Wikinvest Wire

The downside of debt

Monday, April 14, 2008

There's a good bit of "sobering up" going on around the country these days as Americans are coming to terms with the huge pile of debt they've racked up in recent years.

It's hard to argue with the conventional "wisdom" of earlier in the decade.

If the value of your home went up $50,000 or $100,000 during the course of a year and you went into debt by another ten or twenty grand, what's the big deal?

What's wrong with having a little fun? You'd still be ahead by year-end.

Things went on like that for a number of years and people came to believe that that's just the way the world worked in the 21st century. Ain't it grand?

Unfortunately, the world doesn't really work that way - it's much, much different when asset prices are falling instead of rising. These day's you don't hear anyone saying, "The value of my home just dropped $60,000 last year and the bank froze my home equity credit line. I better pay down some of this outstanding debt".

The downside of debt seems to be a lot like the downside of drinking.

Or is it?

According to this WSJ story from last week, apparently there's still a little liquor left in the cabinet - the bar is apparently still serving drinks.

The credit crunch has made it harder for Americans to indulge in their love affair with debt. So what are they doing?

Borrowing more.

While tighter lending standards have cut off all but the most credit-worthy borrowers from auto loans and home loans, many people are turning to credit cards and tapping more of their home-equity lines of credit to dig themselves in deeper.
The rise in borrowing shows just how addicted the U.S. consumer has become to credit. Even as borrowers are cut off in one area, they promptly look for new sources. Workers have increasingly been raiding their 401(k) plans to take out loans over the past year, according to plan administrators and nonprofit groups.

Now, mortgage brokers say some clients are calling them in a panic, worried that their bank will freeze their home-equity lines. Deborah McNaughton, president of Legacy Financial Services Inc., a mortgage lender in Placentia, Calif., says several of her clients have recently borrowed more from their home-equity lines of credit and stashed the money in bank savings accounts.
For the past several years, William Jordan, president of Sentinel Group Inc., a financial-planning and wealth-management firm in Laguna Hills, Calif., has been advising clients to pull equity of their homes and put the money into safe, liquid accounts so they have access to the money. He recently advised one of his clients, Matilda Compean of La Mirada, Calif., to refinance her mortgage and take out cash after she was having trouble making ends meet.
Borrowing at eight percent and getting a three percent return? That might make sense if you're planning to walk away from the place. In fact, that might make a lot of sense under those circumstances.

Many, many years ago (before my wife and I wised up), I remember owning a home and living paycheck to paycheck figuring that, if one or both of us lost our job, we'd just go out and get the maximum cash advances on all our credit cards, stash the money away, and then stop paying the credit card companies so we could pay all our other bills for the next year or two.

Then, when home prices started going up and all that home equity became like a giant safety net, we were finally able to relax knowing that we had an "equity cushion".

Maybe we'd all be better off without equity cushions.

According to this report by Gretchen Morgenson in yesterday's New York Times, we may be about to find out.
In the last 30 days, lenders have sent several hundred thousand letters advising borrowers that their home equity lines of credit are frozen, estimated Michael A. Kratzer, president of, a Web site intended to help consumers reduce fees on home loans.

Major lenders — including Washington Mutual, IndyMac Bank and the Greenpoint Mortgage Unit of Capital One — say that declining property values are prompting the decisions to cut off credit.

Banks have the right, of course, to rescind these credit lines at any time under the terms of the contracts they struck with borrowers. And as home prices have tumbled in many parts of the country, banks are undoubtedly trying to protect themselves from exposure to additional losses.

But these actions are being taken even in areas where property prices are rising, Mr. Kratzer said. What’s worse, the letters provide no explanation for how the lenders determined that the property values underlying the equity lines had fallen.

Frozen home equity lines will surely intensify the consumer spending downturn and put added pressure on an already weak economy.
Just as responsible individuals spent more freely knowing that there was another hundred thousand dollars available to them if they needed it, they are likely to spend less after their credit line has been taken away.

This is not a good development for a consumption-based economy, though you could see this one coming from miles away.

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GPD said...

it was all too good to be true-- when boomers should have been saving they were going further into debt--- you are right "you could see this one coming from miles away"

TheHolyFatman said...

what happened to saving 10% of your paycheck into a savings account? and living below your means? I mean, that is what my father taught me, that's how I live now. Shame my savings account has a crappy APR.

Mathlete said...

Turnabout is fair play. For years, debtors have lived high on the hog with low interest rates. Now it is their turn to cut back and save, while the savers "live it up" by buying underpriced assets and 90% markdown clearance items.

TomK said...

Back in the 1830's China was the true superpower of the world, owning just about all of world's silver and gold. The British found itself depending on China trade which must be paid in silver or gold. The Brits had no more of the stuff. Desperate, they imported opium, which the rich Chinese found instant joy and satisfaction. The Chinese was hooked on the stuff. It was the point-and-click gadget of the era. So profound was the addiction that they not only spent the entire country's vast gold & silver reserve buying opium, but soon went into debt, which grew to gigantic proportions. But the Chinese still cannot do without opium, and by 1900, the country was bankrupt, and was invaded by just about every country that had a navy. The country was sold off to the invaders. By 1900, civil wars erupted and the superpower was dead. It took the Chinese a full century, to 2000, to figure out how to fix that.

It is not easy to turn around a national addiction of such scale. The US opium of debt: $9 trillion for the government, another $9 trillion for the private sector, $25 trillion of national obligations such as pensions. Add to this $0.8 trillion annual trade deficit, $0.4 trillion compounded annual budget deficit, and a dollar dropped in value of 40% since 2000. The US must print debt and borrow from foreigners just to pay the minimum interests of its debt. It has a vast crumpling infrastructure with no money to fix them. And now there is a vast loss of home equity value while the debt just keep piling up. There is no end in sight, and the opium hole gets dig deeper.

The American opium addiction has EXCEEDED that of the Chinese of the 19th century.


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