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October 11, 2009

Paying Off The Past
by John Rubino

Yesterday's Wall Street Journal ran a great, sad article on the effects of the credit bubble on low-income people. A few excerpts:

The 'Democratization of Credit' Is Over -- Now It's Payback Time

Karen King owes nearly $36,000, more than she's ever earned in a year.

All day long, bill collectors call. She hunts for a second job, sometimes skips meals, and stays with other family members at a grandfather's crowded apartment, trying to get out of debt and turn her life around.

She largely holds herself at fault. "Years ago, I lived for now. It was so stupid," the 28-year-old says. "It's depressing, but I can't live that life anymore." Now, she says, "I basically want to live for the future."

The recession has forced a financial reckoning for Americans across the income spectrum. The pressure is especially acute for the low-income Americans who relied on borrowing for daily expenses or to gain the trappings of middle-class life. Shifting credit practices over several decades had enabled them to live beyond their means by borrowing nearly as readily as the more affluent.

Credit Ruined, Now Living for the Future

But the financial crisis and recession have reversed what some economists dubbed the "democratization of credit," forcing a tough adjustment on both low-income families and the businesses that serve them.

"We saw an extension of credit to a much deeper socioeconomic level, and they got access to the same credit instruments as middle-class and mainstream Americans," says Ronald Mann, a Columbia University law professor. Now, "it will be harder for families at the bottom of the income ladder to get credit cards," he says.

The financial crisis has forced lenders to be especially cautious with the riskiest borrowers, a category that low-income families often fall into because their debt tends to be higher relative to income and assets. The ratio of credit-card debt to income is 50% higher for the lowest two-fifths of Americans by income than for the top two-fifths, Federal Reserve data show.

For families with incomes between about $20,500 and $37,000, the ratio of debt to assets rose to 18.5% in 2007 from 14.4% in 1998 -- more sharply than the increase among the overall population -- according to the Fed's Survey of Consumer Finances. In addition, the chances of default and delinquency on home mortgages are higher among lower-income households, according to data from Equifax and Moody's Economy.com.

The democratization of credit began decades ago. Federal legislation in the late 1970s required banks to avoid discriminatory lending and meet the needs of local communities, spawning a wave of home buying and entrepreneurship in lower-income neighborhoods. The rate of homeownership in families with incomes in the bottom two-fifths rose to nearly 49% by 2001 from below 44% in 1989, according to Fed data analyzed by Mr. Mann at Columbia.

Credit-card borrowing took a similar path. One cause was a 1978 Supreme Court decision that let banks charge whatever interest rate was legal in the state where their card operation was headquartered. The ability to charge higher rates made it more profitable to offer cards to risky borrowers. Adding oomph to both credit-card and mortgage lending was the growth of markets where lenders could sell their loans.

By 2007, 35% of Americans in the bottom two-fifths of income had a credit card with a balance, up from just over 21% in 1989. And use of these cards increased. The median balance on the cards, adjusted for inflation, grew 180% over that period for people in the bottom fifth of income and 80% for those in the next higher fifth.

When the recession struck, banks that had eagerly wooed new credit-card customers reversed course. "Rather than keeping accounts that have high loss potential and limited revenue opportunity, the mission becomes to close out those customers' active lines and drive them off the books," said a report from TowerGroup, a research firm. By June 2009, banks were closing credit-card accounts at a rate of 14% or 15% annually, double the rate of a year earlier.

All this means a new reality for consumers like Ms. King. Most of the credit cards she had were maxed out by 2004. She would sometimes just let the bills pile up and not pay the minimum. "I would start paying it, and then my sister almost got evicted from her old apartment, or my grandfather decided he couldn't pay the rent. They needed help," she says.

The article goes on for another thousand or so words, detailing the hardships of people who now have to choose between years of extreme frugality and bankruptcy, and ends with:

"I was a social person. I had interest in a lot of things," she says. "I had dreams. Now I'm just paying off the past."

Some thoughts:

1) The designation of American citizens as "consumers" was always a little bizarre, but now it seems dangerously archaic. A nation of people who buy things will always lose out to people who create things, or who adhere to and spread an ideology, or who save and invest. Duh.

2) The "democratization of credit" was never analogous to civil rights or voting rights. By handing out home mortgages and credit cards indiscriminately, we didn't empower anyone. Instead, we created a generation of people who were an illness, layoff, or blown transmission away from default. Much better for them if instead of paying interest, they'd banked that money until they had the cash to enter the middle class through the front door.

3) There's no way for "good" bankers to stop this kind of credit bubble. When a government is printing paper currency and handing it to banks, the banks have to do something with it. Sitting on it is not an option because that lowers their return on assets, which leads to 1) current management being fired and replaced by more aggressive executives or 2) the bank being bought out by Citigroup or B of A, which then leverage the newly-acquired assets to the hilt. So in the same way that bad money drives good money out of circulation, it also chases away good bankers and replaces them with Angelo Mozilo and Chuck Prince. This is one of those "hidden forces of economic law" that Keynes referred to in his famous quote:

"There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."

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John Rubino
DollarCollapse.com

John Rubino is author of Clean Money: Picking Winners in the Green Tech Boom (Wiley, December 2008), co-author, with GoldMoney's James Turk, of The Collapse of the Dollar and How to Profit From It (Doubleday, January 2008), and author of How to Profit from the Coming Real Estate Bust (Rodale, 2003). After earning a Finance MBA from New York University, he spent the 1980s on Wall Street, as a currency trader, equity analyst and junk bond analyst. During the 1990s he was a featured columnist with TheStreet.com and a frequent contributor to Individual Investor, Online Investor, and Consumers Digest, among many other publications. He now writes for CFA Magazine and edits DollarCollapse.com and GreenStockInvesting.com.