Sunday, October 13, 2013

The Debt Ceiling On A Personal Scale

Some of my more conservative Facebook friends have recently posted this video, and I really appreciate it. I think it does a great job of sincerely expressing how they feel about the debt ceiling, in a way that makes it very understandable. After watching it, I can see where they are coming from, and I can see how they must think I am crazy to disagree. So I'd like to explain how I would tell this same story, with the same underlying facts, but end up seeing things differently, in the hopes that they will understand where I am coming from.

To begin with, I think the video begins on a subtly misleading note by giving the guy an income of $21,000. Sure, I get that it's just an analogy for $2.1 trillion in federal revenue, with an arbitrary number of zeroes chopped off to make it more relatable on a human scale. But $21,000 is just a hair above the poverty line for a family of three. For people living in poverty, they are perpetually on the edge of disaster, with no tolerance for any unexpected expenses like an illness or a car repair. That would be a good starting point if we were talking about Haiti or Rwanda, but we're talking about the USA, one of the wealthiest nations on earth. So let's start this story off on the right track, and say that our guy made $245,000 last year, and is one of the most well-off people in his town. (Note that the video is slightly dated. I'll use updated numbers, but keep everything in the proper proportion. US federal revenue in FY 2012 was $2.45 trillion, so I'm just chopping off 7 zeroes to tell our story.)

It is true that our guy has been spending more than he earns the last several years, and last year his expenses were $354,000. But the video paints the guy as an irresponsible profligate, wantonly spending on flatscreen TVs and vacations to Australia, when that is a completely unfair characterization. A huge part of the reason our guy is spending so much is because he's supporting his elderly parents, who have moved in with him. He doesn't complain, and he is happy to accept the responsibility of caring for his parents, but the fact is that every year they get older, they require more care, which equals more expense. A full 45% of expenses last year went to caring for his parents. Another 19% of his expenses went to maintaining a state-of-the-art security system, as well as a private security patrol. They've talked about trimming that, but his wife is pretty insistent on protecting the family. You see, their own house was burglarized 12 years ago, and several other close neighbors have been hit more recently, and it seems the threat of crime persists. Aside from that, another 13% goes to mandatory bills, 6% to the mortgage, and the remaining 17% is discretionary spending. But by "discretionary", we're still not talking about flatscreen TVs, we're talking about things like putting the kids through school (not nearly the best nor the most expensive), health care (one of the best and by far the most expensive), utilities, transportation, food, and the like.

In the video, the banker asks the guy if he has made any cuts in his expenses. He has made cuts. They haven't been huge, but they're a bit better than the video makes them out to be. He cut $6,000 from his discretionary spending, including $3,000 from the security system and $3,000 between health, education, and utilities. The video banker asks the guy if he has any new income, and the guy just hems and haws. But that's not our guy at all. In real life, our guy has seen his income go up in each of the past three years, is on track to get a nice bump this year, and looks likely to see even bigger increases for the foreseeable future. In 2009, he made $210K; in 2010, $216K; in 2011, $230K; and in 2012, $245K. This year he's looking to clear $270K. Though his business took a hit like everyone else with the recession 5 years ago, he has picked up, and has been slowly growing again, and is looking to grow even more. So our guy is actually in much better shape there than the video portrays. As far as income goes, one thing that should be noted is that he could be making much more if he chose to work more. But about 10 years ago, his wife was really concerned that he was working too much, and she forced him to give up some really large accounts in his business. Truth be told, he could handle the stress just fine, but for his wife's piece of mind, he let those big accounts and the additional income go. If he hadn't let those accounts go, he would be much closer to making his ends meet.

He's been financing his excess spending mostly by drawing against his home equity line of credit (current balance $1.2 million) and borrowing against his IRA retirement account ($485,000). That sounds like a pretty large number, and it's certainly larger than our guy would like. The biggest reason for the size of his debt was the 2008 recession. That hit his business and his whole town pretty hard, but he made some crucial decisions at that time. He could have stemmed his own losses in the short term by laying off a lot of his employees when his business dropped. But he realized that would only be a very short-term fix. As one of his town's major employers, he realized that if he laid off so many people, that would have a ripple effect that would plunge the town into deep depression, sinking his own business even further as the town sunk. Thus, he decided instead to keep employing as many people as he could, just paying them out of his home equity loan to do pro-bono maintenance and construction work around town, until the economy picked up and his business along with it. Though he drew heavily on his own personal debt (probably to the tune of about $450,000), he's seeing the strategy pay off. Major depression was averted and business has been slowly growing again. Another cause for his debt was that extra business he could have had, except for his wife fretting about him working too hard. By working less, he figures he's added $160,000 to his debt.

As big as his debt is, it's still not really so far beyond the pale for a guy of his means. He is completely staying current on paying his loans, his credit cards are completely paid up, and with a recent refinance, his combined mortgage and interest payment on all of his debt is $1,860 / month. Now that might be higher than your mortgage payment, but for a guy who made $245,000 last year, that is nowhere near tapped out. Note that if you look at financial planner's guidance on how much mortgage one can afford, they typically say your mortgage shouldn't exceed 35% of your income, or if they're very conservative, maybe 25% of your income. Our guy is currently paying 9% of his income on his mortgage. Chances are that your total mortgage (or rent) and credit card payments add up to more than 9% of your income. In that light, perhaps our guy isn't quite so financially irresponsible as he was unfairly made out to be.

Which brings me to the most unrealistic part of the video. In the video, it shows a skeptical banker unwilling to extend this guy a loan. Nothing could be further from the truth. Our guy has a top-notch credit rating, and bankers are basically tripping over each other wanting to loan our guy money. They view our guy as the most reliable place to put their money, better than just about any other place they could invest it. They look at the value of his house, which is way more than his current debt, and they look at his current income, his income growth, and his potential for the future, and they are completely comfortable lending him even more money. In fact, they are so confident in our guy that they are willing to lend money to him at rates that are so low that, taking inflation into account, they are practically less than zero. Yes, that's right. The bankers of the world are willing to basically pay our guy to hold their money. And we're not talking about wild-eyed crazy bankers lending like it's 2007. We're talking about sober post-crash bankers. The smart money in the world looks at our guy and sees nothing to worry about.

Actually, I should say the bankers see nothing much to worry about. The one thing that is starting to worry them a bit is the potential instability of the guy's business, because of his wife. You see, his wife has become increasingly nervous about their level of debt, and she and her husband have been squabbling over the best way to grow the business. (At the same time, she continues to be nervous about her husband working too much, and wants him to work less, reducing his income. Somehow she doesn't realize how counterproductive that is to reducing their debt.) Their disagreements have been much more public in recent years, as she has at times taken actions like stopping payment on checks that her husband has written, or held up action at board meetings. As his wife and part owner of the business, she does have the legal ability to cause such disruptions. She is well-meaning, but her actions are threatening to jeopardize the business. From the outside, people just see instability and a business that is becoming less predictable in its management and direction. Most recently, she's threatening to cancel the whole home equity line of credit that enables their ongoing business, not realizing how catastrophic that would be. She truly wants what she thinks is best for her family, but ironically her own actions could lead to great harm to the very thing she wants to protect.

And that, my friends, is a much more accurate analogy of the current situation.

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