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Table of Contents

• Executive Summary
• Debt and Credit: A Brief History
• Credit Cards: Then and Now
• The Marketing of Debt
• The Minsky Peak
• Impact on the U.S. Economy
• A Warning for Emerging Nations 

EXECUTIVE SUMMARY

Much of the U.S. economic growth in the last two decades has been attributed to consumer spending. But now we are learning that the spending has come at an unexpected price—an ever-increasing personal debt.

In the midst of an unsteady economy, analysts are trying to understand the causes behind our escalating consumer debt—currently estimated at a staggering $2.56 trillion. When you add on another $10.5 trillion in mortgage debt, you can understand the mounting concerns about how consumer debt affects the country’s macroeconomics. 

Three factors have economists the most worried:

1.)  the growing number of home mortgage foreclosures
2.)  high credit card balances and rising delinquencies
3.)  an all time low savings rate

Over the past decade, the economy seemed poised to enjoy long-term benefits from loans made available for homes and commercial properties.  But shortsighted mistakes and outright disreputable lending practices resulted in the slew of foreclosure signs that now dot the lawns of empty houses.

The $10.5 trillion in mortgage debt is more than twice the $4.8 trillion mark set in 2000. By the second quarter 2008, lenders were forced to set aside a record $14 billion in reserves for loan losses. Sub-prime mortgages contributed to more than $500 billion in write-downs and credit losses.  Added to this bleak picture is the fastest pace in bank closures in fourteen years, with ten banks closing in 2008.

Are we headed for recession?

Will these financial troubles lead the nation into a deep recession? The answers are conflicting and complex depending on whether the question is viewed from an economic standpoint or skewed from a political perspective.

But regardless of the shakeout from bad loans and crushing credit card debt, one thing is certain; if consumers stop spending, the economy will be in even worse trouble. As author Bill Bonner once said, “The entire world economy rests on the consumer; if he ever stops spending more than he doesn’t have on things he doesn’t need we’re done for.”

On the other hand, if consumers keep making purchases on credit, the results will eventually be the same anyway.  Every dollar that goes toward paying interest on our mortgage, car loans and credit card balance is a dollar that can’t be spent at the grocers, the hardware store or Starbucks. 

A non-stop shopping spree

Why are the citizens of the richest nation in the world unable to hold on to their hard-earned money?  There’s a simple answer to that question: American consumers have been on a non-stop shopping spree, both online and on foot.

When the history of twentieth century America is written, in addition to a chapter on the more recent phenomenal growth of e-commerce, you’ll find a whole section about shopping malls—a symbol of the culture.  Malls are more than a place to shop; they’re a place to work, to be entertained, to socialize, and finally, to validate our identities.  To understand the underlying reasons for that last point, it will require an investigation into the subject of our culture of consumerism and human psychology—a subject this report will explore.

But from a purely statistical standpoint, the numbers tell their own story. The ratio of spending to disposable income rose from below 90 percent in the early 1980s to nearly 100 percent in 2007, and a major portion of that spending was done with credit cards.

It’s no secret that the biggest factor in the pursuit of living The American Dream has been access to consumer credit.  But how did spending and buying on credit get so out of control? Where did this all begin?

We’ll try to answer that question by taking a look at the history of debt and credit as we follow the signposts that lead up to the present day.  We’ll review how the sub-prime loan catastrophe has impacted the lending industry, and we’ll point out the effects consumer debt is having on the over-all economy.

Finally, we’ll compare how the rest of the world is faring now that easy access to credit is becoming more acceptable in emerging economies like Brazil and Mexico. Maybe the U.S. experience will serve as a warning to other nations and they’ll learn lessons from our mistakes.

 
DEBT AND CREDIT: A BRIEF HISTORY

Even though debt has become a major news story lately, the concept itself is nothing new. History books are filled with accounts of credit and debt; it’s only the recent accelerated scope that’s become so newsworthy.

As far back as 8,000 B.C. Mesopotamia, goods were exchanged on a primitive system of buy now and pay later.  Small clay tokens were used to keep track when citizens made loans of livestock, silver or grain. The wedge-shaped symbols placed on those early tokens evolved into an ancient form of writing called cuneiform.



Around 3000 BC, the Sumerians came up with a new idea: charging interest on the unpaid debt. The Sumerian word for interest was mash. Coincidently, that word translates to calves, which makes a lot of sense when you consider that there were a lot of cows being loaned out back in those days, and cows have a tendency to multiply.

