Addicted to Debt

Dave Van Knapp of SensibleStocks.com is a frequent contributor to this site. He publishes a newsletter and two fine books on stocks, Sensible Stock Investing and an annual Top 40 Dividend Stocks compendium. As an aside, high quality dividend stocks are holding up better than almost any other category in this year’s tumult.

You read my thoughts on debt yesterday. Today, I’m happy to share with you Dave’s thoughts in the article below, sent to his subscribers on Tuesday.

Addicted to Debt
by Dave Van Knapp

I’ve been wondering what happened to the thrifty America that I grew up in. When my parents wanted a new refrigerator, they saved for it. Same for everything–a TV, a car, clothes, whatever. We lived within our means, which were not very high–a typical post-World War II, lower-middle class existence. That was fine, we were just like everyone else in our neighborhood.

The only acceptable form of debt was a mortgage, and my parents paid that off as fast as they could. They’d seen the Great Depression, and debt scared them. The “Greatest Generation” was thrifty and prudent. My mother had a “charge-a-plate” for the local department stores, and that was paid off each month. There was no other debt in our family; the very idea was ludicrous. Credit cards had not been invented yet. “Credit” might mean the local car mechanic telling my father to “pay me next time” if he didn’t have the right change.

All of that seems pretty unsophisticated, doesn’t it? But really, what was the better approach? That one, or what we have today?

The vast majority of the current credit problems stem primarily from two areas: Institutional greed, and a lack of individual responsibility to live within our means. The combination has created an enormous bubble of debt.

That bubble is now exploding. It’s been building for years. It required several generations to grow into the out-of-control nuclear device that is now going off. The explosion is destroying decades-old financial institutions, individuals, families, and retirements. Reactions to it are reaching Depression-era proportions.

What caused it all? My guess is this: There was a dramatic attitudinal change toward debt. The change began around the time credit cards were invented.

And the change in attitude toward debt was (and still is) fueled by a massive cultural shift about what Americans feel they are entitled to. The “American dream” has somehow become the American entitlement. As the jingle in the commercial says, “I want it all, and I want it now.” And we get it now–through debt. Essentially given free reign, institutions began offering tons of credit not only to their best customers, but to their worst. And loads of people took it.

In the 1950’s, there was a relatively benign “keeping up with the Joneses” mentality. Have a better car than your neighbor. Plant a bigger tree, or more flowers, or have a better vegetable garden. Work harder, save more, have more. Go out to dinner once a week.

But over the years that natural striving morphed into an addiction to lifestyles so far beyond people’s means that it is difficult to describe. Having a better car than your neighbor has turned into everybody in the family having their own car. “Dad, can I borrow the keys?” isn’t heard much any more: Everybody has their own car and their own keys. Many kids expect and get cars as high school graduation presents.

When my wife and I applied for our first mortgage, we were grilled about our income, required to have a down payment (which we had saved or got a “gift letter” from a parent to cover), and required to buy private mortgage insurance if our down payment wasn’t high enough. We sweated through the whole process, with no assurance that we would get the loan.

What happened since then? Somewhere along the way, hopeful home buyers began to feel entitled to receive the loans. They were urged toward this by ever-less-responsible lenders and lending practices: liar’s loans, no-doc loans, and loans greater than 100% of the home’s value became the norm. No income, no job, no down payment? No problem!

When I took out my first car loan many years ago, one or two years was the maximum term. Over time, the max became three, four, five, and six years–each year adding a little more risk, sucking you deeper into the quicksand. Over time, in all areas of consumer credit, the key question changed from how much are you in debt to how much is the monthly payment? Can’t afford the loan? Then lease! That way you can get the BMW you deserve. Can’t pay off the loan? Just pay the monthly minimum–forgetting (or not understanding) that this turns your indebtedness into a perpetual state.

Now the credit bubble is exploding in layers. First “sub-prime” mortgages went off. Then other mortgages, up the ladder in a chain reaction. Meanwhile at the banks, mortgage-backed securities are exploding. As home prices sink, foreclosures increase, continuing the chain reaction. Upside-down in your mortgage? Just walk away–that’s what happens when you never contributed a down payment in the first place, or kept re-borrowing against the house for more stuff, keeping your equity in the house near zero.

