October 5, 2022

The Zero Sum Game Of Lower Interest Rates And Why Mortgage Rates Will Rise

The Federal Reserve has forced long term interest rates to historic lows in a desperate attempt to “stimulate” both the housing market and the economy in general.  The results have been mixed but the benefits of lower rates to borrowers are undeniable.  Lower rates reduce the cost of large debt burdens carried by many Americans and increases the spending power of those able to refinance.

Exactly how much lower the Fed intends to repress mortgage rates is anyone’s guess but as interest continue to decline, the overall benefits diminish.  Here’s three reasons why the Fed may wind up discovering that the economic benefits of further rate cuts will be muted at best, self defeating at worst.

1.  Lower rates are becoming a zero sum game for the economy as lower rates for borrowers translates into lower income for savers.  Every loan is also an asset of someone else and lower interest rates have merely been a mechanism for transferring wealth from savers to debtors.  Every retiree who prudently saved with the expectation of receiving interest income on their savings have been brutalized by the Fed’s financial repression. Even more infuriating to some savers is the fact that many debtors who took on irresponsible amounts of debt are now actually profiting from various government programs (see Foreclosure Settlement Q&A – A Victory For The Irresponsible).

A significant number of retirees that I know have been forced to drastically curtail their spending in order to make ends meet while others have been forced to draw down their savings.  The increased spending power of borrowers has been negated by the reduced spending power of savers.  This fact seems to elude Professor Bernanke who hasn’t been able to figure out why lower rates have not ignited the economy.

2.  Many consumer who would like to incur more debt are often turned down by the banks since their debt levels are already too high.  Those who can borrow often times chose to deleverage instead, considering the fragile state of the economy.  Anyone saving for a future financial goal (college tuition, home down payment, retirement, etc) is forced to reduce consumption and increase savings due to  near zero interest rates.  The Federal Reserve has destroyed Americans most powerful wealth building technique – the power of compound interest.  A 5% yield on savings will double your money in about 14.4 years while a 1% yield will double your money in 72 years – and that’s before taxes and inflation.

3.  As mortgage rates decline into uncharted territory, the mathematical benefit of lower rates diminishes.  As can be seen in the chart below the absolute dollar amount of monthly savings as well as the percentage decrease in the monthly payment diminish as rates race to zero.

Benefits of a refinance on a $200,000 mortgage diminish as rates decline

% Rate Mo Payment Mo Savings % Reduction Yearly Savings
6.00% $1,199.00
3.00%    $843.00 $356.00 29.70% $4,272.00
1.50%    $690.00 $153.00 18.10% $1,836.00
0.75%    $621.00  $69.00 10.00%    $828.00

Closing costs at lower rates also become problematic, making it impossible to recapture fees within a reasonable period of time.  With closing costs of $8,000 on a $200,000 mortgage refinance, it would take a decade to recoup closing costs.

Many astute analysts have made elaborate and compelling arguments that interest rates can only go lower.  From a contrary point of view, I believe that a future rise in interest rates is a high probability event.  This is the opposite of my prediction in March 2009 when I surmised that mortgage rates would decline to 3.5% – see 30 Year Fixed Rate of 3.5% Likely.

The Chart of the Day has a long term chart of the 10 year treasury and notes that the recent sharp decline in interest rates “has brought the 10-year Treasury bond yield right up against resistance of its 26-year downtrend channel.”

 

What Financial Issues Do People Worry The Most About?

Besieged by the rising cost of energy and food, many consumers are barely able to make ends meet.  Throw in the fact that for many consumers real wages have been stagnant for decades and you have the makings for the establishment of a permanent financial underclass that is living on the edge of financial disaster.

According to a survey of 2,016 Great Britain consumers done by MoneySupermarket, the financial worries most on the minds of people is the rising cost of fuel and food.  Portraying the deep financial distress of the average consumer, only 9% of survey respondents said that they foresaw no financial worries in the next year.

The survey also showed that 8% of people had no one to turn to for help if a financial emergency arose.

The infographic shown below breaks out the financial worries of the survey respondents by age group.  It is interesting to note the older respondents had the greatest worries about the cost of fuel, utility bills and food costs, suggesting that the older age groups have less disposable income and/or are worried about having enough money for retirement.

