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Consumers are cutting back on discretionary purchases and HELOCs are a mess, according to the company formerly known as “Bank of Italy”

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May 13, 2008 – Comments (7) | RELATED TICKERS: BAC , COF , DFS

You might be asking yourself what the heck is that “Bank of Italy” stuff about.  Well, I’ll get to that in a second.  First, it appears as though Bank of America (BAC) is finally starting to figure out that consumers are feeling “significant economic pressure.”  This is the phrase that the company’s president of global consumer and small business banking used while speaking at an investor conference in New York today.  Credit and debit-card purchases for “necessary” items aka food, gas, electricity rose by 13% during the first quarter of 2008 while spending on consumer discretionary items such as entertainment, travel, and retail rose by only 0.5%.  While they may receive a temporary reprieve if consumers waste their government stimulus checks like they probably will instead of saving them for a rainy day like they should, I am remain extremely bearish on specialty retailers, restaurants, airlines, airports...basically any consumer discretionary play that I can think of.

I have a sneaking suspicion that many of the consumers who are racking up this credit card debt are going to have a difficult time paying it back as their wages continue to decline when compared to inflation.  In the past when one’s credit card debt got out of control, they could always fall back on Old Faithful, their rapidly inflating home’s value, to bail them out by rolling their high interest rate debt into a new mortgage or HELOC.  Most consumers won’t have this safety net this time around.  Credit is becoming increasingly tight.  Banks are much more risk averse today than they had been, causing them to be much more selective about who they provide loans to.  Plus, the number of people who have little to no equity in their homes at all is growing by the day.

I am becoming increasingly pessimistic about what the near future holds for credit card companies.  I am particularly down on companies that are more pure credit card plays than Bank of America, like Capital One (COF) and Discover Financial Services (DFS).  After writing about my concerns in the earlier blog post titled “Swish, Swish, Swish, Swish...What's that sound?” I made room in my CAPS portfolio to short both of them.

In the aforementioned speech, the Bank of America representative went on to state that the company’s losses on home-equity loans will likely be worse that it predicted they will be just three weeks ago.  B of A’s losses in its $118 billion in loans that are linked to home values are now expected to be over 2.5%.  Yuck.  I don't know which ones they are, but any banks with significant exposure to HELOCs are likely headed for a world of pain.  HELOCs are subordinate to primary home loans, so they're basically at the bottom of the totem pole when it comes to getting repaid from the proceeds of a home that goes into foreclosure.  Many banks can't even get back what they are owed on primary mortgages.  How much do you think is really going to be left at the bottom of the barrel for HELOCs?  Not much.  Sure, they usually are almost all recourse loans so banks can go after former homeowners for repayment, but good luck at getting it.

That’s all the trash that I’ll talk about credit card companies and Bank of America for now.  You know that you’re an investing nerd when you have had people come up to you on more than one occasion and ask you if you are reading a text book.  I’m currently working my way through a tome called Basic Economics – A Common Sense Guide to the Economy by Thomas Sowell.  It’s extremely interesting and coincidentally I just read a short story about B of A in it this afternoon at lunch. 

In the early 20th century an Italian immigrant in San Francisco who was well aware of the fact that Italians, even those with low incomes, generally did a pretty good job at saving their money and  paying back loans opened a small bank in San Francisco that he called the Bank of Italy.  He used this name to make sure that he attracted his target customer base.  After starting in a small office that had three chairs, an adding machine, a safe, and one teller’s window the company became so successful that it began to expand across the state of California and it started to attract many non-Italian customers.  This is how the company that we now call “Bank of America” got its start.  I never knew that.  Interesting, huh?

Deej

No position in any company mentioned

7 Comments – Post Your Own

#1) On May 13, 2008 at 3:19 PM, Gemini846 (57.52) wrote:

Cool tidbit about BoA.

Ironically the AAA customer base that has been paying thier morgages and HELOC's on time have benefited quite a bit from the fed rate cuts (further squeezing bank margins if the bank had any skin in the game to begin with).

