-hot IPOs and rampant speculation.

- Is Greenspan to blame (or to credit) for both bubbles?
Both the long-running American one and the Sino-bubble? The
thought has crossed our mind.

-"The Fed's commitment to keeping interest rates low for a
considerable period of time fueled speculation in high-risk
assets," says Andy Xie, Hong Kong-based chief economist at
Morgan Stanley Asia Ltd."The byproducts of this
speculation," Xie explains,"are the wealth effect on
consumption in the U.S. and the cheap capital-fueled
investment boom in China - the twin engines or bubbles,
depending on your perspective, for the global economy
today.

-"History [will] not be kind to the Fed," Xie says."Its
accommodation and even encouragement of speculative
excesses [will] be viewed as the primary cause of the
massive bubble in the global economy today, the
consequences of which are yet to show."

-"What happens when two bubbles collide?" the Asia Times
wonders."Do they both burst, or do they coalesce and
become an even bigger bubble - which will eventually burst
even more spectacularly?" That is the question posed by the
growth figures from both the U.S. and China, whose growth
rates are tied in ways that neither seems to want to admit
too loudly.

-"The same money managers who poured funds into AOL, MCI,
Enron and Tyco - all with problems, to say the least - are
now pouring millions into Chinese IPOs with the same
enthusiasm. It is difficult to see any more economic
rationale in the 1,600-times oversubscribed China Green
Holdings than the Internet Bubble of the last decade.

-"But along with this week's figures on economic growth
came another ominous big number. From once being nearly
self-sufficient in oil, China is now the second biggest oil
importer in the world - and is on the verge of needing
massive coal imports as well. The China Bubble has expanded
to a point where it will soon reach the sharp edges of
infrastructural capacity and reckless over-investment to
the point of over-production. That is when bubbles burst."

"China is touted everywhere as the investment destination
of the century," Karim Rahemtulla remarked in this space
last week."Don't believe it. My experience tells me that
the only people who can really make money in China are the
Chinese..."

- Note to Mr. Market and his Chinese counterparts: Avoid
sharp objects.

------------

And now, back to Bill Bonner in Nicaragua... and Americans'
debt...

***"What is perfectly clear from simple
arithmetic," Benson concludes,"is that without a sudden
increase in the number of jobs and the wages they pay,
individual debt can not be serviced by personal
income....Income and job growth are so low that we have
certainly passed 'The Point of No Return.'"

[What happens when we pass 'The Point of No Return'? Paul
Bennett searches for an answer in today's DR guest essay,
below... ]

Benson notes that the Fed's low rates and tax cuts can
create a spending boom - putting Americans further in debt.
But they cannot create a hiring boom. When Americans spend
money, the hiring is done in China, not in the U.S.. No
hiring boom... no growth in wages... no way to pay back debt.

"So, where are Americans and their mountain of debt
headed?" Benson asks."If the days of borrowing more -
courtesy of both the Federal Reserve and Asia's central
banks - are winding down later this year when Asia revalues
its currency, it looks like there will only be two ways
out: increased inflation and debt default. Both are likely.

"When those Chinese goods at Wal-Mart go up 30% in price,
Americans will see inflation. The Fed will accommodate most
of the inflation, but there will be a rise in interest
rates. Inflation, if allowed and encouraged, will save the
wage earner so he can continue to service his consumer
debts. Rising interest rates will smash into housing prices
like a tornado in Kansas. Homeowners who have a 30-year
fixed rate mortgage will come out in the end, if they don't
have to sell their home for at least 10 years. Anyone who
wants to sell their home will see some 'asset deflation,'
and financial institutions will experience substantial
'debt default.' The Federal Reserve will 'print money like
crazy' to fight asset deflation and encourage inflation.
Sometime before or after the Presidential election, the
financial markets will be interesting, but painful to
many."

A modest prediction from your modest editor: sometime
between now and the crack of doom, Americans will turn
their heads towards the stars... and wonder what they were
thinking...