The precarious financial condition of  many individuals in the survey is highlighted by the impact that a relatively small amount of money would have on their financial situation.  Shown below are the survey results to the question of what respondents would do if they suddenly received 1,000 British pounds, the equivalent of US $1,584.  Almost 50% of respondents replied that a 1,000 pound windfall would help to relieve their financial anxiety.

Although the survey does not directly inquire as to what amount of financial assets the respondents had, it appears somewhat obvious from the survey answers that most had very little or no savings on which to fall back on.  Nor does the survey report on what is the biggest problem confronting virtually every developed country in the world – the crushing level of debt burdens on consumers and governments.

Central banks have probably prevented a 1930’s style deflationary depression by printing trillions in paper currency to support over-leveraged banks, consumers and governments.  Unfortunately, Central Banks cannot manufacture what is most needed in weak economies which is  jobs and higher incomes.

Strategic Defaults – The Difference Between The Rich And “Other People”

Million Dollar Home Owners Falling Off The Cliff

“I think you’ll find the only difference between the rich and other people is that the rich have more money” – Mary Colum

If the difference between the rich and “other people” is money, why are the rich walking away from their mortgages just as fast as anyone else?   This question is examined in a recent New York Times article which cites a serious delinquency rate of 1 in 7 for homeowners with a mortgage over $1 million compared to a delinquency rate of 1 in 12 for smaller mortgages.  The Times’ conclusion is that the biggest defaulters on mortgages are ruthless rich folks with no scruples.

Without citing specific statistical analysis, the Times article seems to draw the conclusion that anyone with a million dollar mortgage would have substantial financial resources that could be tapped to keep the mortgage current.   This may well be the case for some, but drawing from my own experience in the mortgage industry, many homeowners with the million dollar mortgages are financially thin and over leveraged.   For a variety of reasons ranging from ego, poor financial planing or irrational exuberance, many purchasers walk into million dollar homes with empty pockets.

Many of the million dollar homes now in default were purchased when eager buyers believed that home values could only go up and that buying as much home as possible simply meant larger profits down the road.  A ten percent gain on a million dollar home results in a handsome $100,000 gain – ten times the profit from purchasing a $100,000 home.

A few short years ago, at the height of the housing bubble, income was deemed irrelevant when banks granted mortgage approvals.   The proverbial strawberry picker or fast food cashier with average credit could use exotic mortgage programs to buy at any price level chosen, without the bother of a down payment or income verification.    Ever increasing home values then allowed cash extraction from a refinance or second mortgage, once again without the hassles of verifying income.  It should come as no surprise that wannabe millionaires taking the biggest risks now have the highest default rates.

According to the Federal Reserve, “half of the defaults are driven purely by negative equity” when the mortgage debt exceeds 150% of a property’s value.  Since high priced homes have seen large declines in value, it should come as no surprise that many strategic defaults will occur at the high end of the market by homeowners with million dollar mortgages.  The open question is – does having a million dollar mortgage imply a wealthy homeowner?

If a statistical study was done on the net worth of defaulting homeowners who have million dollar mortgages, it would probably reveal that many of these alleged “rich” homeowners have an embarrassingly low or negative net worth.  Consider the findings from one of the most influential studies on the mind set and lifestyles of the wealthy from The Millionaire Next Door: The Surprising Secrets of America’s Wealthy, by Thomas J. Stanley and William D. Danko.

Characteristics of the millionaire next door:

  • Avoids buying status objects or leading a status lifestyle
  • 97% are homeowners with an average home value of $320,000, occupying the same home for over 20 years
  • The average millionaire lives well below his means and spends below his income level

The rich did not get rich by being poor stewards of capital or chasing housing bubbles.  The bulk of those defaulting on million dollar mortgages (strategically or otherwise) are simply poor people, living in big houses they could never afford in the first place.

Living Large

Living Large

Will Governor Schwarzenegger Trigger 55,000 California Foreclosures?

California’s long running budget crisis has now degraded to the point where Governor Arnold Schwarzenegger has ordered a pay reduction to the minimum wage rate of $7.25 an hour for 200,000 state employees.

The California banking industry, perhaps sensing an opportunity to rebuild their poor public image, has jumped into the budget mess with a plan to rescue beleaguered state employees.   Spearheaded by $7.6 billion asset Golden 1 Credit Union, banks are tripping over themselves to offer “Budget Impasse Loans”, an easy way for over leveraged State workers to tide themselves over until the budget crisis passes.

