Subprimes, Teen Spending and the Economy; Yup, It’s a U.S. Recession. Can’t Europe Just Ignore It?

Daniel is my favorite economic indicator. He and his guys install wood floors. To get him to do some work at our house last summer, we had to book him two months in advance. When I called him to do another room not long ago he said, “How about next Tuesday?” He told me people were becoming more cautious and pulling back on projects.

With the Daniel Indicator in the caution zone, I decided it was time to look at the rationale for and impact of a U. S. recession for a second time in my writing career. The first time was, I think, in 2001 in the midst of the Great Skateboard Boom. Shops I talked with about any softening of their sales pretty much laughed uncontrollably after they realized I was serious. The recession was short and shallow and the only damage done in our industry was to my reputation for asking retailers such stupid questions.

I’m going to try again. Let’s look at some current U. S. economic indicators with particular attention to the subprime mess and its worldwide ramifications. Then I’ll review the latest stock market results for the publically traded big retailers as well as the companies that are specifically in our industry and see what the stock market thinks is going on.
Housing and the U. S. Economy
Consumer spending represents 70% of U. S. gross domestic product. Keep that in your mind while we talk about the subprime situation.
I need to describe in a few hundred words something people are writing books about. Since a picture is worth a thousand words, check out the chart below.
Source: “The Mortgage Pig in the Python” by John Mauldin. August 3rd, 2007. You can see the article at John’s   I recommend signing up for John’s newsletter.
What this says is that without people taking lots of money out of their rapidly appreciating homes and spending it, U. S. gross domestic product growth would have been a fraction of what was reported, especially in recent years. Now, here’s another cheery table from the same source.
This table shows the dollar amount of adjustable rate mortgages that reset, or will reset, each month in 2007 and 2008. You can see that the peak isn’t until next, well, now. These resets are partly what lead to foreclosures because people suddenly have a payment they just can’t afford to make and the expected refinancing is no longer available. The other piece of the puzzle of course is the decline in housing values. It was just announced nationally that they were down 10.7% in major U. S. cities compared to a year ago. Of course in some markets, it’s worse than that. Much worse. And it isn’t over. I’ll discuss the impact below.
Okay, so sitting in Europe, why the hell should you care about the U.S. housing market?
The house price run-up started with low interest rates and a generally strong economy. It accelerated when banks stopped being banks.  It has historically been the role of banks to evaluate credit, make loans based on that credit, and then get paid back. Then they learned how to “securitize” loans. They bundles them all together, got one of the rating agencies to rate them AAA, and sold them to all kinds of investors who relied on that AAA rating. Suddenly, they’re earning their money from making the loans and servicing them- not from collecting them. They don’t care about the credit risk. Neither do the loan brokers or the appraisers or the escrow companies. Neither do the investors who are buying the bundled loans, because the rating agency says they are AAA. And through some financial magic, you can package some AAA rated loans with a bunch that aren’t AAA rated and still end up with an AAA rating on the whole security. Go figure that out.
Lots of money available, lots of fees to be earned, no worries about credit and everybody wants to get on the house buying band wagon. So they did. And, as you’ve read, many of the loans that financed this spree, especially in the last couple of years, were interest only, or nothing down, or no income verification, or/and adjustable rate. No worries about those low teaser rates on the adjustable loans though. When it’s time for the rate to adjust upwards, you’ll be able to refinance because of all the easy money and the fact that your house will be worth even more.   
Opps. Didn’t quite work out that way. Foreclosures have doubled since the 3rd quarter of 2006. The National Association of Consumer Advocates reports that four million subprime borrowers will see their monthly mortgage payments increase by an average of 40% in the next eighteen months.  House prices have fallen a little or a lot depending on where you live, lending standards have tightened as a result of loses on subprimes, and refinancing your mortgage has gotten more difficult, assuming you can even do it. If you put no money down and your house is worth less than at the time you purchased it, what’s the motivation for the bank to refinance the house since they know they won’t be able to sell the loan? You probably aren’t surprised to learn that the market for bundled loans, even ones that the raters say are AAA (whatever that means now) isn’t what it was some months ago.
