Sunday, August 30, 2009

Some Thoughts on Debt

I've been thinking some about debt. It seems to be the zeitgeist. There is nothing profound in this post. Mostly, I am just presenting a framework to think about lending and borrowing. The last part gives some of my personal debt rules.

Well, what this post lacks in profundity it makes up in length. Here is a small index.

What is Debt
Hedging the Bet
Different Kinds of Debt
When Waters are Calm
When the Storm Comes
Personal Protection

The other day I was in a shop that was being liquidated. I am always curious why businesses must close, so I spent a little time talking with the owners. One of the questions I asked was whether they had to take on much debt to open the shop. They said no, they used equity (the monetary value of a property or business beyond any amounts owed on it) from their home to finance the venture. For them, debt is defined to be any amount owed that exceeds net worth. That is, if you can sell all your property, and have enough to pay everyone you owe, you are not in debt. Even if this were an accurate definition, the home equity loan payments must have affected their cash flow.

What is Debt

The American Heritage Dictionary defines debt as:

1. Something owed, such as money, goods, or services.
a. An obligation or liability to pay or render something to someone else.
b. The condition of owing: a young family always in debt.

The other side of the debt coin is loan
a. Something lent for temporary use.
b. A sum of money lent at interest.
2. An act of lending; a grant for temporary use: asked for the loan of a garden hose.
3. A temporary transfer to a duty or place away from a regular job: an efficiency expert on loan from the main office.

Loans and debt are all about the future. Both the lender and the borrower envision a future where the debt can be repaid, usually with interest. Ben Stein wrote a column about sales in which he recounted buying a car he wasn't sure he could afford.

In 1976, when I moved to Los Angeles, I desperately wanted a Mercedes 450 SLC, a car that was — even in used form — far more than I deserved or could afford at my entry-level, highly tenuous work as a scriptwriter. My salesman at Mercedes-Benz of Beverly Hills, Larry Anish, listened to my objections and simply asked, “Don’t you believe in your own future?” Of course, I bought the car.

In this case, the salesman wanted to sell the car. His financial interests only involved the sale. The loan, its terms, and its collection were someone else's problem. The salesman's projection of the future implied the fulfillment of dreams and faith in the buyer. In this case, I presume the bet was good. Ben got, and enjoyed, his car. The salesman got his commission, and the lender got the money back plus interest.

A different power dynamic occurs when someone wants a loan to start a new business. The borrower is generally the supplicant trying to persuade others that the wish should be granted. The lender usually insists on a business plan that takes into account foreseeable costs, revenue, and risks. The business owner dutifully uses the plan to project a future where the business succeeds and all parties prosper.

Hedging the Bet

Because the future is uncertain, lenders usually hedge the bet. This takes a number of forms.

In a "secured" loan the borrower offers something as collateral. Collateral is property or assets that are offered to secure a loan or other credit. Collateral becomes subject to seizure on default. With a secured loan, the lender is judging that even if the loan is not repaid, the collateral will allow recovery of the money owed. This was the case with the business owners who were liquidating their shop. They put up a portion of their house as a guarantee that they would repay the loan. Even after their shop is gone they must keep up the payments on the business loan or the lender may foreclose on their home to reclaim the remaining balance of the loan (plus interest, fees, the cost of the foreclosure...).

For secured loans, losses are limited to the difference between the amount due on the loan and the value of the property (less any costs for selling).

A standard mortgage is a secured loan where the lender owns the property until the debt is repaid. That is, the property itself serves as a stand in for future payments. The lender can only lose if the property loses value over time. A similar, but more risky, arrangement is used by venture capitalists. In exchange for money, the borrower gives up some portion of company ownership. This includes not only profits, but decision making as well. The business itself serves as collateral. The investors are projecting that if the borrowers cannot repay, the investors can seize the company and make it profitable.

