The Credit Crunch: Taking Personal Responsibility

As we continue to question the softening economy, I’ve noticed lots of finger pointing in the media. Originally it was let’s blame Greenspan and the old Fed for keeping interest rates too low for too long. Now people are blaming Bernanke and the current Fed for not anticipating the credit crisis earlier and brainstorming a solution. Yet others blame the mortgage brokers and banks for not adequately disclosing the terms and risks inherent in certain loans which we now know to be junk. And of course, why not blame Bush? The president has driven up our federal deficit by paying for a war which is totally out of favor with the public. So who should really take the heat for the current economy? You should.

I’m not suggesting that any single reader is responsible for the recent market turmoil. That would be impossible. But I do believe that people skirt responsibility for their actions and then turn to the government for a grand bailout package. That’s not how the United States grew to be so strong and more federal intervention simply makes us weaker as individuals. We survived the Great Depression and we can certainly survive a credit crisis brought on by greedy speculators.

Suggestions such as the government providing an unlimited line of liquidity to aggressive investment banks and brokerage firms make me very nervous. Why should my tax dollars protect greedy financiers who can’t see the danger in buying bad debt, packaging it up, and marketing it to the public as high-grade securities? If the financial industry continues to turn a blind eye to risk, let the banks fail until they get the equation right. That will be our country’s best path to re-gaining our financial prosperity.

On a more personal level, we must consider our own involvement in the current economic crisis. Most people simply are not giving enough thought to the financial decisions they make. When my retired parents hear about negative savings rates and people treating their homes like ATM machines, they are baffled. Do middle class people really understand risk and leverage? Probably not, and most of them don’t know what they’re signing when they take out a new mortgage or some other line of credit.

Based on stories I’ve heard, here’s what often happens: someone, perhaps at the bank or an old friend, talks you into a new loan or shows you a fancy financial planning strategy which will allow you to live richer. The subtle understanding is that your lifestyle will improve and the money you spend to service your debts will be the same--if not lower--in the short run. The unspoken variables in most cases are how quickly your real estate assets will appreciate and how consistently you can earn money to keep pace with servicing debt. The end result, as we’ve seen, is a giant misunderstanding of financial products, the blame for which can be shared between individuals, mortgage brokers, and financial professionals. The prevalence and severity of these financial mistakes has sent a shock wave through the economy.

We must get a grasp on the financial decisions we are making. If something looks too good to be true, it probably is. So, let me return to basics and make a few suggestions which worked twenty years ago and still work today.

Don’t ever have credit card debt. I want you to ignore every person who gives you a reason why carrying a credit card balance can be advantageous. Its all just talk and it’s mostly untrue. The best way to handle credit cards is to use them and pay the balance in full at the end of every month. You should do this even if you’re on a promotion and can carry a balance at 0%. You’ll still get your points and rewards when you pay your balance in full. Until your credit cards are paid off, you shouldn’t save or invest anywhere else.

Put 20% down on your home. In the old days, people put 20% down on their home. This protects the buyer from home price volatility and it protects the bank from home price volatility. Look what happens when we put 0% down. The buyer ends up having a negative equity position and defaulting on the home while the bank takes the heat for it. Nobody wins in that scenario. If you’re buying a condo and it only requires 10% down, that is fine so long as you are able and willing to pay your mortgage comfortably and without sacrificing your lifestyle. Analyze your monthly mortgage payment carefully to ensure that you can afford it. Do not swear by the rule that “home prices always go up.” It’s not that simple and it’s certainly not true.

Stop living above your means. The society we live in is very competitive. It’s tempting to buy a new BMW when it costs nothing up front and only $399/month thereafter. Maybe you can afford that. But, have you considered the insurance costs, gasoline, parking, and tolls--not to mention the depreciation of the car? You must think through the entire purchase before you make it. And, only buy it if you truly love it, not because your neighbor has one and you’re driving the dinky old Toyota. If somebody is basing a relationship on how much money you can spend with them, rid yourself of that relationship. I have a friend like this who always wants to do expensive things together. He has a trust fund and I don’t. I had one honest conversation with him about it and now we’re better friends than ever and spending less money together.

