CHAPTER

3

Debt Begets More Debt

Think what you do when you run in debt: you give to another power over your liberty.

—BEN FRANKLIN

Thinking before you click to buy that shiny new bauble, even if you can’t afford it, probably seems like basic stuff. And you’re right, it is basic. But if living within your means is so basic, then why have so many people accepted the dangerous myth that we should freely use consumer debt to buy the things that will supposedly make us and our loved ones happy?

If your expenses exceed your income, the only ways to fund that gap are either drawing on savings or incurring debt. That’s just the way it works. Unfortunately, many Americans opt to incur debt. Adding more debt increases your interest costs, which puts more pressure on you to increase your income—and getting a raise, as everyone knows, is never easy. Ignoring the simple math involved here is devastating to millions of Americans today. The buildup of debt by the federal government, private corporations, and we-the-people has reached levels that are astounding and that should be alarming to us all.

The following numbers could haunt your dreams if you let them. They’re from the nonpartisan Federal Reserve. In the last quarter of 2018, total household debt went up for the eighteenth consecutive quarter and is $869 billion (6.9 percent) higher than the previous high in total debt during the first months of the Great Recession. Our cumulative household red ink is more than one-fifth higher than it was in the third quarter of 2013. New car loans hit $584 billion, the highest level in the 19-year history of the Fed keeping these data.¹

Here are some other numbers to consider:

   The rate of credit-card holders falling into serious delinquency with their accounts spiked in the fourth quarter of 2018, rising sharply for older borrowers.

   Average total debt per household topped $50,000 in the third quarter of 2018 for the first time since 2010 and stayed above that level in the fourth quarter, at $50,210. At least average household debt is still below the precrisis high of $53,000.

   Auto loans hit an all-time high in the fourth quarter of 2018.²

Adding insult to injury, beware the debt death spiral. When you rack up credit-card debt and late payments, that wrecks your credit score. Once you have a lower credit score, you will pay more to borrow money for basics such as a home or a car. Stated simply: debt begets more debt. Again, that’s just how it works.

We all need to return to the thrift and common financial sense that was the essence of American greatness and long ago woven into our cultural DNA. Don’t believe me? Let’s turn to Benjamin Franklin for his money advice. He had this figured out long before I and other financial authors showed up.

Benjamin Franklin wrote about four basic principles of thrift:

1.   “Gain may be temporary and uncertain, but ever while you live, expense is constant and certain.” Hope is not a financial strategy; we must be realistically and conservatively prepared for the expenses of living and realize that such costs are more than we anticipate.

2.   “Never keep borrowed money an hour beyond the time you promised.” When you take on debt, time costs you money.

3.   “Think what you do when you run in debt: you give to another power over your liberty.” Ben Franklin understood that debt is a prison. It ruins lives, relationships, and families.

4.   “He that is of the opinion money will do everything may well be suspected of doing everything for money.” Align your money decisions with the values you wish to live by. How much do you really need? Counter the temptation to click with the mental trick of remembering how happy you will be if you retain self-control of your budget. “Never let the things you own end up owning you,” goes the famous line in the film Fight Club.

RESPONSIBLE DEBT

There is such a thing as responsible debt, certainly. If you have enough money for a down payment on a home, and if the amount of the loan is not out of proportion to your income stream—and if you have at least a small nest egg to fall back on in case of job loss or personal emergency—then a home mortgage is smart. It is a responsible way to buy and invest over time in shelter for you and your family. In addition, a secured debt, such as a mortgage, is always safer than an unsecured debt, such as a credit-card balance because the lender has collateral. Still, such a serious commitment should scare you silly, unless you’ve got your ducks in a row. Never take out a home loan on faith that your personal finances, or the economy in general, will get better. Always avoid balloon mortgages like the plague they inevitably are, as you will see when we dig into them in Chapter 4.