Let’s assume you lent someone a dozen dairy cows and a bull for one year.  The borrower cared for the herd and got to consume or sell the milk.  The following spring several calves were born.  At the end of the year you could expect to get back the original twelve cows and the bull plus all the calves/mash/interest. 

As lending activity began to be recorded on papyrus for all to see, a more urgent sense of debt and obligation was born. Debt was a great motivator even in those days. The inability to pay could mean the loss of property for the borrower, or in less civilized situations, the loss of a head.

Marcus Licinius Crassus, a contemporary of Julius Caesar, and possibly the world’s first real estate mogul, accumulated his fortune by building houses and selling them through an early version of today’s installment plan.

Early debt in the colonies

When the first Pilgrims loaded their belongings onto the Mayflower and set sail for America, they were escaping the tyranny of King George. But there was something they couldn’t escape—a load of debt still carried on the books in England. In 1641 the Pilgrims consolidated all debts owed to English creditors into four annual installments. If you think credit card interest rates are high now, they’re nothing compared to the thirty to seventy percent interest the Pilgrims were forced to pay.

In the early 1800s Thomas Jefferson may have been the first President of the U.S. to get a collection notice. History books reveal this from his writings:
I was daily dunned by a company who had formerly made a small loan to the U.S., the principal of which was now become due; and our bankers in Amsterdam had notified me that the interest on our general debt would be expected in June; that if we failed to pay it, it would be deemed act of bankruptcy and would effectually destroy the credit of the U.S.

In modern-day vernacular, one might say that Mr. Jefferson had secured a "country equity loan." After returning from a trip to Europe where he’d met with the financers, he happily reported that, “I had the satisfaction to reflect that by this journey our credit was secured, the new government was placed at ease for two years to come."

It’s safe to assume that Mr. Jefferson’s jaw would have dropped had he learned about the $503.8 billion in debt the U.S. has incurred with China—an interesting topic in and of itself, but not one that we can cover in this report.

Installment loans hit the scene

Some of the earliest forms of U.S. consumer credit—installment loans—became popular in the mid-1800s with the advent of time and laborsaving conveniences like the Singer sewing machine. Women who relied on sewing for their livelihood, but were low on cash, began snapping up these machines and making installment payments directly to the manufactures. Unknowingly, Singer had jump-started the concept of building a life on the easy installment plan.

By the early 1920s, Model Ts were popular, but Ford Motor Company didn’t have a payment plan in place.  It cost the average wage earner nearly a half a year’s salary for the privilege of driving the auto.  When that became too onerous, a new industry was launched—third party automobile finance companies.

By 1925, seventy-five percent of cars were purchased on the installment plan. With that, the door was flung wide open for average citizens to upgrade their living standard and make purchases that had previously been out of their reach.

From household furniture and large appliances to farm equipment, the practice of buying now and paying later spread so quickly it prompted Wilbur Plummer, Ph.D. from the University of Pennsylvania to write the "Social and Economic Consequences of Buying on the Installment Plan" which was published in 1927. In it he wrote:

Installment Buying Is Creating a Generation of Spendthrifts — It is the view of some people that this system of allowing individuals to buy more than they can pay for is creating a generation of improvident people—spend thrifts. It is causing individuals to form habits of extravagant spending, rather than the socially desirable habit of saving.
   
But in spite of Plummer’s warnings and stern finger waving, it was too late. Consumers had already gotten a taste of the good life and there was no turning back.

Banks and creative lending

Short-term credit and installment plans are one thing, but major loans are another story.  In the tight-money era of the nineteenth century and early in the twentieth, farmers, tradesmen and the average working class people had a hard time getting loans. But after World War II, millions of families were able to buy into the American dream with government-backed mortgages through the G.I. Bill.

This was a boon to banks as they began seizing the opportunity to boost their bottom line by finding new ways to lend money. Times had changed and so had the old joke about the banker only lending money to those wealthy enough not to need it.

Since then, mortgages, auto loans and personal credit have been liberalized and by 2004, seventy-five percent of U.S. households had debt. The current $2.56 trillion figure we mentioned above is, according to the Federal Reserve Board, up 22 percent since 2000. 

The most common types of consumer debt today are home mortgages, home equity loans, car loans and credit card debt. Loans related to homes, automobiles or other big-ticket items, are backed by the underlying assets. For example, if you are financing a home or a piece of equipment, those assets are the bank’s assurance that the debt will be repaid because the lender essentially has the right to repossess or foreclose on the debt.