Bloomberg: The Golden 1 Credit Union, a lender that caters to state workers, will offer zero-interest loans to customers whose pay falls because of the stalled spending plan, according to a July 2 statement.

Golden 1 said as many as 55,000 of its customers may participate this year, if state-employee pay is cut to the federal minimum wage, currently $7.25 an hour. Flyers that tout the program are being distributed in its 84 offices, carrying a message that says “balancing the state’s budget doesn’t have to affect your own.”

“We could survive off our savings for a little while, but it would be a real burden on us,” said Chava Yniquez, a 49- year-old technician in the Senate printing office who has used Golden 1 budget-impasse loans in the past. “It’s a lifeline.”

The California budget crisis and bankers pushing loans are not the issues to ponder here.  Golden 1 Credit Union’s estimate that 55,000 employees will need a loan after seeing their first pay check reduced indicates the very fragile financial condition of 25% of the State’s workforce.  How many more will need a “Budget Impasse Loan” after two weeks, or a month?  Will the first week of the Governor’s budget balancing plan wind up pushing 55,000 home owners onto the path of foreclosure?  Terminator indeed!

The very banks offering “Budget Impasse Loans” may shortly find themselves offering “Loan Modification Plans” if the California budget crisis eventually requires permanent pay concessions from State employees.

Golden 1 Credit Union, which lost $22.6 million in 2008 and $23.1 million in 2009 may be offering a valuable service to strapped State employees, but is a customer one paycheck away from default a solid credit risk?  Golden 1’s website notes that budget impasse loans will be offered with “rates as low as 0% APR”, implying that some borrowers will be paying a “risk adjusted” rate of interest.  Since Golden 1 is offering depositors a whopping .25% on regular savings accounts, even a “low rate” of, say 4%, would still leave them with a very nice spread.

At a time when the universal “solution” for every financial problem is to borrow more money, perhaps the banks should develop a unique “new program” involving financial responsibility, saving and wealth accumulation.

Finally, in the “too ironic not to mention” department, the Press Release issued by Golden 1 immediately prior to the Budget Impasse Press Release reads as follows:

SACRAMENTO, Calif., June 30, 2010—Employees and business partners of The Golden 1 Credit Union participated in the second annual United Way Toilet Paper Drive on June 18 contributing 15,989 rolls of toilet paper to benefit local nonprofits.

Golden 1’s contributions represented 33.5% of the total rolls of toilet paper collected by United Way in this drive. Of these, 10,205 came from the credit union’s employees and 5,784 came from its supportive business partners.

Perhaps soon, California State employees can contribute to this worthy effort by sending Golden 1 their state paychecks.

Federal Reserve Super Low Rate Policy Crushes Savers And The Elderly

Fed Sees Solution In Zero Rates

The Federal Reserve recently vowed to keep interest rates “exceptionally low”  for the foreseeable future in an attempt to revive the economy.   Since mid 2006 the Fed has brought the Fed Funds Rate down from 5% to virtually zero in an attempt to reduce the debt service burden on over leveraged borrowers.

fredgraph

A world of ultra low interest rates may continue for much longer than many expect.

Fed To Keep Rates Low  (WSJ) –  Fed officials voted unanimously to maintain their target for the key federal-funds interest rate — at which banks lend to each other overnight — near zero and said they expect to keep it there for an “extended period,” which suggested increases are at least several months off.

While consumers are spending, the Fed noted they were “constrained by ongoing job losses, sluggish income growth, lower housing wealth and tight credit.” Meanwhile, “businesses are still cutting back on fixed investment and staffing, though at a slower pace.”

A low interest rate policy has worked in the past to stimulate the economy and the Fed is applying the same prescription to the current economic downturn.   At this point, it is too early to tell if the same policies of super low rates and easy money will work as it has in the past.  Japan stands out as the premier example of a post bubble economy still failing to recover despite twenty years of super easy fiscal and monetary policies.  The Fed prescription of attempting to revive an overly indebted economy with more lending may very well produce the same results as in Japan – slow economic growth, lower incomes and crushing public debt burdens.

Individuals who were prudent enough to save and avoid debt are now left to  wonder if they will ever see a return on their savings.  Short term CD’s are below 1%, money market funds pay a ridiculously low rate barely above zero and short term treasuries have a negative yield.   Those who are retired and depend on interest income for living expenses must now deplete their savings or take on more risk by investing in higher yielding bond funds subject to substantial market fluctuations.

