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 did that deter either the buyer or lender from making sure the buyer could “afford” 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 of 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.

The Collateral was over inflated. When the purchaser, hard pressed for payment, attempted to either re-finance or sell the collateral to raise capital they discovered they had purchased a pig in a poke. The collateral, if it could be sold, would bring far less than what was owed against it. They were now between a rock and a hard place not only facing foreclosure or repossession but also being required to pay the deficiency owed after the collateral had been disposed. Meanwhile, the financial communities were bundling this bad paper and pedaling it as investment grade paper to unsuspecting investors and every government, domestic and foreign, failed to investigate these transactions.

What finally caused this house of cards to fall was Conditions, the overall economy. The Federal Reserve after continuous periods of lowering interest rates to “spur the economy” began to raise interest rates in a unsuccessful attempt to stop the declining value of the dollar and that caused increases in consumer interest rates at the same time those deceptive low mortgage interest rates began to expire and higher rates went into effect. When the rates increased the consumer began to panic upon realization they could not afford to continue paying for their purchases of homes, automobiles and other borrowings including margin borrowings to purchase investments in the stock markets. As they began to try to re-finance or sell off those purchases it produced a surplus of homes and automobiles which drove down the value of those homes and automobiles. It also produced margin calls as the stock market began to decline and equity in investments became less than what was owed in margin accounts. At first it was explained that it was the “sub-prime” market that was to blame but it soon became apparent that it was actually the loans made at zero or little interest that was the real culprit. The true “sub-prime” loans never did adjust and because they were always at a higher interest rate were, in fact, performing far better than the “conventional” loans with the adjusting interest rates. 

The reality was that lending institutions, that had become so accustomed to making at risk loans due to the Community Redevelopment Act they had been forced to operate under for over thirty years, had expanded these loans by creating unusual terms and in many cases letting the purchaser choose the method of re-payment. The patients were running the asylums. This eventually caused an increased decline in consumer spending in other markets such as electronics and apparel. This slow down was primarily due to the consumers, who up until this time had what they thought was disposable income or access to unlimited credit, now diverting their cash to salvage their homes and automobiles and pay for investments (stocks and bonds) they no longer owned. As the economy became stagnant and the dollar continued to fall against foreign currencies, institutional investors began to react as corporate revenues failed to meet forecasts and began to reflect the slow down in consumer spending. Wall Street analysts reluctantly began to issue hold or sell recommendations on stocks that had previously done well creating a sell off of investments.

The “sub-prime” market was nothing more than a euphemism for marginal or at risk purchaser. It was created by the government and lenders who were forced to comply eventually found ways to exploit the legislation so they could charge extraordinary interest or terms on large ticket items for borrowers and consumers who in previous times would have simply been rejected as non-creditworthy.

And during all of this the controls that had been enacted to protect both the customer and the investor were not only ignored by both the creditors and the agencies that were created to oversee the controls were enforced but through the ineffectiveness of elected representatives the controls were legislated out of existence.

The results are historic. The largest bank failure since the Unites States depression. The largest insurance company failure since the United States depression. The recall of the provision of the Glass – Steagall Act that prohibited banks from being allowed to own or participate in investment firms for the first time since the United States depression. The U. S. government bailout of the mortgage, investment and automobile industries. Foreign governments insuring customer bank deposits for the first time. The largest number of business bankruptcies throughout the world including two major U.S. banks and one major U.S. investment house with more certainly to follow. Major retailers filing bankruptcy and closing their doors rather than try to reorganize. The acquisition of failed banks’ assets by other banks and the liabilities of those failed banks being purchased by the government.  A financial crisis that is not confined to one country but the world and has changed the relationship between government and private industry in many countries.

The finger pointing, blame and excuses will continue well into the year 2009 but all of what has occurred can be summed up in one simple equation. A failure of creditors and regulators to recognize and adhere to the four basic principles of credit which are; character, capacity, capital, and collateral.

And for debtors, we think the Clint Eastwood character Harry Callahan summed it up best in the movie Magnum Force when he said “A man’s got to know his limitations”.

The wide use of credit, as we know it today, is relatively young. It began in the late 60’s with the creation of the American Express, Visa, and MasterCard. Today, 40 years after their creation these three credit cards are responsible for the majority of the worlds’ consumer debt and most importantly our attitude concerning credit. Unfortunately, this financial crisis is not over as there is another shoe to be dropped. The credit card industry is at risk and we will soon be aware of the impact. How it responds to the crisis will have a significant determination of how credit will be handled and who will have access to credit in the future.

I wish you well

The information provided above is for educational purposes only and not provided as legal advice. Legal advice should be obtained from a licensed attorney in good standing with the Bar Association and preferably Board Certified in either Creditor Rights or Bankruptcy.