Let me add that it is also possible to have “responsible” credit-card debt. But only if you can pay off what you owe each month. Seriously. This is the only 100 percent certain way to avoid the debt trap. A hugely concerning problem for our society is that many people—tens of millions of people—effectively use debt as a way to expand their lifestyles. This inevitably costs individuals more than they bargained for. Our country at large has become a roiling ocean of debt in which consumers flail and sometimes suddenly drown in high debt. This is what happened during the Great Recession that began in the fall of 2008 and kept taking households down for the better part of a decade.

TYPES OF CONSUMER DEBT

Consumer debt trends are documented by the Federal Reserve, the institution charged with maintaining the stability of our financial system. I follow these data closely. I look at the charts—and while the renewed economic growth of the first two years of the Trump administration is encouraging, our debt crisis is still growing. The Fed’s chart of revolving debt, for instance, shows a gigantic mountain built up since 1968 when credit cards came into popular use (Figure 3.1).³

FIGURE 3.1 Credit-card debt, 1968–2018.

Fed data only go back to 1968, which is around the time credit cards came into widespread use (late 1950s to early 1960s).

Credit cards aren’t the only type of revolving debt, although they are by far the largest component. Another major type is the home equity line of credit (HELOC), in which a home is held as collateral for a loan. Human nature being what it is, millions of mortgage holders tapped their HELOCs for unnecessary and unaffordable luxuries (such as new top-end kitchens and in-ground pools) during the real estate boom. After the 2007–2009 mortgage loan crisis, when home values plummeted like meteors crashing to Earth, the number of home equity loans given out by banks declined steadily. Total household debt also declined for 19 consecutive quarters starting in late 2008 as consumers felt forced into curtailing their spending. This mass “deleveraging” of debt was unprecedented in the history of records kept by the Fed. But, inexorably, starting in 2013, total household debt began to rise again. As it turned out, credit cards were now being used in the same way that home equity loans had been before the crisis—to keep spenders afloat. People in large numbers were again opting not to live within their means. In many ways, government policies abetted this irresponsible spending. Artificially low interest rates by the Fed gave banks plenty of cheap cash to lend out to credit-card holders. To be sure, many people in need turn to borrowing to keep the wolf from the door, but as with many of these situations, the wolf will find another way into the house. In the words of Warren Buffett, “If you buy things you do not need, soon you will have to sell things you need.”

DRIVE OVER THAT BALLOON IN THE ROAD

After the recession, the Fed lowered interest rates and kept them low for almost a decade to stimulate spending and “reinflate” the economy. It should have been warier of what a cycle of “easy money” and deficit spending brought us in the recent past: the dot.com collapse of the 1990s and the housing collapse of the 2000s. What sector is most likely to collapse as a result of the current cycle? I am not that good a prognosticator. But, if you pushed me, I’d say watch the auto loan industry, where subprime loan defaults are ominously blossoming. As noted in a Business Insider column by Wolf Richter in 2018, the delinquency rate for subprime auto loans is at its highest rate in more than 20 years and higher than during the Great Recession. “Auto loans to customers with subprime credit ratings—FICO [Fair, Isaac and Company] scores below 620—are risky affairs. During good times and endless cheap money, though, the high interest rates that can be extracted from car buyers who think they have no other options are just too tempting. Now the losses are coming home to roost.

“Big banks have become relatively conservative in this category and are sticklers for things like income verification and other details, which has made room for specialty lenders with fewer such compunctions.”⁴

So let’s focus on car loans and the big balloon of debt they represent for so many Americans in many walks of life. The total auto debt nationwide, according to the Fed’s most recent report, is $1.23 trillion. Yes, trillion dollars. It is ordinarily considered a good thing for the economy when people buy cars, of course. It means jobs for the workers in the auto industry and positive economic effects that ripple out in many ways.

But I must repeat myself: it is bad for the economy and for your household when debt piles up out of proportion to your ability to pay. Car debt has become a prime example of this happening in too many households.

