If something can’t go on forever, it won’t. That is the first law of practical economics. It may be hard to predict exactly how an unsustainable trend will end, however. And as the retail sector is finding out right now, the effect can be traumatic.
Over the past decade, many households refinanced their mortgages and took cash out. That is, they got a new mortgage for more than they needed to pay off their old one. The extra money went to pay off unsecured debt like credit cards, or to buy new merchandise or services.
This already was common in the mid-1990s, but accelerated as the housing bubble inflated after 2001. Martin Feldstein, who headed Ronald Reagan’s Council of Economic Advisors, studied the phenomenon. He found that consumers withdrew $9 trillion of equity from their homes from 1997 to 2006.
In 2005, a Federal Reserve study by Alan Greenspan and James Kennedy estimated that equity withdrawals financed 3 percent of all personal consumption spending after 2000. By early 2006, equity withdrawals equaled 10 percent of all disposable personable income.
This particular party is over. It was easy to get a “cash-out” refinance when home values were rising smartly and lenders were competing aggressively for more business.
Now that house prices are dropping in most areas, and major mortgage lenders like Countrywide and ResCap are in deep trouble, getting cash from a refi is difficult.
If home-equity withdrawals have been financing some household retail purchases, and this particular money tap gets turned off, then household spending will drop. That may cause major problems in some sectors, especially retail and high-end tourism and recreation.
You may wonder why it will make much difference if Greenspan’s numbers are right. Isn’t a 3 percent drop in sales something most companies can weather?
There are three complications. First, the pain won’t be shared equally across all companies. Grocery stores, economy retailers and DVD rental businesses probably won’t lose much in sales, but Caribbean cruise operators, gourmet bistros and big-screen TV sellers will have to bite a big bullet.
Second, there will be a “piling on” effect. A slowing economy with layoffs, fewer overtime hours and smaller bonuses will cut consumption by itself. Add such normal business-cycle spending declines to the end of the equity withdrawal party, and the pain will be substantial.
Third, the retail industry itself is coming off its own bubble. Capacity, measured by square footage or number of major stores, grew faster than consumption spending for a decade. Big-box consumer electronics and do-it-yourself building supply store construction outpaced demand. An eventual shakeout was in the cards, even if the general economy had remained healthy.
We can see the effects already. Home Depot recently announced it would close 15 stores across the nation after closing three call centers earlier this year. Minnesota-based Caribou Coffee announced a first-quarter loss of $6.4 million, based in part on the closing of 16 stores. These are just the first. There will be red ink, if not blood.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.