Safe Haven | What's THAT Sucking Sound? It's the Global Margin Call, Spawning the "Age of Frugality"!

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May 18, 2009

What's THAT Sucking Sound? It's the Global Margin Call, Spawning the "Age of Frugality"!
by J.D. Rosendahl

A typical margin call is a brokerage firm contacting their client, to ask them to either sell existing securities (assets) within the account or to deposit more funds (cash), to ultimately reduce the margin debt (loan) because there has been a decline in the value of securities in the account that no longer supports the existing margin debt.

In essence, a margin call is really a capital call. It's a request to sell assets or bring capital to the table to reduce debt by raising cash. Sound familiar? We see the capital call in every walk of life today, and I've listed some of the various forms below:

The Real Estate Foreclosure: When a bank forecloses on a home or other real estate assets, it's a forced margin call by the bank or lender. Someone can no longer make the payments on the loan, and the bank is forced to raise cash by foreclosing on the property and subsequently selling the asset to retire that debt. The real estate foreclosure ultimately puts someone out of their home, and while unpleasant it's an economic necessity of risk management just like the margin call in a brokerage account.

Calling a Business Loan: We are starting to see banks call business loans and lines of credit. It goes something like this: A business goes through a period of declining gross revenues, then profitability strains and maybe turns into losses. The business may begin to eliminate expenses and employees, and at some point that business is no longer big enough nor does it have sufficient assets to warrant the existing debt issued by the bank. The bank will usually notify the business owner to pay down the loan or bring money into the company to re-capitalize the balance sheet, either of which are a capital call. Then, if the business owner can't rectify the loan outstanding or balance sheet, the bank calls the loan due and payable. They may notify clients of that business that they are required to make payments (owed to the business) directly to the bank, which the bank will use to retire some or all of the existing debt. This kind of margin call can ultimately force someone out of business much like a real estate foreclosure.

The Reverse Margin Call: Banks aren't waiting for a problem to arise. They've been aggressively eliminating credit card availability to clients through reduced limits or eliminating the availability entirely. Banks are also closing down unused equity lines or reducing the line amounts, as collateral values have declined. And, banks are cutting business lines as well. While this is not a capital call to reduce debt, it's a reduction in the availability of credit. It's a reverse capital call, as banks anticipate a further deteriorating of economic trends or personal balance sheets and thereby seek a reduction of risk via the elimination of credit available to borrowers. This kind of pre-emptive move eliminates options for people and businesses to finance things in the future.

Lower Salaries: There's a new trend developing. It's the reduction in salaries and bonuses to existing employees. Why is that a margin call you ask? The employer needs to raise cash (capital call), and one of the ways they will do that is by reducing what they pay people (expenses). It's a twisted version of the capital call, that's just beginning to blossom as a trend. I expect it to continue and broaden into most industries. The employer will take money from party A (The Employee) and give it to Party B (The Bank, The Bond holders, The Shareholders, etc.).

More Cash Upfront: More and more financing of real estate, cars, businesses, etc. are requiring more cash up front, more skin in the deal as they say, and probably for sound reasons. Recently a friend of mine was buying a new home and wanted to keep their existing home as a rental. The lender on the new home is requiring they have at least 35% equity in the existing home (their new rental). That's correct; the home they are not financing has capital requirements to obtain the financing on the new home (their new primary residence). And they are required to put 20% down on the new purchase. It's a form of a capital call. It's just up front instead of down the road when there's a problem.

The Corporate Sale of Assets: Citibank is unloading a brokerage unit in Japan. GM is selling Hummer. These sales will raise cash they desperately need to help repair their balance sheets. This is a corporate form of the capital/margin call. As companies need to raise cash to survive or meet the demands of the bank/bondholder/government, they will sell non primary units (assets) of their company to raise that cash, and ultimately it will be valued far less than those assets were worth in the bubble days. AIG is under a huge margin call being monitored/controlled by the U.S. Government, which is requiring them to sell off assets/units.

Take it to the Pawn Shop: The pawn shop is bustling with business. I'm not just talking about the one located next to the casinos in Vegas, but high end pawn shops in Beverly Hills and New York, too. They are experiencing a flood of wealthy people selling high end jewelry, art, and collectibles to cover their debts and/or high end life styles. Even the rich have over spent and over leveraged their lifestyle to unmanageable states, which has been exposed during this economic down turn. This flea marketing of high end goods reflects a capital call on the lifestyles of the rich and famous.