The average new vehicle loan is $30,534, and the average monthly payment is $509, according to Experian’s 2018 state of the auto finance market report.⁵ The overall delinquency rate (90 days behind in payments) is 4.3 percent. This is lower than the delinquency rate for student loans and mortgages, but it has been slowly increasing since 2015. A national crisis with delinquent car loans could never be a disaster on the scale of the mortgage loan crisis for the overall economy. Auto lending is simply a smaller business. And Wall Street does not set up as many “packaged” securities and derivatives with car loans that spread around debt like an infection. (Maybe they learned something?) But for the individual car buyer? Delinquency can be a real disaster. One obvious reason is that it is fairly easy for lenders to take back their collateral in case of default. While foreclosing on a home usually requires a long, multistep court procedure, your car is parked right there in your driveway where the “repo man” can snag it.

People with lower FICO credit scores are especially vulnerable when it comes to car loans. After the recession, large banks became more conservative about lending to those with FICO grades equivalent to less than a B or C. They strengthened requirements about income verification and assumed schoolmarmish attention to detail in processing such loans. The Fed reported in 2017 a total of about $280 billion of “subprime” auto loans still outstanding in this country. (Subprime refers to the borrower, not the lender.) There is no hard-and-fast standard for who is assigned a subprime loan, but generally speaking, it means borrowers with FICO credit scores below 600 to 640 on an 850-point scale. These borrowers must secure a subprime loan if they want to buy a car from a dealer that costs more than they have in their piggy banks. As noted in the Fed’s Liberty Street Economics blog,

Further disaggregating the delinquency rates by the origination credit score of the borrower shows that while the delinquency rates for borrowers with credit scores of 660 or higher appear to be somewhat steady, the subprime delinquency rates are really where the pressure is. This is especially stark when we break out auto finance and bank loans, which shows that the delinquency rate—even among borrowers in the same credit score bucket—is considerably higher and rising on the auto finance side.⁶

Almost without exception, the interest rate is higher for subprime loans, as high as 20 percent or even higher. The loans are made by lenders that specialize in subprime auto finance. The subprime specialists make their profit by charging a higher interest rate on money they borrow from big banks at the prevailing rate. Recently, three subprime lenders—Summit Financial Corp, Spring Tree Lending, and Pelican Auto Finance—filed for bankruptcy or were forced into it, raising concerns about the whole subprime loan business structure. The allegations made against those companies in court filings make it sound as if the companies themselves were operating one step ahead of the repo man. The words fraud and misrepresentation were uttered by regulators and prosecutors looking into loans made to people buying “too much car” for their budgets.

There had been evidence of loose standards for making subprime loans for quite some time before these three lenders happened to get tapped by the long arm of the law. For years, regulators and federal agencies have pursued complaints about Santander Consumer, the heavily investigated subprime auto lending arm of the Spanish banking giant. In August 2018, the Consumer Financial Protection Bureau under Trump appointee Mick Mulvaney settled with Santander Consumer USA for predatory lending practices.

Santander agreed to a legal settlement over claims that it allowed borrowers to “make interest-only monthly payments without explaining that doing so would increase the total cost of the loan,” according to Reuters, citing three sources familiar with the deal. It also “failed to explain to customers how an insurance policy—known as ‘guaranteed auto protection’ (GAP)—would not always cover the costs of replacing a car that was destroyed in an accident.”⁷

That wasn’t all. In 2017, the state attorneys general of Massachusetts and Delaware settled another lawsuit with Santander USA over shoddy subprime loans, with Santander paying $26 million. In Massachusetts, for example, Santander colluded with auto dealers that targeted consumers who couldn’t afford the loans. One dealer inflated borrowers’ incomes by at least $45,000 a year, according to Maura Healey, attorney general for Massachusetts.

“Yet Santander continued to do business with those dealers and failed to rein in their practices,” according to Healey. In some cases, Santander required that some dealers buy back loans that had defaulted, she said.”⁸ Santander USA has been hit with subpoenas and civil investigative demands from at least 28 state attorneys general over its lending practices.⁹

Car sales keep on rising rapidly in the country, but defaults on car loans keep rising, too. As when an unstoppable force meets an immovable object, something’s gotta give. Maybe it will be the subprime loan market. Maybe it should be Americans’ fixation on the latest and most luxurious ride they can acquire, unless they can actually afford it.