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The Daily Reckoning PRESENTS: Frank McNamara's plastic
invention -"the epitome of convenience and modern finance"
- has slowly ensnared the U.S. consumer. What happens, asks
Peter Bennett below, when consumers finally reach"the
point of pain"?


MCNAMARA'S EMBARRASSMENT
by Peter M. Bennett

Where would Americans be without their credit cards?
As hard as it is to imagine, there was a day not all that
long ago when general use credit cards simply did not
exist. Before 1950, to be exact.

It was in that year that Frank X. McNamara put his napkin
down at a dinner in New York City, only to find to his
mortal chagrin that he had no money to pay for his meal.
Perhaps it was while an embarrassed McNamara sat waiting
for his wife to arrive with cash to rescue him that he
dreamed up what eventually became Diners Club... and the
world stepped onto the slippery slope of easy money.

Today, of the $2 trillion in total U.S. consumer debt,
McNamara's creation gets credit for about $700 billion, or
about $2,400 per every man, woman and child in America.
According to CardWeb.com, the average American now carries
a total of 7.6 cards, which further breaks down to 2.7 bank
credit cards, 3.8 retail credit cards and 1.1 debit cards.

24% of all personal consumption is conveniently made via
some combination of bank credit cards, retail cards and
debit cards. In the getting-scary category, Visa happily
reports that 43% of property rental companies now accept
Visa credit and debit cards for rental payments.

Play your cards right and you can rack up airline reward
points to redeem for vacations where you can spend even
more... using your cards, of course. The epitome of
convenience and modern finance is McNamara's invention.

Yet the credit card, for all its modernity, predates
McNamara's embarrassment by some 62 years: provenance
belongs to Edward Bellamy's 1888 sci-fi novel"Looking
Backward" envisioned a world of the future where cash is
replaced by"credit cards" that allow humankind to purchase
"whatever he desires, whenever he desires it."

From the looks of things, Bellamy was remarkably
farsighted. With one important exception: in Bellamy's
socialist-style utopia, you never had to pay anyone back
for your purchases.

Unfortunately, unless you're willing to go through the
ignominy of bankruptcy, that is not the case in current
society. As things turned out, credit card issuers very
much want to get paid back, though are quite content should
you decide to take your time doing so. Provided, of course,
you pay them an interest rate on your balance that now
averages more than 14.7%. These days, almost half of
Americans pay only the minimum due each month on their
credit card bills.

Oh, and don't be late. Miss your due date by even a day and
your interest rate instantly vaults over 20%.

How did the formerly virtuous, frugal, fiercely
independent, neither-a-lender-nor-borrower-be American
corrode into an overburdened debtor? Like human nature
itself, the answer is complex and multi-faceted.

There are, however, a couple of clear culprits, starting
with risk-based credit models that have facilitated easy
credit to every strata of the American demographic. These
models allow today's banks and mono-line credit card
companies to be remarkably adroit at matching the interest
rates each consumer is offered to their individual level of
default risk, a free market bastardization of Marx's
dictate"From each according to his ability, to each
according to their need."

These models, and the underlying business practices,
developed in no small part because of Wall Street's harpish
demands for consistent earnings growth and quarterly
improvements in loan book size and profitability - demands
that have triggered profound, structural changes in the
lending markets. The fact is that there are a finite number
of consumers in the U.S. to which lenders can offer credit.
In order to increase their loan books and keep Wall Street
happy, banks and other financial institutions were forced
to reduce creditworthiness standards to the point where
competitively priced consumer credit is now available to
almost all elements of the population.

No matter how low your income, or high your existing debts,
there is probably a company willing to offer you a credit
card.

Of course, some companies get it wrong. In that category, a
relatively recent poster child is the much-heralded and now
bankrupt NextCard. Using an avalanche of Internet
promotions, that ill-fated company became the darling of
the industry by generating over one million credit card
accounts in a period of just over 2 years. Unfortunately,
their models had grossly underestimated the damage that
fraudsters and serial debtors could wreak given loose
Internet offers and looser back office procedures. All
told, between losses to investors and to the FDIC, which
had to take over NextCard, the company vaporized over $400
million.