But credit card debt is considered unsecured debt because there is nothing of value backing the debt other than the borrower's credit history. If the borrower can't make his monthly payments, he has to find a way to come up with the money, which might mean borrowing more from another source.
This is why credit cards and other unsecured debt are the most precarious kinds of debt to accumulate.

 
CREDIT CARDS: THEN AND NOW

The earliest credit card activity can be traced back to the 1920s when individual retail stores did away with their cumbersome open-book ledgers and began extending credit to their customers. Around this same time, Standard Oil issued their first charge cards. In the late 1930s, major department stores introduced revolving credit and chargaplates, giving customers several months to pay off their balances.

   

In 1949, the Diners Club card had more a more judicious business plan than today’s credit card companies. They offered their members the opportunity to spend what they could afford on the spot.   Rather than having to carry cash, members used the card as a back up, but were expected to pay the full balance on their monthly statements.

In 1958 American Express issued the first charge card that could be used internationally, and within five years more than a million were in use across the globe. The company’s payment plans became a popular way to pay off travel costs over an extended period of time. Other companies followed suit and today, by some estimates, 144 million Americans have credit cards, with many families juggling multiple cards.

Payment and non-payment habits

Fifty-five million cardholders pay the balance down to zero on a monthly basis and thirty-five million others pay only the minimum requirement.  But according to reports by the major credit-card issuers  including, American Express, Citigroup, Bank of America Capital One Financial and Discover JPMorgan Chase, unpaid credit card debt is on the rise.  A news release from the Federal Reserve shows consumer credit card debt hit an all time high of $970 billion in July 2008.



A recent Gallop Poll inquired about how consumers paid their credit card balances each month.



This graph does not include the fifty-five million that pay off the entire balance each month.

There’s a harsh word credit card companies use to describe those responsible folks: Deadbeats.  Remember when the term “deadbeats” was reserved for lazy ne’er-do-wells who avoided work and responsibility?  Not any more.

When you pay your entire balance each month, the lenders still have to carry you on their books, but they don’t get the benefit of charging you enormous and continuously rising fees.  In fact, like a visiting relative that wears out their welcome, you’re considered a drag on their business, a deadbeat.

For those that do make monthly payments, you can forget about the original contract’s terms and fees. A credit card company is only obligated to give you a fifteen-day notice of changes in the terms. But that’s not the half of it.

Even if you make your payments on time, they are tracking your everyday financial activities and monitoring your credit score to see if you are falling behind on other payments—even those owed to rival credit card companies—or your auto or house payment.

If your creditor decides you’ve taken on too much debt or are having problems paying any of your other bills, the universal default clause kicks in and your interest rate will be raised automatically.

This clause is becoming standard in the fine print of credit card agreements. Company executives rationalize this by claiming that if you pose a greater risk of not repaying your debt, they are justified in raising your fees.  Of course they want to be repaid . . . just not too quickly.  After all, they don’t want more deadbeats on the books.

Some Chase Bank customers who had been paying their monthly minimum payments on time, recently saw a hike in interest rates from 7.99 percent to 19.99 percent. When they complained to the company, the impersonal and unapologetic response was, “overall turmoil in the credit markets meant higher rates for a number of customers.”

Debt and delinquencies on the rise

Credit card borrowing grew at an annual rate of 4.8 percent in July 2008, up from a growth rate of 3.5 percent in June. But while the volume of credit card purchases continues to rise, on-time monthly payments are falling. 

Consumers have dug themselves in so deep, credit card delinquencies are at the highest level in six years—4.86 percent up in the first quarter of 2008 alone.

There are also the charge-offs—the point at which creditors write off the account balance as a bad debt—usually after six months of non-payment. At this point your outstanding balance is no longer kept on their books as assets payable. You still owe the money, of course, and you’ll be subjected to collection calls and a "charge-off" noted on your credit report.



As indicated in the above graph, after spiking late in 2005 due to a change in bankruptcy law, credit card charge-offs have risen. Delinquencies are at a rate not seen since the 2001 recession.

Debt versus savings

When you compare the skyrocketing debt with the declining level of savings, the situation looks even bleaker. According to a study conducted by the New York Times, the average annual savings per household in 1923 was $5,533 versus $6,219 in debt. By 2008, savings slipped to $392 versus $117,951 in total household debt.