RAISING RESPONSIBLE SPENDERS

Debit spending has become a way of life in America, and we have begun passing it down as a cultural heritage. A good number of us are even handing credit cards to our kids before they have any income. A 2017 T. Rowe Price survey showed how children are increasingly being given access to credit cards. Only 4 percent of children aged 8 to 15 had access to credit cards in 2012. Five years later, 18 percent of kids in this group had credit cards.¹⁰

Again, there is a big difference between responsible and irresponsible spending habits that parents pass along to their children. If done responsibly, giving children/dependents a credit card can help them build credit before they attain financial independence. This will provide them with the future gift of lower interest rates and insurance rates and an easier time of renting an apartment. The parents must have good credit first; otherwise, they cannot provide the child with good credit.

So let’s say you’ve worked hard for a strong credit rating, and you want to add your child as an authorized user on a credit card. Just remember, the child will have the same spending power as you but none of the financial responsibility for the bills. I suggest that parents lay down ground rules and make sure that they are followed. This is what I have done with my current teenagers. If you don’t think your young one is ready for this, try the “sock drawer” method of helping him or her build good credit. Add your dependent’s name as an authorized user, but do not provide him or her with access (hide the card in the sock drawer). By using the card for small charges every few weeks and paying the balance off in full each month, you can build your child’s credit without risk to your own. Another option when deciding for your child might be a secured credit card; this is an account with a low limit of credit, secured by your deposit of cash. You might put $250 on the card and permit your kid to spend as wisely as he or she is able with that. Lessons can be learned, but no major harm will be done.

Debit cards that allow kids to spend money deposited in their bank account on the first of each month are a modern way of providing a cash allowance. Kids learn to budget their purchases against their balance, and again, no big harm results if they run through their balance in the first week of the month. And it is wise to let them experience lean times until the first of the next month!

If you want to home school your kids to become financially literate about credit, here are a few important facts and principles you will want to share:

   Credit-card companies commonly lure customers with 0 percent interest rates for the first year or so. It is very risky to get into debt during this period because the interest rate can balloon to more than 20 percent when it’s over.

   No matter what the interest rate is, never carry a balance on your credit card.

   Pay on time. If you’re late by 60 days, companies can increase the interest rate as a penalty.

In addition, I strongly recommend reminding your kids (and yourself) to understand from the outset that interest rates can rise according to the national economic situation—not just their personal lives. The Fed has the power to lower interest rates to combat the effects of recession and to raise them to prevent inflation. As our economy continues to improve from the Great Recession, rising interest rates are possible. So personal credit-card debt is likely to become even more burdensome in the coming years. Good to know, right?

FINANCIAL HISTORY LESSON

Now that we’ve addressed the problems of debt and what you must teach your children about it, let’s take time for a refresher on recent financial history. It is to each of our benefit to know and understand the basic threads. How did we get here? How did lending get to be so easy and destructive for citizen consumers? Why doesn’t our government teach financial responsibility to help us protect ourselves?

Back in 1933, in the aftermath of the Wall Street crash of 1929 and the ensuing Great Depression that caused runs on many banks, a law was put into place separating banks into two types—commercial banks (for consumers) and investment banks (for corporations, institutions, and high-net-worth individuals). The 1933 Glass-Steagall Act held commercial banks to very strict standards concerning risk in their investments—thus curtailing opportunities for maximum gains but protecting them as stable repositories for consumers’ funds that are insured by the federal government up to certain levels. Over the next 60 years, enforcement of Glass-Steagall regulations gradually weakened as commercial banks pushed and bumped against its limits on what they could do with their own money. Some of you may recall debates in Congress back in the 1990s over the appropriateness of Glass-Steagall to modern-day banking. In late 1999, during the Clinton administration, Congress moved to gut the law. New legislation was passed to allow commercial banks to engage freely in insurance and investment banking with their own money (but not their customers’ funds).