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#2) On May 13, 2008 at 3:39 PM, mandrake66 (93.80) wrote:

I've been short BoA for a good while now, but you convinced me to jump on the short bandwagon for DFS.

A couple of other good shorts, on a related theme, would be FDX (Fedex) and UPS. They're widely considered to be excellent recession barometers, and would be battered by a consumer-led pullback at the same time they were being hammered by rising fuel prices. 

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#3) On May 13, 2008 at 3:46 PM, TMFDeej (99.40) wrote:

Thanks Gemini.  You're right about the Fed rate cuts helping to lower many HELOC payments.  Mine is tied to prime.  My payment has dropped by several hundred dollars over the past year.  Go Fed Go ;).

The reverse will be true if the Fed were to try to begin raising rates again.  Payments that are tied to prime will begin to rise, choking what little economic growth we have left.  I have a feeling that the Fed Funds Rate will be at least this low for much longer than most people believe.  I heard on CNBC this morning that the Fed Fund Futures are pricing in a 40% chance of a 25 basis point rate hike between now and November.  Come on!  I need to figure out how to make that bet.  There's NO WAY that the Fed is raising rates between now and then.  Anyone know how to play the Fed Funds Futures market?

Deej

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#4) On May 13, 2008 at 3:48 PM, TMFDeej (99.40) wrote:

Good point about the transports, mandrake.  Thanks for reminding me.  After reading a piece on how well the transports ETF (ITY) has held up despite the economic turbulance and astronomical oil prices I have been meaning to short it in CAPS.  I'm heading out to try to make room right now.

Deej

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#5) On May 13, 2008 at 4:02 PM, TMFDeej (99.40) wrote:

Oops that ETF is IYT.  Dude you have to take a look at its chart.  It has been on fire.  I couldn't figure out why until I took a look at its holdings.  It has a number of railroads.  I actually like railroads, despite the fact that I don't own any.  This isn't the screaming short that I was hoping for.  The FedEx short that you mentioned is probably a better trade.  Too bad, I like the company.

BURLINGTN N SANTE FE BNI: 9.23%

C.H. ROBINSON WW CHRW: 5.11%

C S X CP CSX: 5.59%

FEDEX CORP FDX: 9.26%

LANDSTAR SYSTEM: LSTR 5.09%

NORFOLK SO CP: NSC 5.03%

OVERSEAS SHIPHDLG: OSG 7%

RYDER SYSTEM INC: R 5.83%

UNION PACIFIC: UNP 12.5%

UNITED PARCEL SVC: UPS 7.3%

Deej

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#6) On May 13, 2008 at 5:04 PM, mandrake66 (93.80) wrote:

Yeah, that group of transports is a bit dangerous, either long or short. I convinced myself that railroads were overpriced a couple of weeks back, but only shorted CSX in CAPS. I couldn't bring myself to do more than one. Railroads actually do have substantial fuel bills, and I've read reports of cars being sidetracked for lack of freight, but still rails are going to fare better than trucks and airlines. I'm really not sure where rails are going from here. I think they'll have some difficulties, but might not be very attractive short candidates except perhaps on a case-by-case basis.

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#7) On May 13, 2008 at 6:50 PM, XMFSinchiruna (27.78) wrote:

Great post Deej!  I have nothing to add to your post, because you summarized the situation beautifully.  :)

 I had wondered about the origin of BOA, so thanks for that info as well.

As for the transports... there is a very real secular story to the demand for coal and other items commonly shipped by rail, and the robust nature of that demand translates in to durable pricing power for railroads to pass on rising fuel costs.  As a group, they have had quite a run, but I would hate to be on the short end of that stick.   :)

Looking at the holdings, I would guess the ETF will move basically sideways, with strength from some rails and certainly the maritime shipping company, but major weakness in UPS etc.  I think you guys are calling this one right... too mixed a bag to be short or long that ETF... especially with options as enticing as SKF out there.  :)

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