As you know, this isn’t just impacting the subprime market in the U.S., but credit markets worldwide. And that means you. There’s no lack of liquidity- central banks all over the world have pushed cash into the system. There is a lack of confidence. Even perfectly good corporate debt has taken a hit. Between the various forms of these bundled securities and the derivatives associated with them, there’s real confusion about how big the risk is and who is holding it. How do you decide how much a security is worth if it’s not trading? The cash is there, but it’s not flowing. Banks that are caught in this have to raise capital and tighten lending standards. That’s as true for Union Bank of Switzerland as it is for Bear Stearns (May it rest in pieces). Basically, securitization let the U. S. subprime problems evolve into a global credit crunch.
Let’s say you were a hedge fund. You have $100 million in capital. The banks (in the good old days) would lend you $2 billion on that, leveraging you twenty to one. And they’ll lend it at, say, 5%. You turn around and lend it for, say, 6%. On the difference between the 5% cost of funds and the 6% earnings of the assets, you’re earning $20 million a year. You have a $100 million in capital, so you’re earning 20% a year on that. And hey, those securities are all rated AAA, so what can go wrong? Life is good.
But suddenly there’s a glitch in the system. The value of those securities you have falls one percent. You’re leveraged twenty to one, so you lose 20%, of your capital, or $20 million. As some panic and a little paralysis sets in, you’re easily and suddenly down 5% (Since these AAA securities are no longer trading, it’s actually kind of hard to know how much you’re down) and all your capital is gone. You get the margin call from hell. You can’t meet it, so the bank steps in and tries to sell the underlying securities. But there’s no market for them. The hedge fund is out of business and the bank is facing serious loses. Cue the lawyers.
You’ve seen some write downs of these securities and you’re going to see more.   But so what? All we want to do is sell a few decks, some pairs of shoes, and various jackets, t-shirts and beanies. Should we be worried that the consumer spending is going to slow is our little part of the world?
Stock Market Wisdom
 The University of Michigan Consumer Sentiment Survey in the U. S. fell to 70.5 in March, down from 80 in October. That’s the lowest reading in 16 years. The survey also reported that inflation expectations rose sharply, but I don’t suppose that’s a surprise to anybody who buys food and gas.
Meanwhile, consumer spending is falling, and the people who watch the stock market seems to think that decline is for real. The S&P 500 retail index (symbol $RLX) is down 25.6% during the nine months ended 31 March. The stocks of Dillards, J.C. Penney, Nordstrom, Kohls, Sears and Macy’s (large US mainstream retailers focused mostly on apparel) are each down between 22% and 48% over the same period. The average decline was 37.7%
But we can argue, and I think accurately, that those retailers don’t necessarily represent our market. Let’s look at some US publically traded companies that do. In alphabetical order, let’s see what’s happened to the stocks of American Eagle, Dick’s Sporting Goods, Ho t Topic, Pacific Sunwear, Quiksilver, Urban Outfitters, Volcom and Zumiez over the same period.
The average decline here is 33.1%. That’s not much better than the average of 37.7% for the general retailers. If you eliminate Urban Outfitter’s positive result, we’re actually worse with a decline of 44.2%.
Some months ago, when I did this exercise over a six month horizon, it looked like Wall Street expected the action sports market to hold up better than the general retail industry. It’s always been an article of faith in the industry that we would. Now, it’s not so clear.
It’s A Small World After All
When I spoke to U.S. retailers months ago, they were cautious, but hoping they didn’t need to be cautious. During trade show, I found this caution had become greater.   Before, they hoped to avoid a recession. Now, they hope it’s not too bad a recession.
That we’re going to have, or maybe are having, some slowing in consumer spending seems obvious to me. Especially since the morning paper announced that Starbucks saw a 1% falloff in store traffic last summer. We in Seattle take stuff like that seriously and that seems as good as the Daniel indicator I started this column off with and that we’re somehow protected because we sell fun.
How vulnerable is our industry? The evidence says we can expect some impact- more than it looked like a few months ago. First, we hoped the problems would be limited to the U.S. housing market. Then, to the U.S. economy in general. Then we hoped that the rest of the world would make up for U.S. economic weakness. But unfortunately it looks like the process of deleveraging the world (which is a good and necessary thing in the long run) is a worldwide phenomenon.
If you run your business carefully, and you have a strong balance sheet, you’re going to find yourself with opportunities while others struggle. Recession or not, people want to have fun.