“Collateral Damaged: The Marketing of Consumer Debt to America
” by Charles R. Geisst is a detailed and captivating examination of the history and growth of consumer debt in America. The book scrutinizes the political, cultural, social, and financial forces that converged to inflate America’s tremendous bubble in consumer credit. Geisst reaches all the way back to the debt problems of King Edward III and beyond to begin his historical review. Every step of the way forward, Geisst describes the various innovations lenders have created to bypass usury laws, to create credit and expand debt levels, and to extract profits even from borrowers least capable of servicing their debt. This process transformed America’s treatment of debt from an onerous burden to a necessary evil to a miraculous treasure chest of opportunity to live beyond one’s means.
The book starts off slowly and a bit choppy given the large expanse of history that Geisst flashes across the pages. Geisst is also a bit over-zealous in emphasizing and repeating his point that American culture dresses up the burden debt with the semantic sleight of hand “access to credit.” The reader who slogs through these obstacles discovers a fascinating journey through the world of debt and the many events and substantial infrastructure responsible for supporting and expanding consumer debt in America.
There are a few key quotes from the book that poignantly describe the context, the problem, and the general remedy according to Geisst:
The Context
“High debt levels cause impoverishment…Interest charges have been viewed with suspicion for three thousand years of Western history, but within the last thirty years they lost their fearsome nature as large numbers of people felt so sanguine about their ability to pay that the odious nature of debt was forgotten. This will prove to be the most egregious error of modern culture.” (p5)
“Savings and prudent banking have contributed to America’s high standard of living, but this high standard also produced the complacency that led to financial disaster. Borrowing became a democratic concept. As a political principle it meant that everyone should have access to credit, even if they have no means of servicing it. Beginning in the 80s, it meant discounting future earnings to have it now.” (p207-208)
The Problem
“The American debt model has been broken and is in need of serious repair. It has become clear that as a nation of spenders rather than savers, many American families are now at the brink of economic ruin because of profligate spending habits aided and abetted by the consumer credit companies and mortgage lenders. The problem is so large that it requires a targeted response aimed at lenders and borrowers.” (p188)
“Checks and balances in the financial system have been removed in favor of market efficiency, ideology, and a belief that markets regulate themselves. As a shadow form of government, it needs the same constraints that are placed on government.” (p215-6)
The General Remedy
“…the patchwork American regulatory framework has fallen into the hands of the private sector, which it was originally intended to regulate in the first place. The financial crisis is a direct result of this broad neglect and is sufficient proof that the regulatory system needs serious overhaul. Consumer credit needs to be included in this overhaul.” (p204)
“The financial crisis was a product of structured finance, and participants in this activity need to be restrained from preying on consumers and investors in the future.” (p211)
Geisst insists throughout his book that the financial industry has a strong and vested interest in driving consumption ever higher and keeping Americans in debt. Many consumer advocates have decried the industry’s complicity in encouraging perpetual indebtedness. Geisst accurately identifies securitization of debt as a prime enabler: investors who purchase securitized debt enjoy profitable cash flows only as long as the borrowers generating this debt stay in debt.
Charging high rates of interest also helps keep consumers in debt for longer. Geisst provides many historical examples of the various tricks certain lenders have used to bypass usury laws. For example, before the 1968 Truth in Lending Act, lenders could charge interest at monthly rates below the legal effective annual limit, even though keeping the loan for a year would surpass the limit. Another example was the practice of “salary buying” in which a worker secured a loan against a future paycheck after paying a “service fee.” These fees could be as high as $5 for a $25 paycheck. Today, this practice is called a payday loan.
Geisst notes how certain states like South Dakota and Delaware eliminated usury laws to entice banks like Citibank to build headquarters in their states. Geisst also explains how the minimum payment on credit cards can turn credit debt into an interest only loan whose effective interest rate circumvents usury limits.
Despite this onerous indebtedness, Geisst acknowledges that the data do not seem to support the notion that Americans are on the brink of ruin. For example, “since 1997, delinquency on general purpose credit cards is only 5% and charge-offs just 0.5% higher. Debt service ratios from the Fed (Financial Obligations Ratio and Household Debt Service Ratio) show there was no credit crisis given numbers are remarkably stable/similar in 1988 and 1998 and 2008.” Even a 2006 GAO report claims that Americans were having no problem servicing debt. Geisst suspects that rising home values masked the problem as consumers increasingly drew down home equity to pay down credit card balances – a gambit that imploded in spectacular fashion in this decade’s bursting of the housing bubble.
The rest of this review provides a short summary of the book’s highlights…
Geisst uses the long arm of history to tell the story about debt, but the early 1900s – when loans to individuals were first made widely available – and the 1980s were pivotal periods.
The establishment of the corporate tax in 1909 and especially the income tax in 1913 motivated the financial industry to create ways to help consumers recapture their buying power. Such innovations included the “installment credit” plan which gradually replaced lay-away plans. A company did not deliver a product on lay-away until the consumer fully paid the cost over a period of time. Installment plans provided immediate delivery of a product with an initial payment and a promise to pay the remaining balance in the future. Sears created the first plan in 1911; it required 50% down and equal payments thereafter. Installment plans also helped consumers afford automobiles.