The Fed’s low interest rate policy effectively represents a massive wealth transfer from savers to debtors.   FDIC insured deposits of bank savings and CDs currently total $4.8 trillion and there is approximately $5 trillion in money market funds for a total of $10 trillion that is earning at best 1% compared to 5% in 2006.  The drop in interest rates from 5% to 1% represents an annual income loss to savers of $400 billion dollars per year.

Congress and the Fed have attempted to bailout out every imprudent debtor  with super low interest rates – homeowners who borrowed too much, bankers who lent foolishly, and hundreds of poorly run, over indebted companies from GM to AIG.   Someone always pays in the end and in this case, the victims are the savers.

More On This Topic

Near-Zero Rates Are Hurting The Economy

Depression In Commercial Real Estate Results In Bargains For Some

Depression Pricing As Empty Hotels Slash Rates

The recent era of easy lending was not confined to residential real estate.  Commercial real estate lending is the next big worry for a banking industry already beset by an avalanche of non performing loans.  The banking industry has $1.8 trillion dollars of commercial real estate loans and many analysts believe that banks have reserved for only a small fraction of current and future losses.  Recent examples of losses on commercial hotel loans  in major travel destinations such as Hawaii and Las Vegas indicate the severity of the problem.

Hawaii Hotel Industry Downturn Worse Than Great Depression

Hawaii Hotels Face Fewer Visitors – For the hotel industry in the continental U.S., this downturn is the worst since the Great Depression. But the Hawaiian resort industry is taking a beating that’s even more severe.

Meanwhile, revenue per available room has fallen nearly 25% in the past two years and now averages $150.75.

Major renovations of existing hotels are common in Hawaii because construction of new resorts has been limited since the 1980s because of steep land prices and local governments’ opposition to expansion. “So the name of the game is to buy, renovate and reposition,” says Joseph Toy, president and CEO of the hotel-consulting company Hospitality Advisors, based in Honolulu. Many of the resorts that changed hands in recent years were built by Japanese owners in the 1980s.

But practitioners of that pricey repositioning strategy now find themselves in a bind due to the recession, the capital crisis and Hawaii’s tourism downturn. “The operating numbers have cratered, the underlying fundamentals aren’t very good, and you have a whole bunch of problem loans,” says David Carey, president and chief executive of Outrigger Enterprises Group, which owns 30 Hawaiian hotels, none in foreclosure.

Las Vegas Hotel Worth 41% Of Construction Cost – Cheaper to Tear Down Than Finish

Doubts Are Cast On Value of Las Vegas’s  Fontainebleau – LAS VEGAS—The Fontainebleau the luxury hotel and casino development at the northern end of the Las Vegas Strip, sits more than half-finished after falling into bankruptcy in June.

But as potential suitors consider rescuing the project, they are facing a grim reality: It may not be worth the money it would cost to complete it. More than $2 billion has already been poured into construction.

“It is going to take $1.2 billion to $2 billion to finish Fontainebleau, and it’s not worth that much,” Penn National Gaming Chief Operating Officer Tim Wilmott said. Penn is currently negotiating to take it over from the project’s creditors.

When the 4,000-room Fontainebleau project was first mapped out four years ago, gambling revenues were soaring and Las Vegas barely had enough hotel rooms to accommodate a flood of visitors.

Now, Las Vegas has a surfeit of luxury rooms. Occupancy rates in August fell to 83% from 94.9% two years earlier, and room rates have fallen sharply.

An outside analysis contracted by some of the Fontainebleau lenders last spring found that Fontainebleau would be worth $1.76 billion if it were completed in May 2010, according to a court filing, far less than its $3 billion total cost.

Depression Pricing For Hotels

Overwhelming supply and weak demand have resulted in hotels slashing room rates to keep the cash flow going.  In many cases, the cost of lodging at major hotels and resorts has dropped as much as 50% from two years ago and vacancy rates still remain high.  For newer resorts that were built during the boom years, the picture is even bleaker, resulting in bargain rates that were previously unimaginable.  On a recent trip to Mexico in September, I had the occasion to visit the newly completed and mostly vacant multi billion dollar resort, La Amada Hotel, Playa Mujeres, Cancun.  The La Amada website describes the property, which opened in May 2009,  as follows:

La Amada Hotel is a 5-star luxury hotel. Here you’ll have a comfortable home base of contemporary luxury. Stylish hotel architecture and decor, generous suites, spotless service, deluxe facilities, and of course, our secluded beachfront setting, all enable you to let your days here happen naturally. Situated just 25 minutes from Cancun International Airport, Playa Mujeres is the newest luxury resort destination in greater Cancun.