Fees, fees, and more fees

It’s not possible to discuss the subject of consumer debt without mentioning the growing fees you can expect to pay in addition to your interest charges. In 2007, the average credit card late fee was thirty-five dollars, up from thirteen dollars in 1994. If a customer exceeded their credit limit in 2007, they were charged eleven dollars.  That more than doubled in 2007 to twenty-six dollars.

The Department of Housing and Urban Development report that mortgage lenders have upped their fees associated with borrowing to buy a home. A seventy-five dollar email charge, one hundred dollars for preparing documents, and seventy dollars for delivering them by courier. The average costs for junk fees are now an average of  $700 per mortgage.

The lenders today focus as much energy on making loans a perpetual earning asset as they do on the consumer repaying the loan.  They’ve also become more creative.

After the Federal Reserve Board put rules into effect rules that bar mortgage lenders from making loans to individuals who lack the resources to repay, lenders started cold-calling homeowners hoping to pressure them into refinancing.

Granted, refinancing can help reduce borrowers’ monthly payments, but the more consumers refinance, the more lenders can get for loan processing fees, and that includes fees for appraisals, credit checks, title searches and document preparation fees.

Negotiations and bankruptcies

In the past, consumers with hefty credit card debt had one last resort to fall back on—counseling agencies like the National Foundation for Credit Counseling (NFCC). These are the middlemen who help negotiate with lenders. Typically, a counselor sets up a debt-management plan that allows a client to consolidate their debt and pay off a balance over a five-year period at a lower interest rate. The debtor makes a single monthly payment to the counselor, who then transfers the money to the various lenders.

Card issuers had been willing to slash interest rates permanently, and in some cases eliminate them all together, just to have a greater assurance that lower payments made it more likely that the principal would be paid.

But some lenders have started backing off from cutting these deals and have drawn the line by keeping rates no lower than an average sixteen percent. Others like JPMorgan Chase, agreed to cut rates to zero percent for consumers who opted for a formal debt-management plan, but the future of these plans seems uncertain.

Counselors have been doing their job for nearly fifty years, but are now complaining that they aren’t being paid for their services as they once were. Where they once collected fifteen percent of the total debt that was paid off, today banks are paying them less than eight percent. If that continues, operations could be scaled way back or discontinued altogether.

Banks have deduced that most borrowers will keep paying their debts even without lowering the rates, and higher rates helps maximize the recovery. But counselors argue that the worse the economy gets, the more people flock to their services.

The NFCC worked with 2.7 million individuals last year, roughly a thirty percent jump from 2006. If consumers are denied the chance to cut their rates, they’ll likely fall further behind and end up in bankruptcy. In fact, in a study by Visa it was found that fifty percent of consumers who gave up on credit counseling programs had to file for bankruptcy.

Credit cards versus small business loans

The huge losses in the lending industry, bank closures, and tighter money are making it increasingly difficult for small start-up businesses to get commercial loans.  This is especially true if the company owns no capital equipment to secure the loan. For the first time in history, small business owners attempting to get new enterprises off the ground have no place to turn but their credit cards.  

This is a risky business in more ways than one.  First there are the uncertainties inherent in a brand new untested venture. Then there is the ever-present possibility of missing a payment on your card while you struggle to get things moving. One payment missed and you’re on the road to escalating interest rates. 

The bigger the initial seed money, the larger the monthly payment, and depending on the payment history, the greater the potential for interest rates to go over the top. Yet, a survey by the National Small Business Association (NSBA) indicates that an increasing percentage of entrepreneurs are using their credit cards to finance start-up companies—from sixteen percent in 1993 to forty-four percent in 2008. During that same period, the percentage using bank loans dropped from forty-five percent to twenty-eight percent.

The survey also found that a third of businesses using credit cards carried monthly balances of more than $10,000. With no interest rate locked in it’s impossible for business owners to finance growth by using credit cards. 

Credit card companies zero in

Small businesses spend an estimated  $4.7 trillion dollars annually, but only $283 million is being charged on credit cards.  Credit card companies are zeroing in on this wide-open market. Of the six billion credit-card offers they mail out annually, twelve percent are targeted to small business owners—that's 720 million offers, or around twenty-six temptations for each small company in the U.S.

This is a risky invitation for consumers to create worse debt and an even bigger hit to the economy.