Credit also expanded by tapping into future earnings as a tool for measuring the ability to service debt. This innovation first appeared in 1925 when Clarence Dillon stole an acquisition deal from JP Morgan using the target company’s future earnings potential to estimate a fair price. JP Morgan’s lower offer used the existing standard method of valuation based on existing assets. Geisst does not provide specifics on how or when this concept translated to consumer finance, but he leaves the reader to assume that this deal originated (or strengthened?) the concept that a consumer’s future earnings could and should be made available to spend today rather than in the future.
Although only 10-20% of Americans participated in the resulting “credit society” of the 1920s, the increased availability in credit helped facilitate a consumption boom unlike anything America had seen until then.
The Great Depression suppressed, but did not destroy, the credit society. With America’s greatest economic calamity in the rear view mirror, the first credit card was introduced in 1946. Consumers paid balances in full every month until Bank of America introduced a credit card in 1958 that allowed payments over time. Innovations in computing in the 1960s allowed faster and higher volume processing of transactions, further expanding the financial industry’s ability to offer credit to more and more consumers.
However, it was the era of deregulation in the 1980s that opened up the spigots of consumer credit and debt. Geisst identifies “the twin ideological pillars” of market deregulation from President Ronald Reagan in the United States and Prime Minister Margaret Thatcher in the United Kingdom that ushered in the government’s “benign” approach to markets. (Geisst draws extensive comparisons between the U.S. and the U.K.) Add in the Federal Reserve, led by chairman Alan Greenspan’s ideas of market self-regulation, and Geisst concludes that the 1980s “…resulted in increases in consumption, borrowing, and speculation not seen since the 1920s.” According to Geisst, it was in the 1980s that finance took over from politics as the central force in American life.
While it is clear that Geisst has an axe to grind against hands-off approaches to financial markets, it was government action eliminating a tax benefit that proved critical to expanding mortgage debt to unprecedented levels. The 1986 Tax Reform Act eliminated tax deductions for interest payments on consumer loans like credit cards. This action ushered in the use home equity loans to transfer credit card balances onto the home where the interest on the mortgage remained tax-deductible. Although interest rates were extremely high during the period, the Depository Institutions Deregulation and Monetary Control Act of 1980 allowed adjustable rates of interest for mortgages (ARMs). By the end of the decade, 60% of all mortgages were ARMs. According to Geisst, this growth saved the mortgage industry. Securitization of mortgages started in 1983, creating a growing cadre of investors ready to finance home lending. Taken together, these factors launched a 25-year boom in mortgages. The drive to finance current consumption by drawing down on future value had reached its apex – what Geisst appropriately dubs “cannibal consumption.” Cannibal consumption became even more important for maintaining standards of living after income growth significantly slowed for most Americans following the crash of the technology bubble in 2000.
From 2001 to mid-2008 Americans created around $20 trillion in gross new mortgages. This growth more than doubled the total mortgages in existence. By 2007, mortgages grew larger than GDP, a feet never before seen in the U.S. From 1996 to 2006, home equity of almost $800B went towards paying off consumer debt. There are no data indicating what percentage of this consumer debt was credit card debt, but Geisst notes that by late 2006 credit card debt fell to under 3% of consumer’s $30.5 trillion debt burden.
As Geisst describes it, the problem of consumer indebtedness appears overwhelming and nearly intractable. Yet, Geisst attempts to step up to the challenge by recommending a comprehensive list of remedies and reforms, many of which are as significant as the problem Geisst portrays. In Geisst’s world, the government is much more active in constraining the activities of the financial sector, and it takes a much more proactive stance to keep consumers out of trouble and away from burdensome debt:
- Use the Tennessee Valley authority should as a model to turn Fannie Mae and Freddie Mac into utilities controlled by the Treasury.
- Eliminating GSE lobbying activity could pay for this transition.
- Reduce tax exemption on housing capital gains.
- Raise minimum credit scores to qualify for credit.
- Take into account total credit a consumer has and cap allowable amount.
- Criminal prosecution for predatory lenders included in a “war” on them.
- Cover all securitized loans giving recourse to investors if bonds go bad.
- Stress tests that include financial collapse scenario.
- Regulate amount of synthetics or derivatives a company can create based on balance sheet.
- Extend regulations as far as possible given tendency of market to stampede toward unregulated parts of the market.
- Slow down flow of securitization process to allow more scrutiny, including circuit breakers for the creation of derivatives.
- Regulate ratings agencies and/or hold them publicly accountable.
- Stop privatization of the money supply through the payments system.
- Reinstate usury laws.
- Prevent unfunded long-term (credit card) debt by giving consumers a limited amount of time to pay their debts.
For anyone interested in today’s debate about financial reform, Geisst writes an extremely timely piece.
Full disclosure: Seeking Alpha provided this book for free on condition of writing a review.