Proverbs 21:5:5 The plans of(A) the diligent lead surely to abundance, but everyone who is(B) hasty comes(C) only to poverty."Anything that we can do to raise personal savings is very much in the interest of this country."--Alan Greenspan
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Twenty years ago, America faced a Savings and Loan crisis that resulted in a tax-payer bailout. The S&L crisis of the '80s essentially stemmed from risky lending practices that resulted in high default rates. Today, America is facing a different kind of savings and loan crisis--lack of personal savings and the overall reluctance of banks to lend in general. Both have largely contributed to the our current economic crisis.
Negative Savings Rate Provides Clue to Larger Economic Problems
In 2005 and 2006, Americans spent more than they earned. Economists refer to this as a negative savings rate. Not since the Great Depression has this happened in American history. The Bureau of Economic Analysis (BEA) defines savings as disposable personal income less personal outlays. The fact that, on average, Americans not only spent all of their disposable income, but reached into their personal savings, tapped into existing equity or accessed lines of credit to support current needs is a bit alarming. Could this have been a warning sign to a more serious economic problem? Why were we not warned of an impending economic crisis?
In retrospect, a negative savings rate did not make front page news because our economy continued to grow and assets were relatively doing well—the stock market continued climbing upwards and home values continued to appreciate. The average person would have seen their assets (or wealth) increase during this period. Retirement plans, individual securities, cash deposits and home values are all considered assets and appreciated in value while Americans spent more than that made. The appreciation of these assets could have attributed to increase in spending of current income—consumers might have thought that we can spend more now because our wealth has increased. The bible tells us that if we act in haste, it will surely lead to poverty. Right before our eyes, this proverb is unfolding as we hastily spend to maintain lifestyles that exceed our income.
Debt-Financed Consumption Artificially Inflated Market Growth
Asset appreciation is often tied to consumer demand and consumer spending. In a very simplistic example, when consumers restrict their spending, the economy slows. As a result of decreased spending (or demand), asset values begin to fall--having an adverse affect on individual wealth.
The author believes that a portion of economic growth was essentially fueled by debt-financed consumption and tapping into equity from appreciated assets. This trend will need to stop if we are to move forward as a country.
By the end of 2007, household debt represented 127% of annual disposable personal income. Between 2000-2008, household debt more than doubled from 7.4 trillion to 14.5 trillion. In addition, between 2007-2008, publicly traded securities (down 35-40%) and home prices (down 20%) decreased significantly. Today, between 12-15% of homeowners have negative equity, meaning that they owe more than what their home is worth.
It has been said that the greatest threat to our economy is savings. To economist, savings represent the absence of consumption. Consumption fuels the economy. Therefore, there is no wonder why we did not see a public outcry when America reported a negative savings rate because it might have reduced consumption levels.
If corporate revenues and profits continued to increase while average wages remained the same and Americans are spending more than they have in disposable income, than it is plausible to conclude that a portion of economic growth was based debt-financed consumption (credit) and depleting past accumulation of assets/equity (e.g. savings, home equity line of credits).
Subprime Lending--Accessing New Markets Proved to be Risky Business
To achieve growth projections, many companies extended credit to risky consumers (subprime consumers) and increased interest rates (e.g. adjustable rate mortgages and credit cards). In 2006, subprime mortgages represented 20% of total loan origination, up from 5% in 1994. ARMs artificially inflated home ownership growth because it provided cheap capital to risky consumers. Nearly 43% of new homeowners did not even provide a down payment for their new home loans. As interest rates adjust, many homeowners found that they were unable to meet monthly interest payments. As a result, defaults and foreclosures dramatically increased.
Defaults Place Downward Pressure on Leanding, Slowing Debt-Financed Consumption
These business practices were largely fueled by bundling consumer debt and selling them to secondary markets. This practice is called securitization. Historically, default rates of these mortgage backed securities (MBS) were low and therefore MBS were considered good investments. However, as consumers began to become more cash strapped and interest payments began to sharply rise, default rates of debt securities increased while interest payment revenues decreased. All of a sudden, these securities did not seem like a good bet.
Eventually, the mortgage crisis partially contributed to the slowing of the credit market—banks were less likely to extend credit for risk purposes in general. As a result, credit lines froze, consumption slowed, demand for goods and services decreased, and asset values declined.
We are facing unprecedented times of economic peril. Past performance is not be a good predictor of future success. To get out of our current situation we will have to do a number of things.
Consider the following:
· Return to savings: Savings will have a positive affect on lending by increasing deposits and bank solvency. Individuals should incorporate savings as a method of wealth accumulation and preparing for future goals.
· Explore new markets: Government should boost efforts to access new markets that demand American goods and services. Accessing global markets could off set domestic consumption decline.
· Promote Consumer Protection, Regulate Interest Rates: Increase transparency of credit card and adjustable rate mortgages. Drastic increases of interest payments might cause higher default rates and prevent private investment of debt securities. We might consider limiting the rate in which interest rates can grow in a giving period of time. Drastic increases in interest payments should be regulated and consumers should be fully informed of proposed actions.
· Renegotiate Principle Loan Amounts: Home values are falling, and the asset is not worth the same as previously assessed. Therefore, principal loan amounts should be readjusted to reflect current market values. Banks would not lend consumers more than what the house is worth, therefore, they should not reasonably expect consumers to repay a principle value that far exceeds current home values. Relegation could help in crease consumer spending.
· Expand Business Tax Cuts: Business are considering all avenues to cut expenses. Reducing small business and corporate taxes could provide additional financial relief that equates to less layoffs. Instead of cutting salaries, the business could forgo a portion of its tax liability through tax cuts.
· Provide Individual Tax Refunds: Return income and payroll tax to consumers. Consumers would then spend, save, or pay debt. All of which is important to the economy recovering.
· Support Safety Nets: Unemployment insurance is depleted in most states. Funding social safety nets would help stabilize family situations. Providing access to health care, emergency assistance, food subsidies, and unemployment insurance is essential to recovery efforts of Americans that have recently found themselves out of work.
· Consider Government as a Consumer: The Government could infuse temporary demand into the market until new markets are identified or current markets return to acceptable levels. The Government seems to be capitalizing on current crisis and using this time to develop new industries that will bring new demands and provide new jobs.