Not all loans are secured. Sometimes the borrower and lender take a leap of faith together about the future. This is usually not a blind leap. Most loans are made with the expectation of profit and a weighing of risk. The amount loaned is balanced against the current situation of the borrower and past history of repayment. At the single loan level the lender generally requires that a trusted person, someone with a history of repaying debts and with current financial means, guarantee the loan. Lenders also vary the interest rate based on projected risk. As uncertainty of repayment increases, so does the interest rate. Over a large number of loans, the lender is assuming a certain percentage of defaults. The interest rate must be high enough to not only cover these bad loans, but to make a profit in addition.

The consolidation of financial information has allowed information about virtually all loans for all people to be tracked and shared. In this way, lenders enter into loans with a reasonably complete history of past borrowing and repayment. Financial models are used to project risk levels, hence the "credit score". In addition, lenders usually require some proof of current income.

The existence of elaborate systems to predict risk gives great comfort to lenders who deceive themselves that they understand the likely future. Unfortunately, the actual future is often unlikely. Every system of prediction devised by humans has failed, often catastrophically.

Different Kinds of Debt

Debt should not be considered a curse word. Much, if not most, of our built environment would not exist without debt. This includes roads, bridges, buildings, automobiles, computers... Most of the debts incurred to build these objects were incurred in good faith and paid off as expected. For individuals, both homes and cars are usually financed by debt and could not be bought without debt.

Debt is incurred for different reasons. Some of this is embodied in the language we use to describe debt.

One of the terms is "leverage". The term is analogy with mechanical system where a lever allows a small amount of force to move a large object. In the financial case, the lever is the borrowed money. The borrower expects a future where financial gains from the borrowed money exceed the cost of the money.

Suppose I wish to buy a commercial property and have $1,000,000. I could invest all of my money and buy a small property outright. If the property increases in value by 10% and I sell, I make $100,000 profit. Suppose instead that I pay 10% down and take out a loan for $9,000,000. If the property value increases 10% and I sell, I make $1,000,000 (less the interest paid on the loan). With the same amount of my own money, I make roughly nine times as much. That is, I have leveraged my money.

In general, lenders of leverage loans insist on knowing the purpose of the loan and do their own analysis of the financial viability.

Educational loans are a form of leverage. The increase in earnings that come from increased knowledge and skills is expected to justify the risk that incurring a debt implies. Even a car can be thought of as leverage if it allows the buyer to travel in a way that increases income (a job across town).

A second kind of loan is "credit". This term is a strange reversal of meaning. In accounting there are columns for credit and debit. That is, credit is the opposite of debit. In more general parlance, credit is something you earn or have. In the lending industry, you can borrow against your perceived financial credit. That is, you can get a "credit line" which is an amount of money the lender thinks you are likely to repay. This gets shortened to credit.

Parenthetically, another twist of terminology is "debit cards". If you use a debit card, the amount is immediately debited to your bank account. Usually a debit card can only be used if you have the funds to cover the expense. That is "debit cards" do not incur debt.

Because the borrower is judged on general reliability, credit loans are typically "revolving credit". That is, there is not a single loan with a set amount and a fixed number of payments. Instead, the amount of the loan and the size of the payment can vary from month to month. The maximum amount that can owed at any time is fixed. This limits the risk to the lender.

Credit loans are typically unsecured and the lender does not investigate how the money is used. Consumers typically use credit lines for everyday expenses. That is, the money is used in ways that do not increase future income. This makes credit loans more risky and, as a consequence, increases their cost to the borrower. Some of the cost is in higher interest. Another part of the cost comes from fees associated with the account.

There is generally a minimum payment that must be made on a credit account each month. However, the interest and fees associated with maintaining a balance are so large that the minimum payment due may not even cover the monthly interest on the loan. As long as most of the loan will eventually be repaid it is to the lender's advantage for borrowers to have a large outstanding balance.

For example, if a credit card company lends someone $10,000 dollars and that amount is paid off at the end of the month, the card company makes only the amount of the money that the merchant paid to accept the credit card (typically a one to two percent of the bill plus a per transaction fee of between four and twenty five cents). For $10,000 this might be a single payment of $100 from the merchant.

