By Sam Peters
Ever since the financial meltdown that began in 2008, the role of debt management has become an increasingly important part of financial responsibility. Bankruptcy has become increasingly common and the amount of national resources dedicated to debt recovery has exploded. At the center of each of these topics is the mindset of the borrower and his or her attitude toward how one should treat the repayment of debt.
The Classic View
As recently as a generation ago, there was a significant stigma associated with bankruptcy. Individuals did not knowingly borrow money that they could not repay, and when financial hardship occurred, defaulting on a debt was a last resort. There was a direct link between one’s good name and the repayment of debts.
Furthermore, the role of credit was significantly smaller under this view as well. An individual purchased goods on credit as a convenience, not as a means to acquire items that he or she could not afford. The only reason to buy on credit, beyond the convenience factor, was if one believed that he or she could earn a better return on the capital investing it, while still fully servicing the debt.
This view of credit and debt changed dramatically as memories of the Great Depression faded. For borrowers that had grown up during that period, or with parents who were able to instill those same values, debt was something to be feared and avoided whenever possible. Aiding the suppression of that discipline was the lenders themselves. In an era when a lender personally knew most of its borrowers, credit analysis was a personal endeavor that had as much to do with character as financial data. The advent of securitization changed the way in which lenders viewed the world, and thus the way they chose to lend money.
Securitization is the process by which the debts of thousands of borrowers are consolidated into a single debt security – a bond – and then sold to investors who wish to participate in the proceeds on interest payments. Under normal market conditions, these securities own a sufficiently diverse collection of debts that one can statically predict what percentage of those debt will default. As long as the collection is broad enough, this default rate can be priced into the security.
Similarly, the rate at which borrowers will repay their debts early, thus eliminating the interest stream, can be calculated. Each of these considerations is made so that the ultimate buyer can make an informed investment decision.
The impact of securitization was twofold. Lenders no longer knew their borrowers personally and they were incentivized to make more loans. Even if the loan was of lower quality, it could be repackaged and sold to an investor willing to take on that level of risk. The lender no longer was obligated to bear the risk of a bad loan, so it was more likely to extend credit.
This initially had a positive effect on the economy because it allowed more borrowers to participate in the credit cycle. Many honest borrowers took loans from well-intentioned lenders and the entire size of the market grew. The securitization market covers the mortgage market, car loans, business loans and credit card debt. As long as the economy was booming, the overextension of credit did not become a problem.
When the lure of increasing profits by lenders was combined with a negative national savings rate and the lure to own things one could not really afford by borrowers, the result was catastrophic. Financial engineering allowed the problems to go unchecked far longer than even the experts expected. Ultimately, however, a significant slowing of the economy led to cascading defaults by borrowers who had become overextended. Not only did these borrowers face financial hardship, the owners of their debts began to experience inescapable losses. Ultimately a bailout was required that came after the end of two of the country’s oldest financial institutions.
In the aftermath of the economic meltdown, some of the discipline that once existed has returned. Lenders are following stricter procedures and the attitude of borrowers has changed. There are now a few very distinct mindsets, even amongst those wishing to move forward with a new sense of discipline. Understanding these is useful in gaining a clear picture of the state of the U.S. economy.
The first group has fully returned to the principle that living debt-free is the only acceptable way to conduct oneself. This group is made up of an interesting collection of individuals. Some who have adopted this attitude have the means to quickly retire their existing debt, while not incurring any additional ones.
Also included in this group, however, are those who have learned the lesson but do not have the immediate means to get out of debt. They are working towards managing their situation, but have largely become trapped in the system and must let some of the issues play out. They are unwilling to incur new debts, but it will take them a period to eliminate existing debts.
A second group has adopted the group mentality that the responsibility for the problem lays elsewhere. These individuals are far less hesitant to declare bankruptcy and become angry at the debt recovery process. Their attitude is that they were victims of the system and should bear little responsibility for correcting the problem. While those individuals in the first group who do not have the means to get out of debt may share this belief on occasion, it is the prevailing view for the second group. The reality that many of these individuals were victims to some extent does not change the fact that they are coloring the economic process to its core.
While there are countless variations of the two groups discussed above, almost every participant in the economy can be classified as fitting into one or the other. Those who wish to take financial responsibility are those who take debt management seriously and are working toward putting themselves in a more secure position. The others prefer to let the process unfold as it may. As the pendulum shift, returning attitude to the classic view of borrowing, one must wonder how many generations down the line this lesson will have to be repeated.