Wednesday, February 04, 2009

Credit Bias

I'm in the market for a house. I'm resolved to not incur unsecured debt in any form, intent on saving money for the rainy day or the house that I want - or both. Is this the right way to go? Common sense would say "yes". But conventional wisdom says "no".

There is some anecdotal evidence to support this contention. I've heard a few stories that go something like this: I know this guy see, he pays cash for everything and has no debt. He works as an employee and he's saved up enough for a down payment on a house. But he doesn't have a credit history, so he couldn't qualify for a loan - any loan. He had otherwise sterling credentials, but since he never borrowed money, he was an unknown credit risk and didn't present the possibility for a profit for a lending institution. Can you say "FICO"?

So I've been talking to loan agents to see what I could qualify for in terms of a loan for a house. And what I've learned is that, essentially, unless we're willing to pay the banker interest, we cannot build a good credit score.

Never mind that I pay my bills on time. Never mind that I keep a prudent reserve. No, good behavior doesn't count unless it pays interest.

What were those economists and policy wonks saying again? "We need to get the banks to loan money again." Do you think if we had money in savings, that the banks would have money to loan?

There are huge systemic problems in our economy, and this is one of them: the need to use debt financing to generate profit. I used to work retail. How that happened when my trade is IT? I decided to do it just as an experiment to see if I could do sales. It was in an upscale home improvement store that was a subsidiary of a much larger corporation.

When I started there, I had to go through training. The training had a strong emphasis on the requirement to ask every single customer the following question: Would you like to put that on your (name of company here) credit card? And the follow up, "Oh, you don't have one? Would you like to open one? It will only take a few minutes."

The reason for this is that the company I worked for relied upon debt financing to make up for the low margins on the products they sold. The numbers were rather startling. For every $100 sold, they would earn $1-2 if paid in cash, $2-3 if paid by a third party credit card, and up to $8 by a company issued credit card.

The widespread use of credit cards has transformed capitalism in the US. Remember the traditional method of making a profit? (Maybe you don't because you can only read about it in history books.) You know, buy supply, or manufacture and deliver products efficiently at a cost below the sales price of your product? Instead, multinational corporations buy a huge amount of inventory to sell at a very low margin on their own lines of credit, usually in the form of commercial paper. Then they sell that inventory to their customers with a higher rate of finance. It seems that the art of selling a product for a profit is almost completely lost on the ability to use financing as a means of increasing or sustaining margins.

Or maybe that's a sign of globalization. If we can't compete domestically with imported goods, then it's a race to the bottom on price with debt maintenance payments creating the margins necessary to sustain the business.

Setting that aside, here's an interesting question: why isn't financial behavior, like paying the bills on time reported and/or given the same weight as making payments on a line of credit? Probably because the money isn't there, there's no incentive if you're not paying debt maintenance charges - you know, like interest. Which means that unless you get into debt, you can't get the credit rating needed to qualify for a home loan at a reasonable rate based on your perceived risk to the bank.

We've all heard about the meltdown and the Federal Government's effort to help out. Most of the help has strings attached. Some bank officials are worried that the compensation caps required by acceptance of this help would prevent banks from attracting real talent. With thinking like that, I'd hate to think of what real talent could do to the country.

I guess they're not that worried now. It seems that the major credit rating agencies want to be lenient on AIG. They're worried that if the rating cuts for AIG are too big, then AIG will have to put up a lot more collateral and pay a lot more in financing costs. It's nice to see how members of the financial industry can be so helpful to each other. What about the rest of us? When was the last time your health insurer gave you a break? Or your bank?

There is also the question of lobbying. The bank and finance committees in both houses took in well over $26 million in campaign finance contributions last year. Nice. So, really, what the banks want is firm control over the economy:

  • You don't get a credit history unless you borrow money and pay interest.
  • If banks make a mistake, taxpayers get to pay for or assume the risk for it, while executives get bonuses.
  • Banks can use interest rates to manage the economy in their favor.