 
THE MARKETING OF DEBT

 “Money is a poor man’s credit card."
   - - Marshall McLuhan

It’s getting more difficult to live within our means when we’re being inundated from all sides with messages to spend. Who can forget the oft-criticized solution offered by George W. Bush in the aftermath of 9-11?  Go shopping! Credit card companies liked that idea, only they took the message one step further.  Yes, go shopping, but don’t take cash.  The message now is that cash is an inconvenience, an uncool commodity that slows down the wheels of progress.

Life takes Visa

Advertising campaigns like the television commercial “Life Takes Visa” is a perfect example. In one of the commercials, there’s a shot from above that resembles a production number cut from a 1930s Busby Berkley musical.  You see a symmetrical pattern of shoppers happily winding through the aisles in unison. They move toward the checkout counter, each swiping their Visa card, completing their purchases without a hitch and move along to make room for the next in line.

It’s consumerism at its finest and all is well in the world. . . until . . . someone has the audacity to pull out cash bringing the whole process to a screeching and intrusive halt.

When the voice-over says, "Don't let cash slow you down," it sends a clear message. The world hums along on credit and doesn’t have time for reflection on the wisdom of unnecessary spending.

For everything else, there’s MasterCard

Whether teens or seniors, all age groups are targeted by sophisticated ad campaigns and direct mail programs. MasterCard understands the inherent guilt many feel about spending money, so they focus on eliminating those worries. In their “Priceless” campaign the message was, you can put a price on a lot of things in life, but for the really “meaningful” things, there’s MasterCard—so there’s really no excuse for not indulging yourself.  Go ahead, feel good and buy now, before you start weighing the consequences.

When gold and platinum cards were first issued, they were intended to add an extra air of prestige to the holder.  Suddenly your status was elevated according to the color of your credit card.  That was the point at which we allowed credit card companies and retailers to snare us into the identity branding game.

That brings us to the subject of culture and social identity and how it contributes to consumerism and debt.

Psychology, social identity and consumer choices

The branding of our world has become one of the major problems linked to consumer debt.  Everything is so branded, part of our personal identity has become tied up with the labels and products we choose. 

A teenage boy walks into an athletic shoe store.  Before he buys anything, he spends a long time just standing there, staring at four walls stocked from floor to ceiling with too many choices. The most pressing question on his mind is not, “Which one will fit best?”  It’s certainly not, “Which one can I afford?”  It’s most likely, “Which one is me?”

If saving money was foremost on his mind, he could shop at a big box discount store with generic labels.  Generic products cost less, but they’ll never give us that sense of identity and of belonging so many seek.  You may get a certain sense of belonging while sipping that cup of coffee at Starbucks, but what does it say about you when your cup of coffee comes from the quick-stop convenience store?

The science of persuasion

For decades, social psychologists have studied the effect of group identity on human behavior. In the science of persuasion there’s a principle termed “social proof” – a system of convincing people that they are part of a larger group of consumers who are all doing the same thing. “If everyone else is buying, then I will too.”

Psychological factors have played a significant role in the transformation of household finance over the years. The vast majority of older household decision makers from the end of World War II through the 1970s had either been faced with the challenges of the Great Depression themselves or had parents who struggled through this somber period. Such stark memories left them with an aversion to consumer debt.

But history hasn’t had much affect on baby boomers.  Now, more than two generations removed from the Depression, they have been much more willing to borrow aggressively to get what they want.

Indeed, the social-proof phenomenon is evident among this generation. When friends and colleagues suggest that a home equity credit line can easily finance a trip to Europe or remodel the home to add on a nursery, the social stigma once associated with debt fades away.

The dramatic rise in spending corresponds to the period in which the baby-boomers have become the dominant force in American consumption, partly due to their relaxed attitude about debt.

The science of persuasion generally achieves the desired results for those who market products. Even when the same science has unintended consequences, it stills proves the same point.

A perfect example is when the Petrified Forrest National Forest in Arizona posted signs along the trails asking tourists to please refrain from taking bits of crystallized minerals as souvenirs.  But the subliminal message that tourists picked up was that all tourists (people just like “us”) visit the park and steal. Almost immediately park attendants noticed an increase in “souvenir gathering” and the signs were taken down.

Sigmund Freud, father of psychiatry and psychoanalysis knew a little something about how the mind worked.  So did his nephew, Edward Bernays.  Considered the father of public relations, Bernays was the first to experiment with manipulating public opinion using the psychology of the subconscious and an indirect use of  “third party authorities.” His work laid the foundation for media manipulation and our culture of consumerism.

