The Downside of Debt: Borrowers Sober Up

There's a good bit of "sobering up" going on around the country these days as Americans are coming to terms with the huge pile of debt they've racked up in recent years.

It's hard to argue with the conventional "wisdom" of earlier in the decade.

If the value of your home went up $50,000 or $100,000 during the course of a year and you went into debt by another ten or twenty grand, what's the big deal? What's wrong with having a little fun? You'd still be ahead by year-end.

Things went on like that for a number of years and people came to believe that that's just the way the world worked in the 21st century. Ain't it grand?

Unfortunately, the world doesn't really work that way - it's much, much different when asset prices are falling instead of rising. These day's you don't hear anyone saying, "The value of my home just dropped $60,000 last year and the bank froze my home equity credit line. I better pay down some of this outstanding debt." The downside of debt seems to be a lot like the downside of drinking.

According to this WSJ story from last week, apparently there's still a little liquor left in the cabinet - the bar is apparently still serving drinks.

The credit crunch has made it harder for Americans to indulge in their love affair with debt. So what are they doing?

Borrowing more.

While tighter lending standards have cut off all but the most credit-worthy borrowers from auto loans and home loans, many people are turning to credit cards and tapping more of their home-equity lines of credit to dig themselves in deeper....

The rise in borrowing shows just how addicted the U.S. consumer has become to credit. Even as borrowers are cut off in one area, they promptly look for new sources. Workers have increasingly been raiding their 401(k) plans to take out loans over the past year, according to plan administrators and nonprofit groups.

Now, mortgage brokers say some clients are calling them in a panic, worried that their bank will freeze their home-equity lines. Deborah McNaughton, president of Legacy Financial Services Inc., a mortgage lender in Placentia, Calif., says several of her clients have recently borrowed more from their home-equity lines of credit and stashed the money in bank savings accounts....

For the past several years, William Jordan, president of Sentinel Group Inc., a financial-planning and wealth-management firm in Laguna Hills, Calif., has been advising clients to pull equity of their homes and put the money into safe, liquid accounts so they have access to the money. He recently advised one of his clients, Matilda Compean of La Mirada, Calif., to refinance her mortgage and take out cash after she was having trouble making ends meet.

Borrowing at eight percent and getting a three percent return? That might make sense if you're planning to walk away from the place. In fact, that might make a lot of sense under those circumstances.

Many, many years ago (before my wife and I wised up), I remember owning a home and living paycheck to paycheck figuring that, if one or both of us lost our job, we'd just go out and get the maximum cash advances on all our credit cards, stash the money away, and then stop paying the credit card companies so we could pay all our other bills for the next year or two.

Then, when home prices started going up and all that home equity became like a giant safety net, we were finally able to relax knowing that we had an "equity cushion."

Maybe we'd all be better off without equity cushions.

According to this report by Gretchen Morgenson in yesterday's New York Times, we may be about to find out.

In the last 30 days, lenders have sent several hundred thousand letters advising borrowers that their home equity lines of credit are frozen, estimated Michael A. Kratzer, president of FeeDisclosure.com, a Web site intended to help consumers reduce fees on home loans.

Major lenders — including Washington Mutual, IndyMac Bank and the Greenpoint Mortgage Unit of Capital One — say that declining property values are prompting the decisions to cut off credit.

Banks have the right, of course, to rescind these credit lines at any time under the terms of the contracts they struck with borrowers. And as home prices have tumbled in many parts of the country, banks are undoubtedly trying to protect themselves from exposure to additional losses.

But these actions are being taken even in areas where property prices are rising, Mr. Kratzer said. What’s worse, the letters provide no explanation for how the lenders determined that the property values underlying the equity lines had fallen.

Frozen home equity lines will surely intensify the consumer spending downturn and put added pressure on an already weak economy.

Just as responsible individuals spent more freely knowing that there was another hundred thousand dollars available to them if they needed it, they are likely to spend less after their credit line has been taken away.

This is not a good development for a consumption-based economy, though you could see this one coming from miles away.

Comments

[rdial54]

We will get out of this mess soon and then look out world.

[WAKEUP]

"The credit crunch has made it harder for Americans to indulge in their love affair with debt. So what are they doing?

Borrowing more."
That says it all. I am now convinced that Americans - used to the very easy life, are totally unequipped for the hard times that are in process of arriving, now. Almost EVERY DAY

[WAKEUP]

"The credit crunch has made it harder for Americans to indulge in their love affair with debt. So what are they doing?

Borrowing more."

That says it all. I am now convinced that many Americans, used to the very easy life, are totally unequipped for the hard choices that are in the process of arriving, now. Almost EVERY DAY, I have to increase my estimate of how long the recession is going to last, based on the more and more illogical responses of the American public to hardship. Apparently the very people who need to tighten their belts most are going all-out, to see how far into debt they can get, before the gate crashes down behind them, and the easily available sources of cash dry up. We are at the beginning of a new phase, one in which literally millions of American families - and - individuals, who don't even have family responsibilities to blame for their financial plight - are forced into a MUCH LOWER STANDARD OF LIVING, a phase that will go on for years and years, as they struggle to regroup and get a handle on their finanical situations. It's now past the time for saying that it's going to get rough, out there; it's already rough, out there, and this is only the beginning. For about 25 years, or so, I've been listening to folks brag about how far they've come, financially, since college. However, a scratch of the surface of their stories revealed that mom and dad staked them to that first house, and they've been living off the largesse of that gift, ever since. Even largesse has its limits.