Almost immediately, this resulted in the launch of a wave of bank mergers and new types of financial entities and vehicles, that is, packaged loans that could be sold and resold repeatedly and often. In September 2000, two giant banks, J.P. Morgan and Chase Manhattan, came together to make the most of these new opportunities. This was the biggest bank merger ever, a $33 billion deal that created a financial institution regulators instantly saw as being “too big to fail”; that is, if the bank went under, it would result in widespread economic disaster. Other mergers quickly followed. Big banks swallowed small banks, and investment banks and commercial banks intermarried.

Things got ugly with the financial upheavals of 2008. On January 11, 2008, Bank of America announced its acquisition of the troubled subprime lender Countrywide Financial Services, crippled by its underwriting of bad mortgages. In the days after the shock waves of the crash, Bank of America swooped in to buy reeling Merrill Lynch on September 14. These deals would not have been possible before 1999. On September 15, 2008, the investment bank Lehman Brothers collapsed.

Then the world’s largest insurance company, AIG, stepped into the barrel. AIG had charged into the derivatives market by using credit-default swaps to insure exotic investments such as collateralized debt obligations (CDOs) that were all the rage in markets fueled by the subprime mortgage boom. These credit-default swaps pushed the otherwise profitable company to the brink of bankruptcy.¹¹ As the mortgages tied to the swaps defaulted, AIG was forced to raise millions in capital. When stockholders got wind of the situation, they sold their shares, making it even more difficult for AIG to cover the swaps. AIG found itself so destabilized that on September 16 the Fed and Treasury released $85 billion in bailout money for AIG to stay afloat (and later another $100 billion).

Then the hyperaggressive Bank of America found itself in trouble as it tried to juggle the impossibly complex, interwoven, and overleveraged investment products it now owned. By October, the Fed and Treasury classified Bank of America as too big to fail and released $45 billion in bailout loans. At the same time, General Electric fessed up and suddenly told the Fed that it was on the brink of being unable to roll over its short-term debt with lenders. No wonder, the nation’s second Wall Street “crash” occurred on September 29, 2008. On that day, the Dow Jones Industrial Average registered the largest point drop in history (up to that time) for a single day of stock trading: 777.68 points.

Lawmakers felt compelled to do something to rein in banks and protect consumers amid the financial crisis and recession. The landmark Dodd-Frank Act of 2010 was the Democrats’ answer and passed on a largely partisan basis. The law established the Consumer Protection Financial Bureau (CPFB), designed by then Harvard Professor (later U.S. Senator) Elizabeth Warren to ostensibly protect consumers but also with an unaccountable structure that federal courts later found unconstitutional.

As some readers know, in my first book, Going Public, I documented my role in many of these controversies, including finding a way to make the Volcker rule an effective tool for managing risk by curtailing riskier investments on the parts of the banks that are repositories for our money. Dodd-Frank also established an intra-agency star chamber named the Financial Stability Oversight Council housed at the U.S. Treasury that I called in Going Public a “Frankenstein-ish super regulator staging a hostile takeover of the SEC’s [Securities and Exchange Commission’s] role in regulating American’s mutual funds, investment advisors and other investment management firms.”

Dodd-Frank brought new and far tougher restrictions on banks, with annual stress tests to gauge their stability in the event of another crisis. In this period, home mortgage lending became so heavily regulated and requirements for down payments so intimidating that millennials and others without substantial incomes turned to apartment life. From 2008 to 2011, total credit-card debt also declined. Ultimately, many asset managers stepped in to provide all types of credit in a much more risk-focused manner than the banks ever had. With Dodd-Frank sidelining the banks through higher capital requirements, the lending field was freed up for more business-savvy lenders.

The crisis seemed to encourage more responsible spending by consumers—I know it did for me. You are free to draw your own conclusions. Mine is that free markets, effective enforcement of existing rules, and responsible spending are all best practices.