Once the suggestion has been planted in the minds of consumers that they are linked to the same habits as others similar to themselves, the marketing mission has been accomplished. It’s the same “wisdom of the crowd” herd mentality that leads to stock bubbles. 

Throughout history, it’s always been the most primitive way of making choices: follow what we think people like “us” are doing. It’s the very thing Keynes referred to when he wrote:

“Knowing that our own individual judgment is worthless, we endeavour to fall back on the judgment of the rest of the world which is perhaps better informed. That is, we endeavour to conform with the behavior of the majority on average. The psychology of a society of individuals each of whom is endeavouring to copy the others leads to what we may strictly term a conventional judgment.”

Live Richly



The campaign, which cost over one billion dollars, urged consumers to lighten up about money. It worked. Hundreds of thousands of Citibank customers were persuaded to take out home equity loans — that is, to borrow against their homes.

As one of the ads put it: “There’s got to be at least $25,000 hidden in your house. We can help you find it.”

There was a time when these kinds of loans were called what they really are, “second mortgages.”  But when you mentioned that dreaded term, you did it quietly lest the neighbors hear. Having to take out a second mortgage was a last resort before losing everything.

But marketing executives simply made it easier for you by changing the language.  Home equity was the new term.  It no longer hinted at financial disaster, rather it had a comforting ring of ownership and fairness.

Today, these loans have become universally accepted, thanks in large part to the change in language and the transformed image. Now you barely notice that you’re becoming, like Tennessee Ernie Ford’s song once lamented, “another day older and deeper in debt.” But once you become aware of the marketing ploy, you realize how insidious these campaigns actually are. 

Typical examples are these taglines:

•    Is your mortgage squeezing your wallet? Squeeze back.
•    The smartest place to borrow? Your place.
•    You’ve put a lot of work into your home. Isn’t it time for your home to return the favor?
•    Need Cash? Use Your Home

It’s hard for a single advertisement to change your perspective, but with ubiquitous campaigns like this, it becomes socially acceptable for everyone to accumulate debt, and so . . .everyone does.

Equity vs. Debt

With the explosion of home equity loans that began in the late 1980s, before they were even known by that term, the portion of homes that people own free and clear has declined.



The number of homeowners who are behind in their payments on home equity loans and lines of credit is on the rise.



Technology and consumerism

On some level, we all know our buying is out of control.  We understand the consequence of high interest rates and growing fees.  But the constant barrage of advertisements tends to numb our reasoning power. When you throw technology into the mix, over-spending and debt picks up speed and puts tremendous demands on our self-control.

We can no longer escape the marketplace by going home at the end of a workday. Flip on the TV. Open your mail. If television home shopping networks or glossy catalogs with toll-free order lines don’t get us to buy, turning on the computer probably will.

The Internet makes it easy for us to continually compare ourselves to others, to see what they have versus what we don’t. Without ever having to leave our desks, we have access to a world of products with twenty-four-hour one-click shopping and transactions that take less than a minute. It puts our self-control to the test, and judging by the statistics, most of us are failing the test.

Government statistics show online sales grew from $4.6 billion in 1999 to $136 billion in 2007.  That’s a dramatic nineteen percent increase. Forrester Research, a technology and market research company, projects U.S. web sales will approach $200 billion in 2008 and could exceed $300 billion in five years.  If that’s the case, we could be clicking our way into astronomical heights of credit card debt!

 
THE MINSKY PEAK

For the past two decades, and prior to the 911 disaster and the subsequent Iraq invasion, economic conditions in the U.S. had been conducive to the high levels of consumer spending that led to unsustainable household debt.  Energy costs were low, there were large tax cuts in place for the rich, the stock market was booming, interest rates were low, housing prices were continuing to move up, and financial institutions were opening new doors for borrowers.

But these favorable conditions encouraged more aggressive financial practices until things are as they are today—teetering on a breaking point. With falling home prices and retrenchment in mortgage lending, conditions have reversed.

Many economists are now asking, “Have we reached the Minsky peak?”  Many suggest that we are approaching the peak of a credit/debt cycle in the U.S. and globally.  But what exactly is the Minsky peak, or as it’s sometimes called, the peak of a Minsky Credit Cycle?

Who was Minsky?

Hyman Minsky, a somewhat obscure American economist who passed away in 1996, spent much of his career promoting a theory that didn’t get a lot of traction during his lifetime. But given the current economic situation, the sub-prime mortgage meltdown, rising prices, and increasing debt loads, his theory is getting more attention.

