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State Of Fear

This article is more than 10 years old.

Seems like there's plenty to keep a panicky stock market stuck in a frozen solid trading range of 10,000 to 10,500 for another five years.

Rampant fears over oil prices. The ongoing Middle East mess and the war in Iraq. Fears that incoming U.S. Federal Reserve Chairman Ben Bernanke will excitedly hike interest rates too high to show he's a gung-ho, anti-inflation Rambo. Anxieties that hurricanes have jacked up already high gas prices, exacerbating the troubles of a middle class bogged down by mounting costs for education, housing and health care. White House indictments. Possible tax hikes, if the Democrats regain control of Congress in 2006.

Sheesh, no wonder it feels like the '60s all over again. In 1966, the Dow only hit 1,000 for the first time, and didn't break through that threshold until 1983, as stagflation, four recessions and a general mood of self-loathing engulfed the economy.

But the smart guys and gals aren't running with the poncho-wearing, drum circle, tie-dyed hippie crowd. OK, maybe that's overstating it.

Even so, David Malpass, chief economist at Bear Stearns , says stop with the hand wringing, this rocket of a U.S. economy won't fall into a recession next year, instead, it will see solid gross domestic product growth in the 3.8% to 4.2% range.

He cites low unemployment, his belief that household and corporate sectors are well insulated from Fed rate hikes, and the fact that the Fed is powerful in combating inflation, which he says is caused not by economic growth and not so much by energy prices, but by monetary accommodation and dollar weakness in 2003 and 2004. He also has reams of data showing the economy was strong going into Katrina, Rita and any other hurricane bound to barrel through.

Barring all that, even if there is a slowdown, who exactly is most exposed if there is a liquidity squeeze next year?

Meredith Whitney, an executive director at CIBC World Markets, recently put out a report, "The State of the U.S. Consumer," that, while circumspect about the fear-mongering "Chicken Littles" now flocking, does shed light on who exactly is most vulnerable.

Whitney says, sure, a liquidity squeeze is scary. "Seismic liquidity breakdowns" led to meltdowns in Asia and defaults in Russia, as well as the crisis at Long Term Capital in 1998. The bond market, too, seized up after the Enron and WorldCom blowups in 2001 and 2002.

But not everybody will fall through the floor if the economy endures another liquidity squeeze next year. "The Fed is raising rates, which will surgically squeeze out the exotic, dangerous mortgages that have imperiled consumers financially," says Whitney, noting this paradox: "But the Fed is also continuing to print dollar bills, which is pumping in liquidity to support both borrowers and lenders. So, it doesn't seem too worried about a house bubble." (That's the lead hand on the printing press that Malpass thinks is largely to blame for inflation.)

Whitney has done some serious number-crunching and analysis, and figures overall, that just 10% of consumers may be hit with what she calls a "segmented consumer recession." Populating this crowd are what Whitney calls the newcomers to borrowing.

Whitney is not referring here to the 26% of the population who have no access to credit, because most are at, near or below the poverty line. Nor is she referring to the 64% of consumers who own their homes and are on solid footing.

It's the remaining 10% Whitney says is what we all should be worried about, specifically, the 5% of that crowd, or the 15 million people, who make up half of this crowd or five percentage points of that 10%, who are first-time borrowers and who would not have qualified for a mortgage prior to 1994, when loan qualifications were dramatically loosened, putting extra snap in mortgage lenders' yellow suspenders.

In the last decade, these borrowers accessed unparalleled amounts of credit, Whitney notes. These are the folks who took out risky interest-only mortgages, or option adjustable-rate mortgages that let them pick their own payment amount, or no- or low-documentation loans.

And these are the folks who have painfully high loan-to-value ratios of 95% or even 120% or more, who were targeted by the sub-prime lenders, a sector that has nearly quintupled in the last decade.

Whitney had crunched the numbers way before statements from outgoing Fed Chairman Alan Greenspan concurred with her findings. He warned the markets in late September that about 5% of borrowers had dangerously low equity positions in their houses.

So, naturally sub-prime mortgage lenders, if they didn't hedge correctly, and credit card lenders will get socked. Whitney says at credit card companies, "there will be unprecedented credit losses" and "profitability will be cut by at least 25%" as more borrowers default, as white-hot competition forces them to charge teensy interest rates, and as more borrowers dump their plastic for lower rate, tax advantaged home equity lines of credit (which Whitney says has grown at 11 times the rate of credit card loans since 2003).

Whitney says this credit card sector squeeze will hurt JPMorgan Chase and Citigroup , figuring 25% of both banks' earnings come from credit card lending. Already, a consumer rush to avoid new, tighter bankruptcy laws has stung their profits.

Plus, Whitney notes these two giants now have to fork over more money during the next few quarters to comply with new, tight U.S. government guidelines that require credit card issuers to jack up the minimum payment on monthly charges. That will translate into less interest rate profits from high credit card balances, and a potential spike in delinquencies and losses. And JPMorgan and Citi face tougher competition from Bank of America , which is nearing completion of its merger with credit card giant MBNA .

CIBC's favorite credit card name: American Express . Just 10% of its revenue comes from lending, as it earns the bulk of its profits as a payment processor, plus its customers tend to be high-end consumers.

As for sub-prime lenders, avoid Ocwen Financial , H&R Block , Annaly Mortgage and Friedman Billings Ramsey . All have concentrated sub-prime mortgage exposure, so watch out for these guys. If you still want to try to get in on the mortgage lending action, maybe buy Wells Fargo , as it's diversified into other bank lines and has avoided massive sub-prime lending.
