The Rational Misers: Inside the Psyche of the Financially Shell-Shocked Former Consumer

This article is a commentary follow-on to two interviews with my old longboarding friend: A Surfer's Take: Who the Mortgage Rescue Plan Won't Help and Why that Stinks for the Economy and A Surfer's Solution: How to Inject Financial Liquidity at the Consumer Level through the Housing Market.

AS WE SPEAK, "stopping foreclosures" continues to be the government's apparent Holy Grail. "Keeping people in their homes," helping "responsible homeowners" afford their mortgages, even forcing the rewriting of private contracts---these are the goals of various federal programs designed to fix the nation's housing mess.

The problem, however, as my surfer friend (whose interviews are published at the links) sees it, is that these measures miss the very large elephant in the room. Yes, stopping foreclosures may "stabilize" the downward spiral in home values. But, at this point, it is hard to see how stabilizing home values might "stimulate" economic growth.

Here's why: the elephant in the room is millions and millions of economically shell-shocked former consumers. These former consumers have been hit with sudden, massive wealth destruction. They are deeply affected by Post-Economic Trauma Savings Syndrome.

Post-Economic Trauma Savings Syndrome

In short, these people are newly minted rational misers. And , according to my friend, the government seems oblivious to the impact of these former consumers on the economy or its recovery.

"Tell their story," my friend said. "Lay it out, step by step. Show where it's going."

Somehow, he says, policymakers must get the fact that the economy affects the psyche, and the psyche affects behavior. Multiply that by several million consumers and, before you know it, you've got a stubborn problem. A problem that only grows more stubborn the more it is ignored.

Meet the Smith Family - Adam, Amy, and their two children

Meet Adam Smith and his family. The Smiths are middle-aged, not quite senior, members of the American middle-class. Adam earns a salary of $100,000 a year. Amy is a stay-at-home mom. The Smiths have always worked hard, kept a significant cash reserve for emergencies, saved, and been cautious with their money.

By 2008, the Smiths had acquired a nice home. They had built up their retirement accounts. They drove older cars. Their non-housing debt was low. When they had money left after paying their bills and funding their savings, reserve, and retirement accounts, they spent it on goods and services they liked having.

The Smith family home

The Smiths bought their present home in 2005. It cost $500,000. They made a $100,000 down payment and obtained a $400,000 mortgage. Under the terms of their 30-year, fixed mortgage, their payments were about 33% of Adam's income. The house was well within their means.

By mid-2008, the Smith family home was valued at $350,000, a 30% decline. This decline represented a $150,000 loss in value off the purchase price. This loss in value was much larger than even the $100,000 in cash the Smiths put in to the home. The Smiths were now underwater on their mortgage. Not only that, there was no prospect of selling their home at almost any price, any time in the foreseeable future.

Refinancing? Not an option

The Smiths decided they would try to lower their monthly payment by refinancing. Their lender turned them down. Although they had good income and excellent credit scores, their home no longer met the lender's 80% loan-to-value ratio.

Adam reminded the loan officer, who had worked with them on their previous home as well, that they had put $100,000 of hard-earned cash into the home---did that not count for something? It didn't. When Adam hung up, he told Amy, "Our money is gone. A down payment is supposed to give you a stake in your home. It's supposed to show your commitment to your investment. But it's like that $100,000 never existed."

The Smith's retirement accounts

The Smiths had been saving for retirement for over 20 years. In the last ten years, they had made a concerted effort to save more. Their combined investment and IRA accounts totaled $400,000. Until the end of 2008, that is.

By that time, their investments took a sharp dive. Although their funds were professionally managed and highly diversified, the Smith's retirement savings declined in value by 40% by the end of the year---and were headed lower in 2009. The cash value of the loss, so far, was $160,000.

When Adam and Amy consulted their financial adviser, they were told that the market would recover, but that it likely would be several years before their accounts returned to their 2008 value.

The Smiths realized that not only had they lost at least $160,000 in value in their retirement fund---an amount that quite possibly could grow larger in the immediate future---but they also had significant lost earning potential. Amy said, "We don't have eight, ten, or twenty years to recover from this. Our retirement, basically, is gutted."