His was a fairly straightforward hypothesis, though some would argue, a pessimistic one: When times are good, investors relax and buy more.  The better the economy looks, the more risk they assume until they reach critical mass where the cash generated by their assets is not enough to pay off the loans they took on to acquire them.

When investors are forced to sell their positions in order to liquidate debt, markets can spiral lower and create more demand for cash. That can lead to a loosening of credit and lending standards. Regulators and financial institutions/lenders begin to look for loopholes, push the limits of prudence, and even evade regulations and oversight at a time when they are needed most—in the midst of a credit boom/bubble.

Three types of investors/borrowers

In Minsky’s view, when investors and speculators begin to borrow excessively, it results in pushing asset prices high. He described three types of investors/borrowers.

•    solvent borrowers, those with enough cash or income to cover both interest and principal payment. 
•    speculative borrowers who only have enough assets to service interest payments but not the principle.  Speculative borrowers therefore expect to rely on liquid capital markets so they can refinance their debts.
•    Ponzi borrowers, those that can make neither interest nor principal payments. He uses the term Ponzi because in order for these borrowers to keep rolling over their debt obligations, they depend on their assets to continually increase in value as a way to stay ahead of the game.

Reviewing the similarities

Considering the current economic situation, it’s not surprising that analysts are wondering if we’ve reached the Minsky peak.  Let’s review the facts and you can decide the answer: 

U.S. consumers have been re-leveraging excessively, spending beyond their means in spite of a weak job market, failing to save and piling up debt. About half of all mortgage origins between 2005 and 2006 were extended to unqualified borrowers, either because of naïve wishful thinking or outright fraud on the part of lender. These loans have now been classified as sub-prime and characterized by at least one of the following:

•    negative amortization
•    zero down-payment
•    no credit checks or verification of income and assets
•    interest rate only
•    teaser rates

Sub-prime borrowers—and some who were qualified but bought on spec with the intention of flipping houses to make a fast buck—fall into Minsky’s definition of Ponzi borrowers.  In the category of speculative borrowers are those who were counting on the ability to simply refinance their mortgages and debts rather than taking the responsibility of paying down a significant chunk of their principal.

As Minsky predicted, mortgage lenders did indeed take irresponsible liberties with the credit and lending regulations, and now here we are. An overheated housing market that led to a mortgage bubble that eventually ended in financial crisis. And because of its massive debt, the household sector is more sensitive to unexpected movements in interest rates and to changes in income.
 
THE IMPACT ON THE U.S. ECONOMY   

While we may have progressed rapidly toward the Minsky peak with a wave of foreclosures and defaults, the end may not be in sight yet.

In July 2008 reports began to surface all over the Internet that the foreclosure epidemic may be worsening.  Foreclosure filings between July 2007 and July 2008 are up 121 percent.  One in every 171 households received some sort of notice related to foreclosure during the second quarter of this 2008.
At the end of June there were 2.72 million first mortgage loans in default at an annualized rate. For all of 2008, defaults could hit 3 million, up from approximately 1.5 million in 2007, and 1 million in 2006.

The news is even more ominous when you consider that there are still more adjustable loans with resets coming due.  A significant rise in interest rates may mean even more foreclosures. In the Seattle area alone, an estimated 12,600 sub-prime loans are scheduled to reset before the end of 2008.
Moodys predicts household credit conditions will continue to weaken through the remainder of the decade, with another 5 million homeowners at significant risk of default.

Banks, already weighed down with defaulted loans could face even more troubled mortgages on their books. Failures are expected to reach such a high level the FDIC, the Washington-based agency that insures deposits at U.S. banks, may not be able to insure all deposits.  They already raised the number of “problem” banks to 117 in June, up from 90 at the end of March.

The 2008 collapse of the IndyMac bank alone–which held $32 billion in assets–could require as much as $12 billion from the FDIC’s fund. Moody predicts that even more banks will come on the list as credit problems worsen and they foresee consolidation among the major investment banks.

The Federal Deposit Insurance Commission recently made some dire predictions that America is due for a failure of another major investment bank. Now they warn that bank failures could metastasize so quickly that the FDIC may need to borrow money from the U.S. Treasury. If that happens, taxpayers would have to foot the bill.