It's also worth pointing to the recent tale of Steve
Borba's dog,"Clifford," who received one of those
ubiquitous pre-approved credit card offers. That a dog
could be sent a pre-approved credit card offer is funny
enough, but funnier still was that when Steve returned the
application as a joke, the company went ahead and issued
Clifford a credit card with a limit of $1,500. Every dog
has its day and, it now appears, its credit card, too.

On the whole, however, modern credit card companies are
properly motivated to get things right: offering credit and
collecting interest can be a stunningly profitable
enterprise. It is for that reason that the sum of all the
credit card and finance companies and banks and department
stores and countless other institutions involved in
offering credit equals one of the largest industries in
America, employing hundreds of thousands of employees and
generating billions in revenues.

But the recent explosion in the sheer quantity of debt can
be laid squarely at the downtrend in interest rates and the
massive refinancing boom. People don't pay nearly as much
attention to the amount they owe as they do to the amount
they spend on the amount they owe - otherwise known as the
ratio between debt service and disposable income. According
to the Bureau of Labor Statistics, this ratio is now at an
all-time high of over 19%.

When an individual's personal debt service ratio reaches
the point of pain, and 19% of disposable income is on the
line, he has two choices: Cut back on spending, or keep
spending until the phone starts ringing at dinner with
hard-sounding creditors on the other end.

Which brings us to the topic of charge-offs. Or, to
paraphrase one of the old Beach Boys' lyrics,"fun, fun,
fun 'til your daddy takes your credit card away."

In recent years the number of individuals pulled underwater
by the siren of easy credit has been growing steadily.
Personal and business bankruptcies grew from 837,797 in
fiscal year 1994 to 1,661,996 in fiscal year 2003 - a
staggering 98% increase. Of the 2003 total, about 1,600,000
were personal bankruptcies, representing about 1.5% of the
104 million total households in America.

Another indication of the current state of things - in our
opinion, maybe the best - are the data on late fees charged
by credit card companies. These fees have risen from an
already high $1.7 billion in 1996 to a positively painful
$7.3 billion by 2002. With regulations limiting the amount
of fees that can be charged, there is only one way to
interpret those numbers: people who had previously built
good, long-term credit histories are now also falling
behind on payments, or stopping payments altogether.
Currently, about 6% of credit card debt is ultimately
charged off by card issuers as uncollectible - definitely
not a magnetic swipe in the right direction.

When it comes to seeing into the economic future, the only
thing that is predictable is its unpredictability. However,
with debt service at 19% of disposable income, bankruptcies
on the rise, and late fees on credit card bills reaching
truly scary levels, we believe consumers are reaching the
point of pain.

Over 70% of the economy is driven by consumer spending.
Should consumers decide to cut back, the U.S. economy will
not necessarily hit a brick wall... but it will clearly be
in for a slowdown in GDP growth.


Regards,

Peter Bennett
for The Daily Reckoning

P.S. As investors concerned with generating absolute
(versus relative) portfolio returns, it is time to look for
ways to profit from the mountain of debt, and its eventual
unwinding. And unwind it will: despite their prolificacy of
recent decades, most Americans hate being in debt and we
are optimistic that most - certainly those who had
previously established good credit - will eventually come
to their senses and want to cut back and clean up.
Unfortunately for our consumption-based economy, the stock
and bond markets will almost certainly follow the GDP down.

What investments will do best as the mountain of consumer
debt starts to erode? In addition to gold and similar
wealth-preservation alternatives, which will benefit as
global markets throw in the towel on the U.S. dollar due to
the government's own mountain of debt, we think that
businesses that serve the tail end of the credit industry
will do well. As consumers return to personal fiscal
sanity, these businesses, operating on a model that calls
for buying debt for pennies on the dollar, and then
collecting nickels, dimes and quarters - helping clients
clean up their credit records in the process - should have
their day in the sun.