What's that sucking sound you hear? It's the continual deflating of the debt/credit bubble forcing a wide variety of margin calls, which collectively create what I refer to as the "Global Margin Call" on society. That sucking sound is the draining of cash out of the system via the capital call to retire debts, repair balance sheets, and rectify financial distress and excesses of the past, or the sad attempt to maintain a lifestyle that's unaffordable.

Consequences of the Global Margin Call: The above represents some of the more obvious forms of margin or capital calls for cash in the world today. This is one of many reasons cash is "King" in this environment, and cash flow is a very close second. It's simply required to maintain or survive.

As the trend of deflating the global debt bubble continues we will experience the continuation of the global margin call in their various forms requiring asset sales or reduced spending to raise cash and cash flow. These forced assets sales ultimately push prices lower compounding the deflationary spiral until debt levels reach some form of equilibrium. And no, we're not there yet, not by a long shot. And this trend of reduced spending creates a new way of American life.

What about all the government bailout plans you ask? That's cash being pumped into the system, isn't it? I equate this socialism styled plan to sticking a finger in the crack of a dam on the precipice of busting. The bailouts will only hold off the inevitable for so long. The bailout programs are essentially there to keep corporate America afloat and cure the balance sheets of financial companies, so the financial system doesn't collapse, and to hopefully slowly unwind the bubble of debt and draw out this financial distress over time. The government is ultimately picking winners and losers with the tax payer's money. There's little if any functional spending supporting growth in the economy coming through the bailout programs. And frankly, our government might be exacerbating the problems, and ultimately creating 2 of the largest margin calls that have yet to come:

1) At some point, the bail out monies will have to be repaid in addition to the already bloated deficits, either by those companies that took money and/or tax payers through higher taxes. I'm betting on the tax payer getting stuck for a significant portion of the bill, which creates potentially one of the largest margin calls yet to take place. Higher Taxes: Now that's the ultimate margin call, isn't it? Yes, higher taxes are coming in a few years. Truthandpolitics.org reflects in 1952, the top tier federal tax rate peaked at 92%. And from 1932 to 1961 they were higher than 63% at all times for the top tier. We had 29 years of exurbanite rates. Today's top tier rates seem cheap compared to prior periods. Sadly, higher rates will create the ultimate margin call and a drain on tax payer cash flow with higher tax rates to pay off exploding government spending.

2) As the government continues its massive overspending campaign of money they don't have, they will continue to deplete the government's balance sheet through the issuance of more and more US Treasury Bonds. As the amount of American Bonds floating the globe spirals out of control, some day foreign governments around the world will lose their appetite for those bonds. In the near future, these foreign governments will seek to diversify their reserve holdings and sell those bonds, which will create another massive margin call. This rebuff of the American Bond will force bond prices much lower in value, and thereby causing a spike in interest rates. Higher interest rates will raise the cost of capital, which will drive asset prices lower and start a new wave of margin calls all over again.

The standard of living as we know it is under assault from declining asset values, a lack of available credit, and subsiding income levels. We no longer feel rich because we no longer have the inflated paper assets or credit availability to spend like a drunken sailor. We no longer have the feeling of security in our income source to continue buying every want in the world. In simple terms we can no longer live like we did in the bubble days of easy money and available credit.

That sucking sound you hear is the deflating of the debt bubble causing a depression in asset values forcing a global margin call. The global margin call has forced a redirection in the use of cash, which forces people and business to spend less. The new era has served as the wake up call that people can't afford their overspending methods of the past, and will need to curb their spending habits in the future, and thus, the global margin call is spawning the "Age of Frugality"!

The Age of Frugality: No more or a lot less Bling Bling
The America way of life is under enormous pressure to change, and this new era is underway because society finally realizes it doesn't have the cash, assets or credit to continue prior spending levels, and thus a reduction in spending habits is a must. As the availability of credit dries up, and assets continue to decline, and personal incomes contract, our purchasing power has taken a hit. We essentially have less money to spend. Its simple math a 5th grader understands.

In addition, we have less confidence in our income stream, or the return of asset prices, so we will defer spending money to rebuild our net worth through increased savings, which also reduces the amount of money we have for consumer spending thereby compounding the hit to the standard of living and our economy.

That sucking sound you hear is the combined margin calls in their various forms drawing cash away from our consumption economy and forcing the sale of assets, which like it or not, has us spending less and for the foreseeable future. This crimp in spending has spawned the 'Age of Frugality".

