So much of our political and economic debate in the U.S. lately has centered on “living within our means.” Virtually every member of Congress talked about the dangers of debt during the months of deficit haggling. To remedy the issue a bipartisan “Super Committee” was formed of 10 middle-aged white guys, one white woman and one African-American man. So whatever happens, as a gender, “men” already have the final say over American finance: 11 to 1. What a relief! You wouldn’t want the ladies to screw things up. After all those govie guys have done such a great job so far…lol!
The task of this super-duper panel is to cut $1.2trillion from the U.S. budget. This includes across-the-board spending cuts including basics like education, defense, environment, government, and entitlement programs. Ironically, $1.2 trillion is the exact amount of the “secret” Federal Reserve loans to cash-short banks reported in Bloomberg recently. Surely that is a coincidence! :)
But aside from hunter-gatherers, Warren Buffet and a coterie of millionaires, billionaires and gazillionaires, who does really live within their means? (By the way, some millionaires live well beyond their means too- it’s all relative you know!) The real question in modern America is who can afford to live within their means?
Case in point: Bank of America. In many ways, this gigantic global financial institution is living on credit-yours and mine: taxpayer, shareholder, bondholder and depositor cash. We put our money in the bank and they use it to loan at interest or invest in other companies. That is why they issue shares, bonds, or borrow from Uncle Warren and the Fed. Their value is based on projected revenues as well as current profits. For example, Warren Buffet’s recent injection of $5bn helps BofA have access to capital long before they earn it! Our banking system functions on credit. If BofA “lived within its means,” meaning relied only on cash at hand, it wouldn’t exist.
What about the rest of us? Do we need access to credit too? Or can we simply “live within our means” and not spend anything more than the cash we have at hand?
The Nature of Credit
To answer that question, we need to step back in time. Pretty far back, four thousand years to be exact—to Ancient Mesopotamia and the beginning of civilization. Before there was such a thing as “money,” there was credit. When human beings moved beyond the hunting-gathering stage into agricultural communities, credit became a basic way of life. To create exchangeable value, ancient societies used clay tokens on which were inscribed commodities like wheat, barley, or sheep in varying amounts. You couldn’t carry a sheep around, so you had a token to represent it. But life was hard in ancient times as it continues to be for large portions of the world’s populations. Farmers and ancient merchants struggled to make ends meet. The lag time between planting and yielding crops might be three, six, or twelve months. How could anyone survive that?
The ingenious answer was credit: Ancient Meso style. That meant there were no rules. Farmers had to strike a bargain to feed themselves and their families any way they could. Enter ancient lenders like Dumuzi-gamil from the Sumerian city-state of Ur who came up with an innovative way to profit from their struggle. DG was the chief grain supplier to the Temple which functioned as a central government for Ur. Those who wanted the protection of the Temple paid “rent” to it, like a modern day income tax.
The Temple would lend to DG at 20% over five years and the entrepreneurial banker would lend it back to the community at 20% a month. He then sold some of the loans written in cuneiform on clay tablets to other lenders and began an active loan trading industry nearly 2,000 years B.C. Needless to say, good old DG became a very wealthy man, profiting on local farmers struggling to survive. The ancient entrepreneur had figured out the fundamental key to credit: “time is money.”
Perhaps remarkably, archeologists discovered that charging interest was more of a natural phenomenon than financial innovation. Proof of this is in the origin of the Sumerian word for interest—“mash” which also translated to “calf.” It worked this way: you lent 2 cows to a local farmer, in a year’s time you expected at least three back. In so many ways, the natural world is our primary source for economic innovation.
The ancients regulated interest more heavily than modern America. The Babylonian kings understood the human tendency to exploit others and limited interest to 20%. They did not realize, however, that lenders could maneuver around laws by manipulating terms and lengths of loan agreements. During the mortgage lending bonanza between 2002-2007, the poorest most desperate home buyers in the U.S. (those with terrible credit scores and histories) were charged double the interest rates of everyone else. Predatory lending was a system that set borrowers up for failure. Somehow human beings had not learned the perils of exploitation of their ancient past.
There weren’t a lot of flat-panel TV’s, iPods or home equity loans to purchase in Ancient Mesopotamia, yet the citizenry became mired in debt not dissimilar to our current era. The system of credit and debt became the noose around their necks. Given the laws of nature, they needed credit to survive. But without limits and regulations, the system of mounting debt became more tragic with each weather catastrophe, failed crop, accident or illness. The ultimate cost in Mesopotamia was your life. You traded your life’s labor and sometimes your family members’ too just to survive!