[iThinkBig]

Sure their are some with advisors perpetrating scams to take money out of a house and put into the bank, then walk away. What is not mentioned here is the fact of inflation making guys like me shuffle things around. My wife is back to work in homehealthcare and I now work 14 hours a day in my consumer healthcare media as the CEO. My job is a glorified VP of Sales position, where I assist sales in building efficiency spreadsheets to use our data products to shave off costs, instead of using the data for customer acquisition programs. I struggle in my mind because of two things:

1) Socialism - Why didn't I act irresponsible for the last five years and had a better quality of life, instead of a massive tax bill I know is coming to support the irresponsible? Add to the fact I now search for States to live in that have not created endless laws and use the courts and police to tax there citizens via stealth methods. Hand me my bitter Socialist toast upfront please so I know what it means in real terms...

2) The political leadership is rotten, NYC & Washington D.C. are encapsulated and not much effected and therefore doing nothing or overlegislating/taxing. The next batch of leadership looks no better and who is talking about innovating to give the global consumer what it needs to maintain a quality of life? Cannot leadership grasp the simple concept Main St. is now pulling down Wall St. and this will only intensify?

[Pierre Coupet]

I have finally wised up and come to terms with what my economics teacher had told our class 32 years ago, "with the exception of a home purchase, you should only buy what you can afford to pay cash for." This would prompt us to develop a "save and invest" mentality instead of the current "borrow and spend" mentality as well as generate in turn a great deal of "personal" wealth versus a great deal of "corporate" wealth.

[Ah YES!]

A very cogent article! I am also a saver. We have ample income, but live as though we will be unemployed tomorrow. We are renters and must endure the brash, rude and sometimes humiliating comments from the "in crowd" of local political hacks, bankers, Realtors, appraisers, developers. But we have morality on our siude. They can be smug, but we will watch as they suffer the consequences of squandering their future.

Today I celebrate! Two years ago a self-styled flipper bought the house we lived in. He was boorish and crude. He introduced himself as though he were Royalty and quickly proclaimed with a smile and chuckle that HE was gvcing us notice that he was raising our rent 100%. We have no rent contyrol, so we submitted. A few months later we saw the loan documents in our mail box. HELOC! Yes, he bought a new RED VIPER for $100,000 from the HELOC proceeds. We later learned he bought FIVE houses in 6 months. He was escorted and trained by local Realtors who acted as cheerleaders.

Today, I visited his largest house----FORECLOSED. It was beautiful inside - 15 foot ceilings and large columns of white plaster. Now at half the price he paid for it. AH YES--- He lost his house and five more. I cje\hceked his prfile with the country recorder and I found TEN IRS liens on him. DO WE WANT TO BAIL OUT THIS PIG?

So, I had the Realtor snap a few photos of me, waving at the camera so I could rub it in. I have no debt---this pig is a slave to debt---by his own choosing. I realluy feel good about his pain. yessss.

If I get wiped out in the next deporesssion---I still HAVE NO DEBT. Its a lot easier to recover when people owe you. I am contemplating on trying to buy one of his debts at 30 centys on the dollar. NOW HE WILL l OWE ME---WITH 12% INTEREST.

I feel that even though I drive an old car and rent----ITS OKAY. I HAVE OVER $600k in LIQUID ASSETS. I PULLED MY MONEY OUT OF STOCKS, BONDS AND the cheating banks. They (The Fed and banks) are killing the value of a dollar---but I am still ahead of them. I HAVE NO DEBT ---I bought some hand tools so I can earn money as a skilled laborer during the next DEPRESSION.

VISIT Runonthebank.org to learn more.

Its only months away. Believe it. If you pay a mortgage - sell your house---or WALK!! You will need cash when the economic depression hits. If you have a pension, 401 K etc it has already lost 20-30%. Pull it out now. Hide your money in FDIC insured CD accounts at max of 200K each. Cash out enough to live for two-five years without work. Learn a useable trade. No one hires clerkls or service people during a depression. Learn how to fix a car or repair plumbing. A JOB THAT IS IMPORTANT FOR LIVING.

WAMU IS LAYING OFF---BEAR STEARNS is laying off--- who hires stock brokers in a crash?

[Stephan]

I am a German lawyer. If it is true that one could borrow on real estate without being personally liable to it, it is very understandable that people shift the borrowed money to saving bank accounts. In Germany debt even mortgaged is not reduced to a piece of real estate saying that even one would walk away you would still owe the debt reduced by the amount the bank gets from the foreclosed sale.