This 922-acre (373 hectare) luxury development includes a boutique hotel, upscale residences, a golf, yacht, and beach club, and Cancun’s first marina situated on tranquil Playa Mujeres in the Mexican Caribbean. Envisioned as an exquisitely and carefully developed sustainable community, La Amada is a destination where culture, ecology, history and art are integrated in a stimulating style.

La Amada, located in the Marina section of the Playa Mujeres “master planned’ community, is a 552-unit project of one, two and three bedroom residences, a 110-room five star boutique hotel, and a top of the line spa. In addition, the developers have created a “marina village” with 150,000 square feet of commercial space for restaurants, bars, cafes and shops, creating an ambiance akin to top European resorts such as Puerto Banus and St Tropez. No expense was spared on this spectacular creation; residences can even fly in and land on the properties private helicopter pad.

La Amada is a spectacular luxury resort hotel.  Equally spectacular are the discounts  – luxury suites are being offered at $280 per night, marked down from $700.  Apparently, even at these discounted prices, income stressed consumers are saying no.  During three visits to the property, I saw only one couple on an otherwise deserted beach.  Finished units remain empty with no guests to be seen.   The planned bars, cafes and shops have not opened.   Virtually all of the 176 slips in the Marina remain empty.  La Amada was built during an era of easy money when it was assumed that prosperity, based on eternal asset appreciation, would never end.  There is little doubt that the investors in La Amada have created a truly fabulous resort – far less certain is whether or not they will ever see a return on their investment.

La Amada sign points to empty hotel

La Amada sign points to empty hotel

Deserted La Amada beach

Deserted La Amada beach

Beachfront La Amada

Beachfront La Amada

Empty boat slips at marina

Empty boat slips at marina

La Amada - where are the guests?

La Amada - where are the guests?

Discount prices fail to lure guests

Discount prices fail to lure guests

Greenspan Revisionist Babble

Debt Is The Greenspan Legacy

Alan Greenspan, former Federal Reserve Chairman, today expressed his concern about the level of the US national debt.

Sept. 16 (Bloomberg) — Former Federal Reserve Chairman Alan Greenspan said he’s worried that lawmakers will hamper U.S. central bank efforts to rein in its monetary stimulus, and that inflation might “swamp” the bond market.

The former Fed chief, who counts Deutsche Bank among his clients, also warned that the U.S. must rein in its “very dangerous” level of debt, citing the threat of increased issuance of Treasuries undermining the dollar.

Greenspan said one threat to Treasuries is the “very dangerous” level of U.S. national debt. “We’ve got to confront that issue immediately,” he said.

Mr Greenspan’s sudden concern about the buildup of the US national debt seem to imply that this situation occurred after his long tenure (1987 – 2006) as Federal Reserve Chairman.  The facts speak otherwise.  During the Greenspan era of easy money and easy credit, the US national debt had already spiraled out of control, increasing from approximately $1 trillion to $9 trillion.

Did Mr Greenspan not notice what was happening during his two decade reign at the Federal Reserve?  Mr Greenspan’s  current concerns about the explosion of US debt seem to be a disingenuous attempt at historical revisionism to obfuscate his central role in the creation of the greatest debt bubble in history.   For Mr Greenspan to suggest that he had nothing to do with fostering the current “very dangerous” level of US  national debt is like trying to argue that Hitler had nothing to do with World War II.

federal-debt-dollars

Mr Greenspan also commented on the potential risk of inflation:

“It’s the politics in the United States that worries me, whether the Congress will basically feel comfortable” with the Fed withdrawing its stimulus, Greenspan said in a broadcast to Tokyo clients of Deutsche Bank Securities Inc. today. He later said that “if inflation rears its head, it will swamp long-term markets,” referring to bonds.

Greenspan, speaking via videoconference from Washington, indicated that successor Ben S. Bernanke and his fellow Fed policy makers have until next year before inflation will present a danger.