As more and more Sumerians became trapped in the vicious credit-debt cycle, King Rim-Sin had no choice but to cancel all debts. He couldn’t collect taxes if his people were enslaved by lenders. So to save the city-state of Ur in 1788 B.C., Rim-Sin declared “all debts null and void.” The first recorded financial crisis in human history occurred some 3800 years ago and we still have not figured out how to avoid it!
21st Century Credit Crisis
In the early 2000s AD, there were lots of flat-panel TVs and home loans to be scooped up. People lived way beyond their means, because leverage simply became the way of life. Wall Street securities firms levered up to risky proportions. In the case of Bear Stearns, Lehman Brothers and Merrill Lynch, these firms were reportedly mired in debt to asset ratios as high as 45 to 1. Main Street did the same and somehow miraculously purchased homes with absolutely zero savings. Other people “bought” homes with no job, income or assets. But they really didn’t buy one at all; rather they borrowed one and lived it in for a while.
It doesn’t really matter in 2011 whether you borrowed “within your means.” You are still living beyond “your means” if you mortgaged a home. Even if you bought a house pre-2008 with a good credit score, low burden of debt (30% of income), and large down payment, you were borrowing money like BofA on earnings that had not yet materialized. Anything could happen between purchase and the 30 years of the loan: illness, disability, job or income loss, plummeting housing value, or a financial crisis of monumental proportions like the current one. You may have done everything “right” in our leverage-based system, and it could have all gone horribly wrong.
Prime borrowers began defaulting in record numbers from 2009 on due to diminished home values and high unemployment. The inefficient government program HAMP was meant to help homeowners adjust their principal and payments for the new economic realities of declining housing and job markets. This homeowner help never materialized in any significant amount because banks had no legal or economic motivation to do so. America’s top banker, JPMorgan Chase CEO Jamie Dimon responded to requests for principal reductions on troubled Washington Mutual home loans with, “That’s off the table!”
But JPM’s inherited albatross, WaMu and BofA’s burdensome Countrywide Financial were as exploitive as any Mesopotamian lender by giving billions of dollars in home loans to anyone with a pulse! Michael Winston a former CW exec explained that rational underwriting and risk standards in the subprime mortgage frenzy were tossed out the window in favor of company motto: “Fund ‘em.”
Sadly, not only BofA pays the price for CW’s bad behavior, but all of us pay the price for that lender and the dozens of other equally irresponsible lenders. We pay personally and collectively in diminished incomes, asset values and net worth, but even more challenging than that in growing unemployment, foreclosures, credit defaults, bankruptcies and the general economic malaise the U.S. and the EU are currently wrestling with.
The moral of the story is really simple: we cannot live by cash alone. Nor can we live by credit alone. But a reasonable balance between the two is the place we want to be. So how do we get there now that so much has been thrown off track?
Lately, the Fed Chair and many others, including all of us at Good-b, have been calling for job stimulus programs to right our sinking economic ship. Yes we need this! But our economy will not recover until something major is done about the devastated housing market.
A group of economic activists called “the New Bottom Line” claim that reducing loan principals for underwater homeowners would create one million jobs and give $709billion back to struggling borrowers. While ideas like these are unpalatable to free market policy makers, we have to stretch our minds outside the box to solve the growing economic disaster. Outside of Wall Street, things are tough and getting tougher. Inside Wall Street, massive lay-offs are planned this fall due to on-going financial stress. The problem is not going away just because we want it to. Drastic problems call for drastic solutions.
The negative side of unchecked free markets reared its ugly head in the “fund ‘em” market philosophy of the credit-happy decade. Jamie Dimon doesn’t want to pay for reckless bankers and lenders that didn’t do their homework—neither do I and I would imagine, neither do you. But pay we must. The issue is how much do we pay? And do we pay now or pay later?
Before we exacerbate the current economic woes and allow the gap between rich and poor, middle class and wealthy to widen even more, resulting in increased homelessness, unemployment, welfare, crime and more burdens on society, we have to strike a balance: between paying something now or paying more later.
To “live within our means” necessitates adjusting debt to income ratios for all Americans in the post-2008 world. What level of home could you afford now in relation to your income? What amount of debt should be relieved given the changes in asset values and net worth to live within your means? Debt, as our Babylonian and Sumerian ancestors learned, is a burden shared by all society: borrowers and creditors too.
Perhaps 2011 is the right moment to finally learn the lessons of our ancient past: outsized exploitation of those “without” by those “within” will inevitably result in increased misery for all.
(“Living on Credit” is adapted from Monika’s soon to be released book, co-authored with Peter Ressler, Conversations with Wall Street: The Inside Story of the Financial Armageddon and How to Prevent the Next One.)
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Category: Sustainable Small-B