If the borrower does not pay back the loan at the end of the month, the lender starts collecting interest. Currently, credit card annual percentage rates for interest range between ten and twenty five percent. On $10,000 a fifteen percent rate would be $1,500 a year or about $125 per month. In an economy where a five percent rate of return is considered healthy, fifteen percent is very good money. Of course if the borrower defaults on the loan, the lender is out the principal loaned. At fifteen percent, it takes about seven years to collect as much in interest as the original loan.

Lenders who want their borrowers to carry the highest possible level of debt do not have the borrowers best interest in mind. It is very difficult for many people to defer desires. The promise of immediate cash is almost irresistible. Most adults know someone with a large number of credit accounts, many of them "maxed out". They may even be borrowing money from one account to make minimum payments on another. They are literally "borrowing from Peter to pay Paul".

When Waters are Calm

Everyone who has watched "It's a Wonderful Life" knows that the credit system is based on trust. As George Bailey says:

No, but you... you... you're thinking of this place all wrong. As if I had the money back in a safe. The money's not here. Your money's in Joe's house... (to one of the men)...right next to yours. And in the Kennedy house, and Mrs. Macklin's house, and a hundred others. Why, you're lending them the money to build, and then, they're going to pay it back to you as best they can. Now what are you going to do? Foreclose on them?

The system is built on debtors paying their loans in an orderly fashion. George Bailey's building and loan acts as a middle man. In George's bank the people lending the money are the depositors. The people borrowing the money are the homeowners. Often the borrowers are also depositors. If the amount of deposits, loan repayments and withdrawals are predictable the bank can have enough cash on hand to satisfy the small number of depositors who wish to withdraw their money.

There are three pillars of stability.

  • The vast majority of loans will be repaid.

  • Assets that secure loans maintain their value and are liquid (can be sold quickly).

  • There is a predictable pace of repayment.

In orderly times (any time when this month looks a lot like last month) the system is resilient and can tolerate a certain number of loans not being repaid. As long as the average rate of default can be predicted the lender can factor that number into the interest rates for loans. The interest rate is not just a return on investment. It also covers losses from the few loans that are not repaid.

This desire toward order can be seen in pre-payment penalties. Some loans have a condition that penalizes the borrower for paying the loan before expected. The lender expects a certain amount of interest to be paid over a set amount of time. When the borrower pays back the loan early, the lender no longer gets interest payments. The pre-payment penalty compensates the lender for this "lost" income. Typically loans are repaid early because the borrower has found a lender with a lower interest rate. The pre-payment penalty keeps borrowers from jumping ship.

When the Storm Comes

Danger comes from disorderly times. Unfortunately, destructive feedback cycles magnify small problems and guarantee that there will be disorderly times.

The economy as a whole is incredibly interconnected with money flowing from person to person and organization to organization. This network does not just involve formal loans, it involves all non-immediate transactions. As an employee you are typically paid for work some time after it is done. This is not a formal loan, but you have loaned your labor with the expectation of a future repayment.

When expected cash stops coming in, the person or organization that expects the money does everything possible to recoup the loss quickly and to reduce the exposure to future problems. The response is typically two sided. One side is trying to replace the lost money, the other side is to reduce expenses so that the losses do not affect payments to others.

To replace lost money, organizations will typically try to be first in line for future repayment. In addition they will add fees and penalties to the amount due. Virtually every business invoice contains a provision for interest to be paid when the amount is past due. Usually there is increased emphasis on finding new customers.

Everyone who has worked for a large organization has seen it protect itself against cash flow problems. The first step is to reduce discretionary spending. The "Tuesday doughnuts" disappear. Training and travel are curtailed or eliminated. Then come hiring freezes, furloughs, and layoffs. When the problems are severe, expenses that are expected to yield future profits are eliminated. First to go is administrative staff followed by research and development. The sales force is a company's most immediate investment in profit. When layoffs hit the sales force it is a sign that the company is close to insolvency. Bankruptcy often follows.

