Keeping up with the Jones' is never easy but consumer spending (fueled by home equity debt) has been on a tear for several years. History tells us there are natural market cycles but most people would prefer the booms over the busts.

How long can the spending spree continue though?

One sign of our amazing economy is the ability to make lemonade from lemons. Here we see a market innovation, derivatives, coming to profit from personal finance problems.

As Home Owners Face Strains, Market Bets on Loan Defaults

New Derivatives Link Fates Of Investors and Borrowers In Vast 'Subprime' Sector 'These Are the Marginal Guys'

By MARK WHITEHOUSE

Wall Street Journal

October 30, 2006

Mr. Whalen, who manages a multibillion-dollar mortgage-bond portfolio at Los Angeles-based Metropolitan West Asset Management, stands to gain if Mr. Spirou, a financially stretched homeowner in New York City, reneges on his mortgage loan. That's because Mr. Spirou's $360,000 loan was packaged with thousands of others into a bond, and Mr. Whalen has entered a newfangled derivative contract -- similar to an insurance policy -- that will pay off if enough loans in the bond go bad.

Mr. Whalen represents a new breed of investor: people who are using financial instruments to bet against the homeowners they consider most likely to suffer in a housing downturn. Many such investors, including Mr. Whalen, don't expect the current slide in house prices to lead to widespread economic malaise. Rather, they're betting on trouble for folks like Mr. Spirou -- so-called "subprime" borrowers who have become homeowners thanks to the increasing availability of easy credit.

Whatever happens with Mr. Whalen's wager, there's a lot more at stake than his fund's performance or the roof over Mr. Spirou's head. Subprime lending has put as many as two million families into homes over the past decade, helping push the U.S. homeownership rate up to 69% from 65% -- a major shift toward an "ownership society" that politicians of all stripes have touted as one of the nation's economic successes. As the bets play out, they will show how much of that success is permanent, and how much a temporary phenomenon fueled by overly aggressive lending.

The advent of the subprime market reflects a sea change in the way banks make home loans. As recently as the mid-1990s, potential homeowners had to get over high hurdles to borrow money. Background checks could take weeks or months. Lenders typically required down payments of at least 20% of a home's value. People with dented credit, or young folks without adequate credit histories, had few if any options.

Foreign investors have played a big role in making money available. Analyst Mike Youngblood at investment bank Friedman, Billings, Ramsey & Co. estimates foreigners snapped up about a third of the $2 trillion in subprime-backed bonds issued since the beginning of 2002, often through investment vehicles known as collateralized debt obligations, or CDOs. These divvy up pools of bonds into slices with different levels of risk and return.

That means the market for derivatives on subprime debt could be here to stay, too, along with all the other infrastructure that allows investors to parcel and trade the risk of lending to U.S. home buyers. Some believe this will make the economy more resilient to the current housing downturn by keeping the credit lines open. "You have given people better tools to manage the risks, and this gives you hope that the pendulum's not going to swing as far back as it has in the past," says Martin Mühleisen, an economist at the International Monetary Fund who has studied the mortgage market. "But this new financial world has yet to be tested."

When people spend more than they make, they get debt. The most expensive debt is also the easiest to get, namely credit cards. And credit card debt continues to climb. As housing refinances fall, I would expect to see this climb a lot more in 2007.

Borrowing by Consumers Eases, But Credit-Card Balances Jump

By MARK WHITEHOUSE

Wall Street Journal

November 8, 2006

American consumers eased off on borrowing in September, though a persistent rise in credit-card balances suggests some are feeling the impact of the housing market's downturn.

The Federal Reserve reported U.S. consumer credit, which excludes mortgage debt, fell at an annualized rate of 0.6% in September to $2.366 trillion, or about $21,000 a household. That was up 3.7% from a year earlier, well below the average year-to-year rise of 7.1% over the past decade.

In recent years, rising home prices, easy credit and tax breaks on mortgages have motivated people to borrow against their homes instead of running up credit-card balances and taking out auto loans. As a result, total mortgage debt has almost doubled over the past five years, while consumer credit has risen by less than a third.

As of the second quarter, mortgage payments had reached 11.6% of disposable income, the highest level since at least 1980. Consumer-debt payments had fallen to 6.5% of disposable income, the lowest level since late 2000.