In 2016, the political pendulum swung hard to the Republicans and President Donald Trump, who had made a campaign pledge to “dismantle” Dodd-Frank. He could not deliver on that one, but in May 2018 he signed a measure that was the product of years of bipartisan negotiation and called it just the “first step.” Midsized banks (often known as community banks) and credit unions now face much less scrutiny and are exempt from the annual stress tests. Banks with less than $10 billion in assets are once again free to engage in trading with their own money (through a holding company).

Trump appointed Congressman Mick Mulvaney—a consistent critic of the CPFB—to head it. There was a lot of political scrapping over that because Democrats seemed to have hoped that an unelected head of the agency would be in charge forever.

Once he took charge, Mulvaney:

   Immediately stopped hiring at the CFPB, stopped collecting fines from violators, and ordered a review of all active investigations.

   Shut down public access to the CFPB’s online database of consumer complaints.

   Fired its entire advisory board in June 2018 and replaced it with a new board in September.

   Issued a series of decisions siding with payday lenders being prosecuted for charging high rates of interest.

In my view, like it or hate it, the CFPB was never needed. It duplicates the same consumer protection rules enforced by other well-established agencies, including the SEC, and has little to add for the taxpayer’s investment. Rather than waste time neutering its powers, simply eliminate the agency.

YOUR MOVE

So whatever cycle of regulation and enforcement we are in, your basic situation remains: you need to protect yourself against debt. Once you have debt, you need to deal with it. If you have too much debt to pay off, it may take several years and a lot of sacrifices to reverse that.

Here are the steps I recommend you always follow:

1.   Stick to one credit card. Pay it off monthly. Use cash whenever you can. Remember, paying only the minimum amount due on a card will mean that you pay a lot more, for a long time. For example, if you pay only the minimum payment due each month on a $1,000 balance with an 18 percent annual percentage rate (APR), you could take an estimated seven years or longer to pay it off while paying an additional $1,000 to $1,730 in interest.

2.   Become a smart car shopper. New cars depreciate faster than a speeding Ferrari, so research the options: used, preowned, and dealers’ test-drive vehicles. Look on Craigslist and use CarFax. (You must subscribe, so keep an eye out. See Chapter 2.) Consider one car for your household, if possible. How about riding a bike? (You won’t have to pay for parking, either!)

3.   Reduce your housing costs. Downsize if you can’t afford your home. Take on a roommate. Buy a duplex (you’ll save on taxes too). That’s a topic for Chapter 4.

4.   Pay attention to your credit reports. You can probably get your credit report for free from your bank. Credit reporting agencies must also by law provide you with a free credit report once a year. Pay attention to those little notices attached to your bank statement that tell you if you are spending more or less than you deposit from your earnings—and then spend less.

5.   Set an amount for discretionary spending each month. Do this to cover the unavoidable things that come up and the occasional must-have latte. Don’t use credit to go over that limit.

If you have excessive credit-card debt, you must form a concrete plan to dig out. Bring your brains and your self-interest to the table; don’t just sign up for the first credit-card counseling service you hear about. It’s like dating. Watch out for big promises and smooth operators. Stick to the simple math and commonsense that gets lost in the money game: paying back your debt requires spending less, making more, and making sacrifices to do both. Yes, you should pay off your higher-interest-rate cards first, and you can consolidate your debt onto one card where you pay zero interest for a set amount of time. This can simplify the task, but the task remains—restructure your behavior so that you don’t go further into debt, and pay off your balances. Then you can build your personal balance sheet.

Some options include:

   Set up an accountability partner, a trusted friend or family member who will hold you to your budget and perhaps in special situations loan you an amount to pay off the debt if you are accountable to your plan.

   If you have, ahem, an excess personal inventory of goodies—say, a third car, a second set of golf clubs, or two Rolex watches—sell them. It is likely you couldn’t afford them in the first place.

Most of all, when it comes to credit-card debt, like speeding on a country road with your arm out the window, paying blackjack at the casino when you’re drunk, or planning your bachelor party for Las Vegas, don’t ask for trouble. Believe me, it will find you.