“The second vice is lying; the first is running in debt.”
–Benjamin Franklin,
“The Way to Wealth,” 1758
Benjamin Franklin — he of “a penny saved is a penny earned” fame — would be stunned by America’s current love affair with debt.
In a nation that once saved all it could, and resisted taking on debt, Americans no longer just borrow money to buy houses. They load up on debt to purchase stock. To go on vacation. To pay the light bill. To buy groceries. Even to pay federal income taxes.
Americans have gone on an unprecedented borrowing binge in recent years, even as the U.S. government has started slashing its debt and is looking forward to paying it all off.
The numbers are startling. A record $4.5 trillion in debt has been accumulated by U.S. non-financial corporations, up 67 percent in the past five years, according to the Federal Reserve, and household borrowing has risen almost 60 percent to $6.5 trillion.
“As long as I can get the money, there’s no sense in not getting what I want,” proclaims Matt Doscotch, a 28-year-old lawyer who is borrowing the full $200,000 purchase price for his Minneapolis home. He has no savings and $100,000 in other debt.
More debt isn’t necessarily bad, of course; it has helped companies expand and boosted consumer demand, thus fueling economic growth. But alarm bells are starting to ring, and not just because borrowings are at record levels. Adding to concerns is the fact that companies and consumers who may be able to least afford more debt have been adding the most to their borrowings. If the economy turns down, many loans could go bad.
“We’ve expanded our access to debt in dramatic ways, which is wonderful for the country, and it’s helped the economy,” says Diane Swonk, chief economist at Bank One Corp. in Chicago. “But there’s no free lunch. The riskiest borrowers seem to be piling on debt, and we may be building a house of cards.”
Adds James Paulsen, chief investment officer at Wells Fargo Corp.’s Wells Capital Management unit: “The real debt problem is lower-income people, who have been adding debt. That’s what’s scary to me.”
Low-income consumers and people with bad credit histories who once had a hard time borrowing money are finding it easy now. More than $160 billion of “subprime” mortgage loans to lower-credit borrowers were made last year, 11 percent of all mortgages. In 1993 the figure was $40 billion, just 4 percent of the total, according to the Mortgage Bankers Association.
While home buyers once had to make a 20 percent down payment, and thus needed to show a history of financial well-being, today more than 40 percent of new-home mortgages are made with down payments of less than 10 percent, according to SMR Research, a financial-research firm. “At least a quarter of all new mortgages go to people who are basically broke, and the figure could be much higher,” says Stuart Feldstein, president of SMR.
On the corporate ledger, “junk” bonds — bonds sold by companies with the highest credit risk — have soared to $529 billion from $173 billion a decade ago But numbers don’t tell the whole story, optimists counter. Despite more debt, they say, the U.S. is safer than ever from a serious debt crisis. America is borrowing more money in part because there is more money to borrow. Thanks to “securitization” — the bundling of loans into debt securities — lenders can sell their loan portfolios to investors, take the money from the sale and then make even more loans.
This has spread credit risks, because thousands of loans end up in these debt securities. So when some loans go sour, it has only a minor effect on investors who buy them, typically mutual and pension funds and insurance companies.
While the risks may be a matter of debate, there is no dispute that a remarkable cultural change is behind this voracious appetite for debt. During Benjamin Franklin’s time, many Americans were suspicious of debt. In our century, this was reinforced during the Depression, when many businesses went bankrupt under heavy debt, leaving scars on a generation. But the forces of financial innovation and Madison Avenue marketing, along with growing prosperity, combined to change attitudes about being in hock.
“By the 1980s people started thinking it was cool to spend. There was a nonchalant use of credit,” says Eric Einhorn, executive vice president at McCann-Erickson World Group, the advertising agency. “People no longer feel guilty about using debt.”
Indeed, the average U.S. household now sports 13 credit or charge cards, and carries $7,500 in credit-card balances, up from $3,000 in 1990.
Nowadays, even a poor credit history doesn’t preclude someone from being deluged with offers of credit. Joan Ritz, a 52-year-old bookkeeper in Philadelphia, filed for bankruptcy last November, unable to keep up with payments on $67,000 in auto-loan and credit-card debts. But she kept getting mailings trying to sign her up for credit cards, including three in one week in January. “On the one hand I was getting threatening letters from some companies, on the other they were making me great offers,” says Ritz. “It’s like feeding booze to an alcoholic.”
Most lenders maintain that rising debt levels aren’t a major worry. While household debt is a record 101 percent of income, up from 84 percent in 1990, the cost of paying off loans has fallen with interest rates, says Richard Berner, an economist at Morgan Stanley Dean Witter & Co “Most consumers are actually in better shape than a decade ago” due to rises in stocks, home values and incomes, adds Dan Castro, head of asset-backed securities research at Merrill Lynch & Co. In fact, household debt is about 13 percent of assets, about the same as a decade ago.
But pessimists counter that things look good because economic times are good. Even so, the heavy debt burden carried by many resulted in about 1.3 percent of all U.S. households declaring bankruptcy last year, off a tad from recent years but up from 0.8 percent in 1995.
What will happen, they wonder, if the economy slows sharply? Corporate profits and personal income would probably fall. So, too, could real-estate and stock prices. The debt burden would start to pinch if the unemployment rate, currently about 4 percent, goes to 5.5 percent, some economists say.
“Banks have been more aggressive in lower-quality lending during this expansion than in times past,” says Michael Mayo, a bank analyst at Credit Suisse First Boston. “So it’s hard for them to quantify the effects of a lower stock market, higher unemployment, lower incomes and higher defaults. Lower-risk lending is untested.”
Any drop in home values could prompt some borrowers to simply stop paying their mortgages because so many have made puny down payments and thus have little to lose if their homes are repossessed.
Even banking regulators can’t quite put their fingers on the risks. The Office of the Comptroller of the Currency, which regulates the biggest banks, is only now trying to come up with accurate figures for all mortgage lending to lower-credit borrowers. The government itself could be on the hook if participants in programs for lower-income individuals and veterans, sponsored by the Federal Housing Administration and the Veterans Administration, stop making payments.
“Were the music to stop, those most leveraged would be in a precarious position,” says John Dolan of Hyperion Capital, which invests in mortgage-backed securities.