Layoffs extend the problem from the business to individuals and families. Individuals and families protect themselves in much the same way as businesses. They try to increase income by finding new work or starting new businesses. Expenses not directly related to day to day survival are eliminated. Then credit card payments (past expenses) are ignored. Utility and shelter payments are next to go and finally food.

In our interconnected system, problems are infectious. If those who normally give you money pull back, you cannot spend as much with others. Those expecting your spending must, in turn, pull back. When a large portion of the economy is affected it is called a recession or depression. Recession and depressions are an economic infection so large that no single individual or organization can adequately respond.

Not every downturn spreads widely and there are different causes. When a single company fails, the surrounding economy usually replaces the missing goods or services and the workers find jobs in other firms. Some downturns are more widespread but do not affect the whole economy. The mechanization of agriculture causes farm labor needs to plummet while production remains high. Individuals lose their jobs and are forced off the land. When this happens the workers generally move to urban areas with more opportunities. This often leads to an increase in urban population and a large number of unemployed people, sometimes for a generation or more. This is devastating for the individuals, but the economy as a whole is often largely unaffected.

Personal Protection

Loans are about hope and the future. Don't discount your potential and your future, but try not to sabotage it either. There may be a time when you make a decision to "go for broke" because you think the potential rewards outweigh the potential risk. This is a good thing, but walk in with your eyes open.

The first step in protecting yourself and your family against financial trouble is to accept that trouble will come along. Someone will lose a job. The car will require expensive repair or replacement.

Temporary setbacks can be smoothed over by a reserve of cash. If the car breaks and you have some extra cash, you simply repair or replace the car. If you lose your job, the cash may see you through until you find another source of income.

Low income families may not be able to create any reserve. These families have no recourse and must respond to events the best they can. There are government programs (food stamps, section 8 housing ...) that may help, but basically you are on your own. When thinking about government aid, just remember:

The law, in its majestic equality, forbids the rich as well as the poor to sleep under bridges, to beg in the streets, and to steal bread. (Anatole France from The Red Lily, 1894)

One of the first responses to financial trouble is to reduce expenses. It is in this area that loans become dangerous. Loans are typically a fixed monthly expense. That is, they are an expense that cannot be reduced without starting a chain of negative repercussions.

Once again the poor get the short end of the stick. If you have no cash reserve but do have access to a line of credit, you can smooth over trouble by borrowing. Long term, this is a losing strategy. Loans always involve fees and interest and short term loans are the most expensive. If you cannot afford to create a cash reserve, you probably cannot afford the fees and interest. However, such loans may be the only recourse available.

Currently I am fortunate. I have sufficient income to cover my expenses and to create some reserve. Part of this is income, part is inherent conservatism. It is in my nature to avoid ongoing expenses.

If you can afford them, I recommend some rules of thumb.

  • Never use a credit line except to consolidate payment. I use a cash-back card for many purchases but I pay the balance in full every month without dipping into cash reserves. In fact, I go one step further. I do not put anything on the card unless I currently have enough money to pay for it. That is, I do not buy something on the fifth of the month with the expectation that my paycheck on the fifteenth will cover it.

  • Do not incur a regular payment that prevents you from saving a little every month.

  • Only borrow as leverage. That is, the money should be used in a way that will pay for the total amount of the loan. For a family, a mortgage is in this class. Shelter is an expense that cannot be avoided. If you intend to live in a place for some time, paying a mortgage rather than rent may make sense because the non-interest portion of the payment buys property that can be sold later. This can be a good long term investment even if the property decreases somewhat in value. Rent is simply lost.

  • In flush times, pay down debt. I bought my current car with a loan. A couple of years after the purchase I got some unexpected cash. I used that to pay off the car which eliminated a fixed monthly expense.

  • One way to create a cash reserve is to pay ahead on loans. I am several months ahead on my mortgage. When a cash crunch comes, that gives me an expense I can eliminate for some period of time.

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BeyondBankrupt said...
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