This new age of frugality will permeate our culture and influence changes or trends in spending and human behavior and ultimately the economy. Some of those spending changes or trends have already taken hold, and I've identified a few below:

The Country Club: I was discussing the country club industry dynamics with a friend the other day, as I feel it's a perfect microcosm of what society is going through: Americans bingeing on home equity or peak level incomes to join country clubs back in the bubble days to maintain their high end lifestyle. There's a country club 5 minutes from where I live. A few years ago it was $80K to join, and now it's down to $25K, and there's still no interest. In fact they have a waiting list over 100 to get out. Country clubs are struggling all across this land, as people realize they either can't afford it, or would rather have those monthly dues and year end maintenance calls in their pocket. As people right size their living standards high end discretional items like the country club experience are getting discarded.

Major League Sports: Have you noticed that most major league sports franchises have declining attendance issues? The cost to go to the "Game" with your family or friends has been quite the expensive ticket, no pun intended. I gave up my season tickets to the Oakland Raiders years ago, when I realized financially how ridiculous it was to pay for tickets ($60-80 each or more), $20 parking, $6 drinks, and $5 hot dogs. By the time the day was over the cost of going to the game was a small fortune, not to mention going to every game as a season ticket holder, and for something I can watch for free at home. I suspect, people are realizing this in masses today, and season ticket sales and attendance are struggling. The trade down from season ticket holders to watching it on TV represents the consumer "product substituting" a different product for a similar experience. Product substitution is done to decrease expenditures or raise cash flow and its becoming the norm.

The Big Box Syndrome: I live in the greater Bay Area of California, and during the bubble days of real estate development, the big box home was being built everywhere. The big box home is a 3,000-5,000 square foot house built in rows one after the other on 6,000 s.f. parcels. Where I live, we have flooded the market with high end real estate, and in the current environment it's not selling. Why? In the age of frugality who needs or wants the big box? Who wants to finance 50-70% of their income, and work solely to make a mortgage payment? Who wants real estate taxes of $1,000 per month? Who wants to pay the gas and electricity to support that monster? In the age of frugality, the big box home will struggle to sell, as it's the classic symbol of over leverage, over supply and over development of the real estate bubble. In the age of frugality, people are going to enjoy saving money and not living to make their mortgage payment, which supports the trend of basic housing to support living standards.

The Monster SUV: Americans have gone through a long phase of falling in love with their monster SUVs, and not just the practical ones that cost $25-30K, but we all wanted the $50K plus SUV. It has to have four wheel drive that no one ever uses and all the amenities of a stretch limousine. And, I see two parked in many driveways. In this new age of frugality, the monster SUV will slowly be replaced by more efficient and practical cars. And along the same line of thinking, the age of frugality will give rise to the notion of buying well maintained used cars over new cars for simple financial practicality. The monster SUV has been the day to day iconic American symbol of trying to keep up with the Joneses. Do we really need or want that $700 to $1,000 car payment? Do we really want the cost to replace tires? The age of frugality will put the kybosh on the big box automobile and for good reasons.

Dining Out: During the bubble days, dining out became the rage partly because of a lack of time between work and family, and partly because we felt rich and everyone else was doing it. I remember growing up in the 1970 and 80s, and dining out was the occasional treat, and now it's become the everyday event. As we compress our spending habits, we will dine out less and less, and realize there is a huge cost savings to dining in, or dining with friends at home, and an improved social experience by doing so. Dining in is another form of product substitution in a sense.

Dumpster Diving: There's a new trend called dumpster diving. There are people out there scrambling through large trash bins looking for things of value. I've read stories of the most frugal of individuals looking for packaged food to eat, to an individual who built a home out of discarded building materials. Yes, both sound quite extreme, but it goes to show that someone's trash is someone else's asset. It also goes to show how far the age of frugality has come. Why are we paying full retail pricing for anything? If it's not on sale, it will be in the future. Along similar lines, there's also a growing trending of buying used. Whether it's a vehicle or shopping at a thrift store for clothing.

No more Bling Bling: I have a piece of gold jewelry I can't wait to sell for its value. I have no interest in wearing my bling bling, and highly prefer the cash in my bank account. You see the announcements all over TV to send in your gold and silver jewelry for cash. For some, it's a means of staying financially alive, and for others it's the off loading of material wealth that's highly unnecessary.

The big house, big car, country club, and bling bling all represent money pits. These are cash and cash flow killers that exhaust personal discretionary incomes. There's a sense of freedom (financial freedom) one enjoys when we realize this and dump the money pits, and trade them in for every day necessities and increased savings and live the frugal life.

The Age of Frugality will hit Warp Speed Upon the Baby Boomer Switch:
In a few years we will see what I call the Baby Boomer Switch. The Baby Boomer generation in mass will begin to hit retirement age, and when they do retire their demographic spending trends will switch significantly.