The impact on the Smith's financial psyche

The economic downturn affected the Smith's finances, and future, in many ways. They accepted that their home could lose value off what they paid for it. But they never imagined that, in a short period of time, it would lose an amount equal to more than their entire $100,000 cash down payment.

It was the loss of their down payment---loss of access to that real money and loss of its financial "meaning" in the mortgage market---that was the last straw for the Smiths. Focusing only on their down payment and retirement accounts, the places where they had actually deposited cold, hard cash, the Smiths calculated that, in a matter of months, they were out cash and asset value to the tune of $260,000.

Sure, the Smiths grew up on "buy and hold." And, yes, they knew very well that some would say their losses were "on paper" and, therefore, "not real." But none of that mattered to them, really. The Smiths could not shake the sinking feeling that, for all intents and purposes, in a matter of months and for the foreseeable future, they had lost at least $260,000.

Two hundred and sixty thousand dollars. That was a lot of money---almost triple Adam's salary for a year. It had taken the Smiths many years to save that money up in the first place. Not only that, they still had their mortgage---which now also felt ridiculous---to pay; they could neither sell their home without coughing up more cash at the table, nor refinance it as a way to reduce their monthly housing costs.

Adam and Amy also worried that the economy, and thus their financial position, might deteriorate further. They always thought Adam's job was secure. Then again, they also always thought Lehman Brothers was too big to fail.

The rational response: stop spending

Ultimately, the Smiths decided they'd better be even more careful with their money than usual. After all, it was clear no one knew how bad things actually might get. There was talk of higher taxes. Amy watched the news on the economy and remarked, "If they hammer all the financially healthy people, only the financially sick people will be left."

Even if things got better, and soon, the Smiths realized that their personal recovery from this global financial catastrophe was going to be a long, hard haul. The Smiths had what money they had in the first place because they had hunkered down over the years. Now, they would hunker down again. The Smiths immediately stopped spending.

The Smith's previous discretionary spending

Prior to the crash of 2008, the Smiths spent about $20,000 a year in purely discretionary purchases. These were purchases of goods and services the Smiths enjoyed having, such as a lawn service, an in-home security service, a gutter-cleaning service, a book club membership, expanded cable television, dry cleaning, chain store oil changes, parking fees at Adam's work, hair and nail salon visits, regular dining out and Starbucks.

They had no trouble pulling the plug on all this and more. After all, the Smiths were looking at a huge mountain to climb in their personal finances. And they were in a state of lasting financial shock.

In addition to purely discretionary spending, the Smiths identified about $10,000 a year they could chop off their expenses. The first thing they saw they could do was cut back drastically on their grocery bill. Steak? No, chicken would do. Frozen burritos? No, tortillas and a can of refried beans are fine. Laundry detergent, dish soap, toothpaste, socks? Buy cheaper ones. Name brands? Forget it.

It all adds up

All told, the Smiths took $30,000 a year that they had been putting into the consumer economy and put it toward rebuilding their financial position instead. At that point, nothing could make them spend that money the way they used to.

Adam jokingly told Amy that he should get a t-shirt that said, "You'll get my discretionary income when you pry it from my cold, dead hands."

On February 27, Bloomberg and other financial news sources reported that the U.S. Gross Domestic Product shrunk at a 6.2 percent annual rate from October to December. Most analysts pointed to a severe contraction in consumer spending as the cause of the GDP drop. It was the first time since records began being kept in 1947 that consumer spending contracted more than 3% in consecutive quarters.

What is missing from the Smith's story?

The Smith's decision to stop consumer spending was not based on the foreclosure rate. It was not based on whether foreclosures would continue or stop. Nor was it based on whether the decline in the value of their own home would continue or stop.

The Smith's decision to stop consumer spending was not based on a job loss or other change in their income. It was not based on lack of consumer credit. It was not based on fear of what might happen in the future.

