November 2008 - Chairman: Kay Davis, Lone Star Materials
""Everyone Is To Blame" Part I
Everyone should now be aware that not only the U.S. financial markets but also numerous foreign markets are in severe financial woe. The question being debated and that will continue being debated is how did all of this come about in the first place? What happened to the “controls” that were put into place long ago to prevent such an occurrence from happening again? And who is to blame. There will be congressional and parliamentary hearings and finger pointing but anyone with a lick of common sense knows the two primary reasons we are in this mess today can be explained by two words greed and stupidity. If anyone is offended by our being so blunt we are not sorry. We have been watching creditors, whether they are in the mortgage, automobile or commercial lending industries, for some time enticing buyers with some of the wildest financing schemes since the inception of credit as the primary means for purchasing goods and services. And purchasers, like fish in a barrel, have been jumping at these lures with no thought of how they were going to eventually pay for their purchases when payment became due.
We think key answers can be found in four words that are known to most business credit professionals and should have been adhered to by all credit professionals regardless of products or industry. These four words are character, capacity, capital, and collateral. These are commonly referred to as the four C’s of credit and we think it is safe to say that they have been ignored by our brothers and sisters in both the consumer and commercial financial areas for some time.
Character is often referred to as recognizing and doing what is ethically and morally right. For some time we have witnessed and may have even participated in doing just the opposite. One can certainly point the blame at the mortgage industry for offering mortgages with terms that featured little or no down payments and a variety of re-payment terms. However, why should the mortgage company shoulder all of the blame? What about the home buyer? They took advantage of acquiring a home with a mortgage that required very little or nothing down, a low monthly payment and the belief that in three to five years they would have the ability to handle a monthly payment two to three times higher than they would be initially paying. C’mon, were they not just as greedy as the lenders who concocted this crazy financing? Everyone wants to live in a nice home, it is every individuals dream but you don’t buy a $600,000 house when you’re only bringing home $3,000 a month. The reality is one can afford and maintain a $100,000 property on that type of income. However, rather than use common sense the purchaser allowed their emotions and greed to make a financial decision they would later regret. When they got stuck later when the initial low interest / low payment term expired, they then cried to anyone who would listen as to how they had been taken advantage of.
The real question is who took advantage of whom? The same can be said about the automobile financing schemes where buyers now find themselves up-side-down because they have been in reality making only interest payments and have no equity in their vehicles. Credit, as we all recognize, is an excellent tool to obtain the things we want, today! But if credit is not handled properly, by both the seller and buyer, credit can easily evolve into bad debt and that is exactly where we are today. It is safe to say that both the lenders and borrowers displayed a lack of character when it came to both the housing and the automobile markets during the previous years. And let’s not forget government especially in the United States.
It was the Congress during the Carter administration who created the Community Recovery Act (how easily these pompous men and women forget). This Act forced lending institutions especially banks, at the risk of losing their charters, to lend money to “at risk” individuals and businesses who did have the capacity or capital to repay their financial obligations much less any new debt. Yes, folks it was the government who legislated the “sub-prime” market way back in 1976. Then this august body in 2000 passed the Commodity Modernization Act that essentially removed all the controls passed in the early 1900’s. The passage of this Act resulted in the creation of hedge fund markets and derivatives that are now being pointed to as the primary culprit in the financial crisis. The U.S. Congress has a long history of holding committee meetings so they can place the blame with others rather than admit to their constituents that their actions in matters they do not understand are the reasons for the current situation we find ourselves in today. George Santiago, the philosopher,once said that those who do pay attention to the past are doomed to repeat history. Historically, when government involves itself in a free market disaster follows.
Then there is capacity. Capacity is defined as the ability to pay and if ever there was a period when we lacked capacity this was it.When we have automobiles selling for as much as houses did fifteen to twenty years ago and average individual income growth of less than eight percent during the same period one does not have to be a finance major to determine there is definite lack of capacity. But that did deter either the buyer or lender from making sure the buyer could “afford” what they wanted, not what they needed mind you but what they wanted and don’t forget the CRA.
Zero percent down, no interest and deferred payments on every type of goods one can imagine encouraged the buyer to spend money they not only did not have but were not going to have later either. And that brings us to capital. Capital, the ability to raise additional money through asset financing or selling except the assets they were purchasing had no added value because they were so highly leveraged. Thus there was zero capital due to the lack of equity in their purchases. Remember the ratio total assets minus total liabilities equals equity? More often than not the result was negative equity. What the buyer failed to realize was the zero down payment provided them zero equity. And because the cost of the asset was inflated to allow for no down payment or zero interest they were immediately up-side-down in relation to debt to asset. There was nothing to borrow against and if they sold the asset more often than not it would result in a short sale meaning there was a deficiency balance still to be paid.
David Balovich is a certified credit consultant specialized in commercial credit. He is a proud member of NACM of Texas and can be contacted at 3jmcompany@gmail.com>
