Tuesday, June 19, 2012

The Debt Debacle ... Consumer Borrowing In A "Whole New Ball Game" Credit Scoring System

The Debt Debacle

The world is awash in debt. Nations, households and individual states as well.

How did this happen? How did we get ourselves in this mess? And why didn't we see it coming and stop it before the tsunami hit us? And how do we escape? How long will it take to "return to normal?" And what is "normal?"

Was this just a simple matter of human greed, or is there a genuine lack of understanding about debt and its obligations among We the People?

Debt Deflation and Its Effects

Today in the U.S. it's much more difficult to qualify for a home or any other personal loan at the bank than was the case until very recently. My Dad once told me that banks were there to loan money to people who didn't need to borrow. He was right about that. Now let's examine why.

We'll begin our discussion with an example of what banks refer to as asset based lending to businesses.

Financing a Business

So let's assume we want to buy or build a small business. That will require us to finance its purchase of the necessary land and buildings, as well as ongoing inventory and receivables. With good management, we can use suppliers to finance most of the receivables from customers and perhaps some considerable portion of our required inventory as well.

We'll plan to get paid by our customers in an average of 30 days and will plan to pay our suppliers on average in 60 days. If we can then conduct our business with an amount not exceeding 30 days in inventory, our investment in inventory and receivables is a total of 60 days. Since our suppliers are willing to wait 60 days for payment, our "working capital" can be financed without borrowing.

We'll assume further, however, that the lender is willing to finance up to 70% of inventory and 90% of receivables, since these assets are most likely to be converted into cash quickly. Thus, inventory and receivables financing isn't a problem.

The financing problem relates to the land and buildings. They're slow and often hard to sell at top dollar, too. So perhaps our lender will only loan us 40% of the amount we've invested therein. That means we need "equity" equal to ~60% of the investment in land and facilities. That's our "down payment."

Financing a Home

Now contrast that with a home purchase, including the necessary down payment and such. Our personal "working capital" is earnings from the business that employs us. The home mortgage, at least in today's world, from the lender won't amount to 100% of the home's purchase price, so we have to have a down payment. Maybe 20% or more.

Historically, that's where the government knows best "help" entered the picture. In the form of Fannie Mae guarantees, they told our bank lender that they would purchase the mortgage from the bank. That in turn let the bank off the hook in determining our creditworthiness, since the government institution was in effect buying our bank loan.

Thus, government sets the terms of its purchase of home loans from the bank, the bank complies with those terms, the bank loans to individuals in accordance therewith and the bank is off the hook. The government is the "owner" of the loan. Now you know all you need to know about credit scores. In effect that's how the bank unloads its home loans to taxpayers, aka the government.

To repeat, all the bank has to do is meet the credit score requirements set forth by the government. A good description of how this works today is provided in Fed Wrestles With How Best To Bridge U.S. Credit Divide. The article tells about how much harder it is today to get credit approved for a prospective borrower and the havoc that is wreaking with our overall economy, individuals and many would-be home buyers as well:

"The U.S. recovery is hobbled by an economic divide that separates Americans not by income or wealth but by their access to credit.

The housing bust left behind millions of people with credit records damaged by plunging home prices, lost jobs, past overspending or bad luck. Many are now walled off from the low interest rates engineered by the Federal Reserve to spur the economy and remedy the aftereffects of the borrowing boom.
Millions with good credit, meanwhile, are taking advantage of the easy money, a windfall in many cases for people who don't especially need it.
Last year, nearly 90% of all new mortgages originated went to households with high credit scores; before the financial crisis, it was about half . . . .

Shrunken access among credit have-nots is triggering more than personal plight. It has weakened the influence of the Fed—one of the best hopes for spurring stronger economic growth—and raised doubts within the central bank about whether it is doing much to reduce unemployment.
The debate is especially important now. Fed officials are weighing new steps at their policy meetings Tuesday and Wednesday, following a period of disappointing jobs growth and financial turbulence in Europe.

The credit divide factors into their thinking. Fed officials have been frustrated in the past year that low interest rate policies haven't reached enough Americans to spur stronger growth, the way economics textbooks say low rates should.

By reducing interest rates—the cost of credit—the Fed encourages household spending, business investment and hiring, in addition to reducing the burden of past debts.

But the economy hasn't been working according to script.

After surviving a crisis caused partly by loose lending, banks remain reluctant to extend credit to households with even a hint of financial problems. Fannie Mae and Freddie Mac, the two government-backed mortgage finance firms, tightened their own standards after the crisis. Banks worry Fannie and Freddie will return any troubled mortgages."

The Financial Instability Hypothesis (FIH)  ... Hyman Minsky

When we take out a home loan because we "qualify," we're leaving the credit decision to the government.

If there's a problem down the road, it won't be the bank's problem. Most likely it won't be the government's either. It will be strictly our problem. So now let's look more closely at how borrowers should think about loans they're contemplating.

In his Financial Instability Hypothesis (FIH), Hyman Minsky categorizes borrowers into three types: (1) hedge; (2) speculative; and (3) Ponzi. {Please bing or google Hyman Minsky or Financial Instability Hypothesis.}

Hedge borrowers are able to make interest and principal payments as scheduled and out of earnings. Least risky borrower.

Speculative borrowers can make interest payments as scheduled out of current earnings but aren't able to make principal payments. Thus, they need lenders to continuously roll over or extend their loans. More risky borrower.

Ponzi borrowers need the value of the asset to appreciate so they can pay off the loan, including its interest. Most risky borrower.

(All need sufficient income to service the loans, and that money generally comes from their jobs.)

Loans to businesses which generate earnings and cash in their normal operations also require assets as collateral and "equity" as well. Then if the borrower defaults, the lender can be repaid, if all else fails, by seizing  and selling the assets for more than the loan amount outstanding. The business borrower loses his equity, of course, but the bank is largely unaffected, as is the general economy, government and the taxpayers, too.

Loans to individuals for household asset purchases are very risky, both to the borrower and perhaps to the lender as well, although the lender is often backstopped by the government.

Rock and a Hard Place

Credit score tightening today has corrected the prior error of treating Ponzi borrowers as if they were hedge borrowers. By substituting government judgment for that of individual borrowers and their banks, borrowers flocked to purchase "can't miss" home owner "investments."

After the bubble burst, today only hedge borrowers are welcome. It's just like the days that Dad first described how banks work to me. And it's also just like the conditions that were in effect when my wife and I purchased our first home many years later. But back to today.

In turn, that means those who bought a few short years ago probably can't sell their homes for anywhere near the price they paid. But they still owe what they "paid." And the prospective new buyer has lots of homes from which to choose when making his purchase. Hence, it's very much a buyer's market, and that probably means low prices for a long time to come.

In simple terms, the rules of the game were crazy and but for government loan guarantees of "low credit scoring" Ponzi buyers, the Ponzi game never would have been possible.

Finally ....

Home prices will stay low for years to come.

People are stuck with homes that aren't worth close to what they paid and what they still owe.

Banks now won't loan money to buy those same homes at the prices the current owners paid.

The credit scores have tightened and fewer potential home buyers qualify for home loans under the new and now appropriate rules of the game.

What this all means to us is that we must always differentiate between loans for business and personal loans.

Personal loans should be of the hedge loan variety and rarely, if ever, speculative in nature.

And they should never be of the Ponzi type.

Sadly, however, and with the encouragement of the government acting on behalf of We the People, that's what many home loans were during the housing bubble --- Ponzi loans.

Thanks. Bob.

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