Based on Greenspan’s past poor record of not recognizing the inherent dangers of overleverage, it is highly likely that he is now missing the big picture again.  We are now experiencing a post bubble credit collapse of epic proportions.  The deleveraging process that we are now witnessing will not unwind 20 years of reckless credit expansion in one year.   If Greenspan fears inflation, it’s a good bet that the real danger is the continuation of a deepening deflation.

Commenting on the need for a systemic risk regulator, Mr Greenspan noted that “I’m not in favor of a systemic-risk regulator because I don’t think it’s feasible.  I think we have to recognize that there are limits to what we can do.”  No argument with that statement Mr Greenspan.

Loan Sharks “Salvation” For Many At 2,437% Interest Rates

Loan Sharks: The New Subprime Lenders With A Twist – They Expect To Get Repaid – And Why A Loan At 2,437% Interest Makes Sense

For every loser, there is a winner.  Since the demise of the subprime lending industry, loan sharks have been reaping profits by lending to the same foolish crowd that used to be the target of subprime lenders.

In this country, the new subprime lenders are called payday lenders, who operate legally.  In Britain, the new subprime lenders simply call themselves, well, loan sharks and operate without the courtesy of government sanction.  The Wall Street Journal had an interesting article on loan sharking in the UK that should have been titled – “Why The Foolish Can’t Be Protected From Themselves”.

In a recent report, the U.K. think tank New Local Government Network said it expects the number of people with debts to loan sharks to jump to more than 200,000 in Britain this year, from an estimated 165,000 in 2006. A confluence of indebtedness, poverty and the diminished availability of regulated subprime credit are creating the conditions in which many are borrowing “from nefarious sources,” the report says.

But perhaps no country in the world was more addicted to debt than the U.K. By the end of 2008, the average British household had a debt-to-income ratio of 180% compared with 140% for the average U.S. family, according to the Organization for Economic Cooperation and Development.

That is coming back to haunt the U.K. The number of individual insolvencies rose by almost 30% year-to-year to 33,073 in England and Wales in the second quarter of 2009, the highest level since records began in 1960.

New Lending Lessons For British Borrowers

Apparently, over leveraged U.K. borrowers took every nickel they could from lenders foolish enough to lend to them, oblivious to rate or terms.  The actions of these borrowers could almost be viewed as rational since the money they borrowed and spent that they couldn’t pay back is now being absolved in bankruptcy courts with little repercussions from now defunct lenders.   U.K. borrowers who now have to deal with unlicensed loan sharks are shocked to learn that the loan sharks actually expect to be paid back – or else.

Some consumers are going to loan sharks to fund purchases for items including new televisions, overseas vacations or expensive clothing.

In mid-2007, Donna Ockerby, a 45-year-old auxiliary nurse in Manchester in northern England, turned to a local loan shark after her hours were cut at work. She borrowed £700 from Johnny “Boy” Kiely to help pay for a wedding dress.

Mr. Kiely, who charged interest rates of up to 2,437%, was jailed earlier this summer for five years for offenses including blackmail and illegal money lending. Ms. Ockerby now lives in a one-bedroom apartment on government benefits. She was moved out of her childhood home by police to protect her. Ms. Ockerby, who says she is on antidepressants, says the decisions to borrow from a loan shark ruined her life.

I’m sorry Ms. Ockerby but you are a financial idiot who deserved to pay the market rate of 2,437% interest.  Did you ever hear of “if you can’t afford it don’t buy it”?  What was the problem with buying or renting a used wedding dress for a fraction of the cost?  Johnny “Boy” Kiely risked his capital, is now in jail and out his £700.  Johnny “Boy” did not ruin your life – you did.

How The Government Encourages “Ruthless Defaulters”

The Delusion of Lenders

The old banking rule of lending only to those who had the capacity to repay was gradually relaxed and then completely abandoned over the past two decades.

New techniques such as loan securitization spread the risk far and wide, theoretically reducing the risk by spreading the risk.    No income verification for mortgage loans became routine since home price appreciation seemed to further diminish the risk – a defaulted mortgage loan could be fully recovered by seizing and selling the collateral.  Risky unsecured credit card lending seemed to have limited risk, as well, since a troubled borrower could simply borrow more to make loan payments that were beyond his income ability.

It all worked fine until it didn’t and economic historians will be debating for decades what went wrong.   The short answer is, of course, that loans extended to those without the ability to repay will eventually default.