The Smith's decision to stop consumer spending was based on one thing: how they felt about their perceived financial losses. They knew very well that the money they used to have for a down payment on a house, and for their retirement, did not grow on trees.

Rightly or wrongly, the Smiths went into a lasting state of Post-Economic Trauma Savings Syndrome. They were now rational misers.

The Epilogue

There were millions of former consumers like the Smith family. They still had their jobs, homes and some assets saved up. Therefore, the government ignored them (when it wasn't targeting them for higher taxes, such as a cap on the home mortgage interest deduction). No one seemed to contemplate how the financial losses suffered by these former consumers affected their psyche, and thus the economy.

Regardless of what the government did to "help" others, the Smith family pursued their own survival plan. There were ten other families on Maple Street, where the Smiths lived, in the same situation. These families had the same reaction to their financial losses. The reaction of these ten families alone resulted in about $300,000 (10 x $30,000 per household) in discretionary consumer spending, much of it in the local economy, screeching to a halt that year.

Joe's Lawn and Trees

Here's one example. Over the years, based on word of mouth (and especially good-looking lawns), the Smiths and many of their neighbors had signed on to the same lawn service, Joe's Lawn and Trees. The Maple Street clientele had been very profitable for Joe's. They paid their bills on time and, the better their lawns looked, the more services they signed up for.

This spring, however, the neighbors began to feel that paying someone to mow, edge, trim and fertilize their yards was a luxury they could do without right now. Plus, they joked, their homes were "worthless" anyway, so why keep up the yard? Adam's next door neighbor told him, "You'll never be jealous of my turfgrass again."

One by one, the families dropped their annual contracts with Joe's Lawn and Trees. Joe was devastated. At the same time he was losing his most loyal, most profitable long-time customers, he was having no luck at all signing up new ones. In fact, he'd signed up zero new customers since last Fall.

As it became more and more clear that his core customer base was tanking, Joe had no choice but to forego new hires. He also had to start thinking about letting employees go.

Then things got worse. Joe's wife lost her job at a daycare center. People were cutting back on child care expenses. Without as many customers, the center simply could not pay so many teachers.

Joe and his wife had never been dependent on her income. But with his own once-solid business quickly disintegrating, they now were in trouble. In a few months, Joe and his wife called their lender to say they could no longer make their mortgage payments. In a few more months, their home went into foreclosure.

Brain check

In my previous interviews with my surfer friend, he argued that nothing the government does to "fix housing" will work until it somehow confronts the reality of why those who could support the real economy more, aren't. His point is, if the government wants to fix the bad effects of the housing market, it first needs to understand all the ways in which the housing market affected everyone's financial situation.

"Foreclosures hurt everyone," my friend said. "But that doesn't mean stopping foreclosures, as great as that might be, will help everyone. More than that needs to be done if the government wants to unlock the consumer markets."

My friend's ideas centered on tax deductions and credits tied to a homeowner's stake in the housing market. For example, he advocated a deduction, with a carryover, that was a multiple of one's present home mortgage interest deduction.

The idea, he said, was, if the government was going to spend a bunch of money anyway, spend it to "free up" and "unlock" --- in other words, to "stimulate," emotionally --- the spending of families who still had some wealth to spend. It might not be dollar for dollar, but it was, according to him, a much better bet that tax breaks for all homeowners would dilute, at least somewhat, the shock of their financial losses. This, then, at least had a chance of mitigating the profound effect of widespread Post-Economic Trauma Savings Syndrome.

In the budget blueprint released in February, the White House proposed a cap on the present home mortgage interest deduction.

Previous related articles:

A Surfer's Take: Who the Mortgage Rescue Plan Won't Help and Why that Stinks for the Economy

A Surfer's Solution: How to Inject Financial Liquidity at the Consumer Level through the Housing Market

Sources:

Timothy R. Homan, "U.S. Economy: GDP Shrinks 6.2%, More Than Estimated (Update 1)," Bloomberg.

John D. McKinnon and Martin Vaughan, "White House Rethinks Tax Hikes," Wall Street Journal Online.