Basically, what we're looking at is the top of the kleptocracy created by the banks. They get to sit on their bum and collect principal with interest while the rest of us work for our money.

It's clear to me at this point that public policy must change with regard to standards used for assessing risk for secured loans, such as for a home. A person or company that seeks to borrow money for a secured loan is a far lower risk than for an unsecured loan. Yet, the measurements used to assess the risks rely almost completely on the record of payments for unsecured loans, usually credit cards. In other words, you have to start with unsecured credit first before you can qualify for the really big stuff like cars and houses, which are used as collateral in a loan.

This is so totally wrong. The weight of emphasis should be on payment of day to day bills, not payments on credit cards. We need to reverse the emphasis and place it on paying the bills on time and saving money as the basis for assessing the risk for secured debts like houses or cars.

This just in: Now Experian doesn't want you to get access to your credit score. It's bad enough that we have to pay for our own information (if we want it more than once a year), collected by agencies that will sell the same information to other companies. But it could get to the point where ordinary people cannot get access to their credit files. Gone is the time where you could dispute information on Experian's files because you can no longer see it. Seems like I should be paid everytime my information is disclosed to someone.

I want to leave you with one last thing. This is courtesy of NPR. Go to this page and you will see a chart. Here, we see the comparison of Debt vs GDP. There are only two years in the last century to date that debt was 100% of GDP: 2007 and 1929. Can you sense the sea change?

Monday, February 02, 2009

What does "stimulus" mean, anway?

So it has come down to this, a stimulus plan. Everyone is talking about it.

All this after an economic calamity that resulted in shriveled retirement accounts, deflated property values, and diminished expectations for employment. Estimates of losses in real estate and stocks amount to the trillions.

And there is plenty of news about how the financial industry, in recognition of their superior advice, talent and transparent management, gave themselves $18.4 billion in bonuses last year. There are some who are saying that the bonuses and compensation paid could not be justified by technology or experience. Who could've known? They're lucky they aren't in China - for they surely would be doing hard time in prison for their mistakes, instead of getting a handout.

More recently, we saw the story of Bernie Madoff, who ran the biggest Ponzi scheme in history. Harry Markopolos had been telling the Securities and Exchange Commission about Madoff for many years. But the SEC was unwilling to look at the scam and chose to remain willfully ignorant for as long as possible until it could not be ignored any more. That was when Madoff finally admitted to it in public. This is the free market at work. And for all you Southern California people, remember that former Senator Chris Cox, that great free market champion, failed to catch this on his watch. The free market will regulate itself, right?

I think it's also worth noting that during these hard times, CEO's aren't going to bed hungry. The vast majority in the financial industry aren't going to be out on the street anytime soon. They will try to find smaller firms to work for so that their bonuses don't make the news. And by the way, if you're looking for a good advisor that doesn't do Ponzi, check this out.

President Obama has made it clear that the middle class has been subject to plenty of abuse by the upper class. Those losses discussed above, were the most painful for the middle class. The middle class can't afford to lose half of their retirement account. For the upper class, they'll make it back in a few years. Even if they don't, they can probably take some time off to make a better plan while living in a house they still own.
The point of this post, is that for at least the last 8 years, the middle class has received a beating like none other since the great depression. And what the uppity class seems to have forgotten is that they really need the middle class. You see, when the upper class thinks of Mexico, they don't think of going there for vacation. No, they think of that great, captive employment market and yearn to bring it here. Just ask Gore Vidal.

The stimulus plans being discussed mean one thing, plain and simple: Ooops. We just beat the living daylights out of the middle class and we're so sorry. If we don't give them something to work for, they will stop working for what we are willing to pay them. We need to make sure they keep working until we can find a way to ship their jobs overseas.

Just how are we going to fix this? We can start by making the bailout plans god-awfully painful for executives who come to the government hat in hand after making really dumb mistakes. We can put an end to the conservative nanny state. This is the land where conservatives get their government intervention into the economy without the headlines the way progressives get it.