The government has already bailed out Bear Stearns and the financial world is holding its breath over the potential bailout of Fannie Mae and Freddie Mac, and now the FDIC?  It all becomes a matter of how far the country wants to run up the bill for the deficit and national debt.

Good news

We’ve given you the bad new, but if there is any good new, it’s this. It’s going to force Americans to start saving again.  As boomers approach retirement and watch their homes decline in value, their stock market investments falter, and social security in peril, there is a renewed understanding about the importance of saving.

If the recent $600 stimulus checks didn’t do much to boost the economy, it’s partly because some opted to sock it away for the future.
In May 2008 the savings rate as a percentage of personal disposable income actually moved up 4.9% and in June to 2.5%. This was unexpected after the rate had stood at virtually zero for nearly three years—the lowest since 1933! 



If this new trend continues, it could help create some economic equilibrium down the road. That’s not to say that it won’t have a negative impact on consumer spending in the short term, but we’re already all to familiar with the effects of overspending and under saving.
 
A WARNING FOR EMERGING NATIONS

Credit card fever is spreading like a virus around the globe, and with it, the rising level of consumer debt. At a time when the U.S. is suffering from excessive borrowing, analysts fear the consequences could be even worse in countries that still struggle with poverty and inequality of income.

A generation ago you’d never have seen a billboard posted in a poor Indian shantytown, advertising the wonders of buying without cash.  But now credit cards and easy credit are taken for granted in places like India, Brazil, Mexico, China, and elsewhere.



Turkey

With a population of 71 million, only 10,000 cards were in circulation in 1984.  Now in Turkey there are 38 million cards, all of which accounted for a total $100 billion in charges in 2007 alone.  The situation is a result of easy access to credit. In downtown Istanbul, you can stroll up to a sidewalk kiosk and apply for a credit card.

Turkey is an ancient country where borrowing money had previously been a strictly private family affair, and where debt carried a fearful stigma. It appears that mimicking America’s appetite for buying on credit has been a much easier transition than changing old values.

With credit card debt exceeding $18 billion, defaults spiking, and consumer groups protesting high interest rates, the old world and the new are colliding. The stress of too much debt has driven some cardholders to the brink of violence where they have ended their own lives as well as the lives of others.

Brazil

The number of credit cards in Brazil rose ninety-one percent between 2002 and 2006, while personal credit has risen to 12.3 percent of GDP, approaching U.S. levels of 18 percent.

Some analysts worry that the interest rate burden from multiple installment payments could make for a dangerous situation in a country where many are still financially illiterate.

From the beaches of Rio to the streets of Brasilia, credit card vendors hand leaflets to passersby that promise "fast money" in bold letters.

Consumers buy everything from appliances to groceries with five to twenty installments, while ignoring the fine print about interest rates of up to thirty-one percent a year. As one might expect, it’s led to out of control personal debt, escalating default rates, and support campaigns like "Live Without Debt" that advise consumers about the risks of borrowing too much. 

India

Credit card transactions in India have risen by forty-two per cent during 2007-08 due to more companies issuing cards and a larger number of merchant terminals. Banks are also wooing customers with cash-back offers for using their debit cards as a strategy to encourage account-holders to keep more cash in their accounts. Growth of e-commerce has also fuelled the usage of cards for services like booking air and railway tickets.

However, with the higher credit card balances and growing default rates, banks are concerned about massive write-downs in the future.

China and Mexico

Chinese consumers, once recognized as among the world's most prudent savers, have gotten on the charge card bandwagon. The total number of bankcards, including debit cards, reached 1.58 billion in March 2008.

In Mexico, access to credit has grown faster than consumers can be educated on how to use it wisely. Credit card debt has become so out of control, consumers are actually turning to a radio host David Paramo, the wheeling-dealing savior of Mexico's growing number of credit card addicts.  On his show, Don't Throw Away Your Money, Paramo not only offers advices to listeners who call in, he also calls up bank executives on the spot and works out payment plans on the air.

A warning of things to come

These same stories are being repeating around the world again and again. Credit has become too easy for the unqualified and ill prepared, banks look for ways to bolster their bottom lines and instead end up with burgeoning defaults on their books, and consumers are digging themselves in deeper and desperately reaching out for help.

Easy access to credit may be a compelling way to jump-start an economy.   It paints a rosy picture and makes promises of better living.  But until the Minsky Peak theory is proven false, or consumers get a handle on spending, the end result will surely be the same.

It seems logical that the rest of the world might take notice and learn from the U.S. mistakes.