Tuesday, June 24, 2008

Americans Are Upside-Down In Everything

I am an optimist. I have been an investor and financial advisor for 30 years and am almost always fully invested. Over time that has been the right thing to do. The stock market goes up two years for every year it goes down and for all the mistakes I have made along the way I have done pretty well for myself and my clients over the long term.

That's why I'm so conflicted right now. My positive nature has never been more challenged. Not during the Crash of 1987, the Savings and Loan Crisis, the Tech Bubble, the Aftermath of 9//11. Never.

During each of those periods of dislocation, there were one or two dramatic events that shook our national confidence. Many people who were too close to those situations lost a lot of money and, for a time, consumers and the financial markets extrapolated their fears to the broader economy which, in fact, turned out to be fine. Eventually the markets and consumer confidence recovered and we moved on to new highs.

But this time it feels very different because Americans seem to be upside-down in everything. Being upside-down in a loan means that the borrower owes more money on an asset (mortgage, car, etc.) than the asset is currently worth. For example, if a homeowner owes $1 million on his mortgage but the house he bought with the mortgage money is only worth $650,000 then the borrower is upside-down on that loan.

We have all heard a great deal about the mortgage crisis. There are actually two crises. The first is that many people can not afford to make their mortgage payments. The second far-greater crisis is that millions of homeowners are upside- down in their loans. Many of them can make their payments, but it makes no financial sense for them to do so since they can simply give the home back to the lender and walk away. I'm sure there's great pain associated with that, but it would be worse to pay $1 million plus interest on a house that is only worth $650,000and dropping in value.

What we haven't heard about is all the people who are also upside-down in their car loans, credit card debt, and many other things.

I am part-owner of a Suzuki car dealership in Tucson. Last week, a woman came in with a good credit rating wanting to buy a car. She wanted to trade in her 2005 Suburban (on which she had never missed a payment) for which we were willing to pay her the $10,000 it is now worth. The problem is that she had taken out a six-year loan on the car when she bought it and still owed $28,000 in payments--on a car that is now worth $10,000.

To buy a new car, she would first have to pay the $18,000 difference between what she owed on her old car and what it is now worth. Then we would add on the payment on her new car. Of course she couldn't afford to do that so she left and will keep her $10,000 car on which she owes $28,000.

The biggest financial challenge facing Americans and our financial institutions is not just a sub-prime mortgage crisis. It is the following:

The value of the things people own (homes, cars, investments) is going down sharply and the price of the things people need to buy (food, energy, travel) is going up sharply at the same time.

And this is all happening at a time when most people and our cities, states, and country, are heavily in debt and don't have the flexibility to really address the situation.

Our country's leading banks have been laying off tens of thousands of people and raising billions of dollars in capital to help offset the loan-related losses they are realizing. At this point, the banks have dealt with most of the sub-prime problem. Unfortunately, they haven't begun to deal with the broad-based upside- downedness of many of their customers.

We are in the the third or fourth inning of this painful game--not anywhere near the end.


Anonymous said...

Interesting. So what do we do?Regards Fp PS Don`t you sleep? 4:30am,worse than me.

Larry Gellman said...

I think the first thing we need to do is demand that our political leaders and media be honest with us. They haven't done that in a long time.

Have you ever heard of a country fighting a war for five year and spending close to a trillion dollars without a single minute being spent discussing how we are going to pay for it and not requiring anyone who doesn't want to fight to do so?

We've been living in a fool's paradise and now that the bills are coming due all we here about is that unscrupulous lenders or speculators are to blame.

Will Rogers once said that the first thing you should do when you're in a hole is to stop digging.

That's certainly a good first step. It is going to be long and painful and will require a lot of people to start living within their means for the first time in their lives.

No politician wants to deliver that message but until we confront the truth we're still digging.

By the way, 4:30 in the morning is a great time to think clearly.