Institutions now hold hundreds of billions of mortgage packages that are impossible to value, because they don’t have a market. The Feds had to invent a market: first, the increasingly popular “lending window,” which is daily accepting shakier and shakier collateral for loans to banks; and as we speak, a huge bailout package is being considered to just have the government buy everything.

What are the next layers? I would nominate “prime” mortgages, car loans, and credit card debt, which may turn out to be the mother of all bubbles.

Greed at so many levels has crept into our society. Debt (which sounds bad) became “leverage,” used cleverly at every level of the financial system to increase returns. Debt-based investment packages of increasing complexity were invented that are scarcely understood even by those who are supposedly experts in them. The investment banking industry is sliding into non-existence because of them. Genius fails again.

Can anybody think of a significant financial failure of the last 20 years that has not involved massive leverage? Long Term Capital Management was leveraged to the hilt, and they kept doubling down on their misguided bets until the world’s financial system was imperiled. It required extraordinary government and private cooperative measures to bail out.

Such measures are no longer extraordinary, they are policy. LTCM was just the tip of an iceberg that is now coming into fuller view. Bear Stearns, Countrywide, Freddie, Fannie, Lehman, Merrill Lynch, AIG, IndyMac, and a few smaller banks have gone down. Banks don’t trust each other any more. Nobody will accept anyone else’s collateral for loans. The credit markets are seizing up, with everyone now looking to Washington for a massive bailout program that will transfer all that toxic paper from our banking system to our government.

All of those failed institutions were leveraged to the hilt. They are the institutional counterparts to the individuals who took out mortgages, car loans, and credit-card debt that they could not afford. All motivated by greed, all fueled by debt.

Somewhere along the way, has the concept of personal responsibility died in this country? Yes, there were ill-advised, uncontrolled, and predatory lending practices. But in millions of individual transactions, people had to sign on the dotted line.

Many citizens are wailing now that taxpayers are going to be left holding the bag for all of the ill-advised, stupid investment and credit decisions–by individuals and institutions–o
ver the past 20-30-40 years. A portion of the bailout will be self-funding, but inevitably a lot of it will end up being paid for by the government, which means you and me as taxpayers.

Terrific, considering that the government itself is upside-down too. You see, the government is also addicted to debt. (That’s probably how the bailout will be paid for, by more government debt.)

The United States–paragon of capitalism–is on the verge of enacting nationalization policies that one senator today (Tuesday) called “financial socialism.” Other G-7 countries are refusing to follow similar paths, insisting their banks are not exposed to the same level of reckless lending that put U.S. banks in the red and America at risk of a ruined financial system. What irony.

Don’t get me wrong, not everyone fell into this trap. There are millions of debt-free, thrifty, sensible, hard-working citizens walking among us. We pay our taxes, credit card balances, and mortgages on time and in full. We live within our means. Unfortunately, many of us are the taxpayer/victims who will have to chip in to clean up the mess that the Masters of the Universe–with the complicity of the government–created.

I would like to think that the country–individuals, institutions, and the government–will learn from this massive tragedy. That the debt-driven culture will actually change, that debt and credit will return to some sensible, productive level.

And for a short time, that may happen. After the immediate crisis is dealt with, the critical issue will be how to fix the overall structure. Personally, I feel we must toss out the extreme deregulation mentality. Good regulations must be developed with the thought of establishing fair and intelligent rules of the game. Certainly that is not too much to demand of institutions that are being bailed out by taxpayers. At the same time, I believe that many individuals will dig themselves out of their own personal holes and vow never to fall into the credit trap again.

But long term, I have less faith that any reforms or cultural changes will be truly lasting. Just as the country turned its back on the obvious energy alarms of the 1970’s and became even more addicted to oil, and just as key provisions of the Depression-era Glass-Steagall Act were repealed in 1985, helping lead to the current mess, I suspect that over the next couple of decades, the United States will turn its back on current reforms when conditions ease.

What’s the real recovery rate from addiction? Isn’t the addict always “in recovery” but never truly recovered? Somewhere down the road–say in 20 or 30 years–much of this will be repeated. Greed will not die, and the entitlement culture will prevail. Which means that there will be a relapse instead of a true recovery from the addiction to debt, unless another Great Depression comes along now and wipes it out for as long as the last one did.

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