As part of my job, I look at personal balance sheets, and for the past 15 years, I've noticed the typical boomer doesn't have enough funds set a side for retirement. In fact, most of their net worth centers in their primary residence, which is a non income producing asset.

Thus, the majority of their cash flow for retirement will stem from Social Security, and maybe some low paying part time job. If they're lucky, they will have some sort of pension income, as well, but the reality for most Boomers entering retirement is a large reduction in gross income, which is ultimately a large decline in their purchasing power.

What's really interesting for this segment of society is they are probably now shifting their spending habits to something much less to fall within their income levels today, which reflects the current economic environment. And, they will have to shift those spending habits downward again as they retire.

As the Boomers head into retirement, whether they want to or not, they will be forced to embrace the "Age of Frugality". They will curb their need for the large home and down size into a small home or mobile home. They will down size out of expensive states (like California and New York), and they will watch their pennies tightly because they are on a smaller fixed income with limited assets. That's simply what the majority will do when retired.

Unfortunately, right when our economy will need consumer spending the most, the massive boomer generation will enter spending hibernation via retirement. It's this baby boomer switch in their spending demographics that is one of the reasons we will continue a deflationary spiral, and it's not that far off in time. The lead age of boomers are now 63, so the front end of the wave of boomer retirement should start in size in a couple years.

As the boomers leave their primary careers, they will be replaced by younger and cheaper workers, as corporations attempt to improve their profit and loss statements. The following generations will not enjoy the same standard of living as the boomer generation which will also compress the economic trends of the day.

While the age of frugality brings uncomfortable change, it's not all gloom and doom, and as is the case with any major trend changes in life, there will be fruits of this new environment.

The Benefits of the Age of Frugality:
While the age of frugality will bring significant changes to the way we live our lives, and many of those changes will be painful or discomforting, I see three benefits stemming from this era.

1) On April 14, 2009, Stephen Moyer wrote an article posted at safehaven.com, "Real Estate/Credit bubble Deflation 18: Tick-Tick-Tick..." In that article about deflation, he discussed in the last paragraph the good news:

"I hope for a return to traditional American roots. The age of materialism is over; it is time to savor and appreciate family, good friends, relationships, neighborhood and community. The next ten years are going to be tough; we don't need to waste money and buy things and run up debt to be happy. We can appreciate those around us, engage in meaningful and enjoyable conversation, watch after each other, instill proper values in our children, volunteer, coach little league, play board games, plant vegetable gardens, expand our horizons, further ourselves."

I believe Steve's view reflects one of the major benefits of the deflationary environment and the age of frugality, which is the emphasis on family, friends, and community. For too long, our society has been caught in the greed of bubble chasing wealth, and we've lost focus on what's really important. The age of frugality will return Americans back to what's really important, and this part of life will experience a sharp improvement for those who embrace all that it brings. I believe the trend has already started. There's been an explosion on websites, like Facebook, where friends and family are reconnecting at record pace.

2) For those who embrace this new era, there will be a day and time when you can buy certain assets you feel are important to you or your family for a fraction of their peak values. Instead of pinching to save a 20% down payment on your dream house, double that same down payment and you might buy that house all cash in a few years.

It's the people who see the new trends and shift their assets to protect what they have and/or reduce their spending habits within their means to allow for the build up of savings that will be well positioned to take advantage of the fruits of this environment. Eventually, just about everything will be much cheaper because we are going through an extended period of over supply and low demand that will cause prices to drop further, much further.

3) The biggest benefit of all might just be the change in politicians to, dare I say it, "Responsible Government". What a notion. I know I'm stepping out on a fragile limb. There's a quote I love that states, "Man (society) gets the politicians they deserve". And we have been (as a society) greedily chasing rolling asset bubbles, and climbing the ladder of material wealth for a couple of decades now, and we have politicians that reflect the values of greed. We have some of the narrowest minded, self-interested, and narcissistic politicians seen in centuries. Frankly and sadly, we have the politician we deserve.

However, as the age of frugality continues, and society begins the adjustment of living with less, living within our means, being net savers, and focusing on the quality of the human experience, those attitudes will reshape the conscious of American society, which will in turn (I hope) demand those very same qualities from a new fresh face of American politicians. Politicians that, dare I say it, provide responsible oversight, prudent financial management, reduced spending and living within their means with our money. Hopefully we'll have politicians that do not answer to the few but the many, and embrace the American middle class! Then, and only then will the great American dream be reborn for all!

Hope all is well.

J.D. Rosendahl

J.D. Rosendahl is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, we recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.