The government’s answer to cure defaults by over indebted consumers is to encourage banks to extend more credit to postpone the day of reckoning.  Unfortunately, the government’s “solution” won’t work this time since it is the day of reckoning.

Businesses and the average American consumer have the good sense to realize that borrowing more when they can’t afford the debt payments they have now is total lunacy.  The result is stricter lending by the banks and reduced demand for loans.  Consider the reduction in bank lending taking place:

Loans Shrink as Fear Lingers

Lending continues to slow as bankers and borrowers refrain from taking risks, in a bearish sign for the economy.

The total amount of loans held by 15 large U.S. banks shrank by 2.8% in the second quarter, and more than half of the loan volume in April and May came from refinancing mortgages and renewing credit to businesses, not new loans, an analysis by The Wall Street Journal shows.

The numbers underscore two related trends weighing on the economy. Financial institutions are clamping down on lending to conserve capital as a cushion against mounting loan losses. And loan demand is falling as companies shelve expansion plans and consumers trim spending to ride out the recession.

The slow pace of lending has created political heat for the Obama administration. On Friday, Rep. Spencer Bachus (R., Ala.) pressed Treasury Secretary Timothy Geithner to “tell me why we didn’t really see that multiplier effect” from banks funneling their TARP money into lots of loans.

The disturbing part of the above article is that politicians view tougher lending standards as an economic negative when, in fact,  it is extremely positive.

Bankers, businesses and consumers see the new economic reality and are cutting debt and rebuilding balance sheets –  essential actions for a sound economic recovery.  Those encouraging more lending and borrowing should consider the following chart.

Debt VS Savings

Debt VS Savings

Courtesy: Credit Writedowns

Debt Burdens Double

With income growth declining and debt burdens already intolerable for many,  what rational lender would seek to lend and what rational borrower would seek to borrow?  The debt burden for many has reached levels where default is the only option – more credit would only lead to a larger future loss to a lender.

Growth in debt that is commensurate with growth in income promotes sound economic growth.  Unfortunately the debt burden has expanded far in excess of income growth, with debt to income ratios doubling since the 1980’s.

hhdebttoincome43

Household Debt To Income

Courtesy:  continuations.com

Debt Repudiation And Unintended Consequences

Ironically, the biggest impediment to future bank lending is the growing trend of debt repudiation directly sponsored and encouraged by a government concurrently seeking to encourage more lending.

Consumers having trouble paying their debts can now chose from a long list of government programs for debt forgiveness, loan modifications, rate reductions, 125% loan to value mortgages and more programs on the way.  Their is no  longer any shame or embarrassment associated with defaults and bankruptcy.  Defaulting on debt has become a rational choice for many with little repercussions.

How does a banker factor into his risk adjusted lending rate “defaults of convenience”?  The problem of debt repudiation is large and will get larger as described by the New York Times.

When Debtors Decide to Default

Those on the front lines of the debt industry say there is a small but increasingly noticeable group of strapped consumers who, like Ms. Birks, are deciding they will simply stop paying. After loading up on debt eagerly provided by the card companies during the boom times, these people now find themselves trapped in an endless cycle where they are charged interest on interest and fees upon fees while the lenders get government bailouts.

The lending industry term for these people is “ruthless defaulters.” In a miserable economy where paychecks, savings and expectations are all diminished, their numbers will surely grow.

Collectors are noticing a shift not only in ability but in willingness to pay. “With all the bailouts the government is giving everyone, no one has any personal accountability about their own debts,” said Roger Knauf, who runs a trade group of debt-buying firms.

Much of the blame for the excessive debt that consumers took on can be placed on fee crazed bankers who did not properly evaluate risk.  As loan losses continue,  expect bankers to act like bankers again and to continue tightening their lending standards to avoid future defaults.

Lending will remained constrained and intelligent consumers will continue to borrow less and save more – the exact strategy necessary to work off the insane debt binge this country has been on for decades.

Biggest Fool Still Borrowing

Unfortunately, there is still one drunken fool at the party,  relentlessly expanding the borrowing insanity that has put the world on the brink of economic ruin.  Uncle Sam needs to sober up and rethink the flawed theory that unlimited credit equals unlimited wealth.

US Deficits and Debt Increases

US Deficits and Debt Increases

Courtesy: Wikepedia