I used to consider myself a conservative, but I noticed over the years that I felt more and more uncomfortable with that association. At one point I was a libertarian, and I still hold some libertarian values (but I don't eat any books). The nanny state conservative is what the extreme "Right" has become: theologically dominant, morally "superior", belligerent, paranoid, and above all, self-righteous (just one ego fills a typical aircraft hangar when uncompressed). To the nanny-state conservative, economic policy is great if it drives income up and grants advantages to people who already have money and power. But somehow, it's really bad for the economy if the middle class gets to make more money.

Notice that the conservative Republicans are again pushing tax cuts. They're really, really worried that we're spending too much money on this stimulus plan. Gosh, we just spent $350 billion on banks who aren't even telling us how they spent their TARP money (though there is substantial evidence that domestic banks are buying other banks around the world rather than making loans at home). And we're getting ready to unload another $350 billion on them. Only this time around, we're going to make them accountable. Yeah, right. I didn't see anyone floating a tax cut to fix that problem. Notice that there was "bipartisan" support for that measure, too. And I didn't see any Democrats holding their breath in a pouting contest before that measure got passed.

I don't like the idea of spending, and I would prefer that we did nothing when it came to bailing out the banks. But if we have to choose between spending and tax cuts to save the economy, I'll take spending. Why? There is empirical evidence weighing against tax cuts. One really obvious clue is that tax cuts aren't going to do you any good if you're not making money. With many people out of work, and many more fearing for their jobs, people just aren't going to be making any discretionary spending decisions in favor of spending money. And let's not forget that we have eight long years of nothing but tax cuts for the benefit of the top 5% who saw their income grow at a much faster rate than the rest of us. Did they spend their money? If they did, would we be in a recession now?

For any of your doubters out there, here's an interesting quote to consider:

"As I've often said... this [increasing income inequality] is not the type of thing which a democratic society—a capitalist democratic society—can really accept without addressing." - Alan Greenspan, June 2005

...that subtle, yet discernable admission is from a fierce capitalist, a really big fan of Ayn Rand (see also, the libertarian link above), and an acknowledged expert on economic policy who was in charge of the Federal Reserve Bank for about 20 years.

So what is the return on investment when comparing a tax cut vs. spending? The simplest explanation put forth by Robert Reich, the former Labor Secretary in the Clinton Administration, is this: giving tax cuts to people who already have money doesn't make them spend more money. They've already spent the money they want to spend and so they only save more of it with tax cuts. On the other hand, giving money to people who have none guarantees they will spend it since they live paycheck to paycheck if they have one.

Here is one example of how a tax credit (which is a synonym for tax cut) didn't work. According to this article, between 1994 and 2004, the telecommunication companies, like AT&T, Verizon, and Comcast, were given an opportunity to improve their Internet access services with $200 billion in tax credits. What they did instead is cut costs, jobs, and increased prices for their services. So instead of remaining at No. 1 in the world for high-speed Internet access market penetration, we're No. 15 and falling. Oh, and they also gave the executives bonuses. Yeah, tax cuts are really great if you're making money.

By now, you may have noticed that I've been citing Dean Baker here and there. I like him because he's the only economist I've seen who is willing to go on camera and say what he really means. Dean points out another reason why spending is better than tax cuts. If the government doesn't spend the money, NO ONE ELSE WILL.

So let's look at the stimulus plan as a way to say "Sorry, my bad," all around, from those wonderful free-market conservatives. Who could blame them for having faith in the market.

And lets hope that the current administration is and continues to be mindful that we can make a meaningful change here for the better. Kudos to President Obama for making the effort to reach out to the other side. This is the first President I've ever seen that is actively seeking ideas from around the country instead of just inside the beltway. Perhaps the conservatives, noticing some of their ideas didn't work last time around, will wait their turn and give this new president a chance, too.