Stop financing things. A few years back I would have given different advice. I would have suggested that you take advantage of interest-free financing and earn interest on your funds in the meanwhile. It’s a balancing act that organized people can often do very efficiently. Forget about it. Dedicate your time and energy to earning real money, not playing games with the banks to earn a few hundred extra dollars each year. The easy availability of credit is what brought on this entire crisis which has driven down the stock market and caused lost jobs and hurt feelings. Let’s just start paying for things with cash that we have either in our wallets or in our bank account. If you can’t afford to pay cash for a new couch or TV, don’t buy it.

Like many financial planning concepts, this stuff isn’t rocket science. It’s more about discipline and being conscious of our own decisions. If you’re not typically “good with money” find somebody, a financial advisor or otherwise, who can help you understand your lines of credit and iron them out. The current economic crisis is one that probably could have been avoided. Let’s do our part to get past it as soon as possible.

Comments

[Just Say Whoa!:]

Could you please send a copy of this to the U.S. Gum'mint?

They got some crazy fellers in there now whose mantra is "Tax Cut & Borrow".

My future grandkids, who ain't even out of the chute yet, will be paying for his Most Excellent Adventure in Iraq for decades.

Kind of makes anyone long for the days of "Peace and Prosperity" when some old Horndog was piling up budget surpluses back in the Good Old Days (1990's).

2008 Mar 27 08:06 PM

[ikh:]

Very sound advice. However, I'm afraid practically everybody is going to ignore it.

2008 Mar 27 09:02 PM

[vboring:]

bad housing advice:

the person who put $0 on their house has the ability to dump an of decreasing value for somebody else to worry about.

the person who put $100k down is out $100k and still has negative equity, so it is still in their best interest to leave it to the bank.

i'd be mad as hell if i put 20% down on a house in Miami 2 years ago.

2008 Mar 27 09:20 PM

[User 169238:]

Good advice on credit cards. I think that most homeowners were acting in an economically rational way before the housing price collaspe. Historical evidence based on many years pointed to housing price appreciation. The average person had no idea that housing prices would collapse. Therefore, nothing down and equity withdrawals were rational. Monday morning quarterbacking is rampant.

2008 Mar 27 09:58 PM

[Timmothy Posey:]

At the end of the day, all those "rational" home buyers were speculators. We all do this when we buy any type of asset, whether its a car, house, stock, or even gold. Intrinsic value of any asset varies based on supply and demand. Back in 1999, everybody was saying that "stock prices always rise", and in 2005, people were saying the same things about houses. If they simply wanted a roof over their head, they would have rented a house. But we have been beat over the head by various pundits that owning a house is always a "good investment". There's a corollary to the popular phrase: [insert asset here] prices always rise--until they don't.

2008 Mar 27 10:28 PM

[ezrasfund:]

I just read a Bloomberg piece which included a guy whose house value went from $210,000 in 2001 to $540,000 in 2006 to $450,000 today. Is this a problem? AAPL went from $16 ( to $80 to $54 to $200 ) to $140. Too bad if you own AAPL? If your view is short term the traders will use the noise in the markets to clean you out. Add trading fees ( or closing costs ) and it's even harder to beat the market. But if you are in it for the long term ( Buffett ) prices are likely to rise. With all this talk of the Great Depression, I'm glad I'm not stuck with any property that Grandpa bought in 1929.

2008 Mar 27 10:44 PM

[steveballmer:]

McCain was right about this one! Everybody wants to be bailed out with government money!

2008 Mar 28 01:16 AM

[bearfund:]

Why should I take any of your advice? Instead of platitudes and infinite-term "best for everyone" thinking, let's look at the incentives we actually face today.

Low interest rates (good luck finding a 3% CD) encourage more borrowing and discourage saving. Inflation (4.1% YoY) encourages more borrowing and discourages saving. Together we have negative real interest rates, which is an extremely powerful disincentive to save.

Moral hazard is alive and well - why should I save at negative real interest rates when I can buy bank stocks for well below book value, secure in the knowledge that the government will cover my losses while I collect yields of well over 5% with plenty of capital growth upside?

Real estate - there's talk of setting a floor under prices. Sounds like a good reason to get in now, whether or not I can afford it. No down, interest only? Sure, I have good credit. Why not?

When prudence is penalized, only the foolish act prudently. Load me up, on margin if you please. Thanks, Uncle Ben. I'll pay you back later, if I feel like it. You know I love you.

2008 Mar 28 03:35 AM