A Brief Overview of Debt In the United States

I just finished a great book that taught me a lot about the history of debt in the United States.  It’s called Borrow by Louis Hyman.  Debt has always been around ever since money existed, simply because people have always had an immediate need for money even if they didn’t have enough.

Early in America’s history, the ability to borrow was scarce and hard to come by.  Only business owners could borrow, and it was predicated upon the assets they could put up as collateral.  For example, farmers went into debt in order to buy tools and materials in order to farm their land.  Even though they could only harvest once a year and sell their crops, they needed to continually expend resources throughout the year in order to get a good yield.  Bankers from New England started to finance farmers’ move out west, and allow them to take out mortgages to purchase land.

At this point in the story of America’s debt I was surprised to learn that it was around this time (early 20th century) that the original mortgage-backed securities were invented.  They were called “participation certificates.”  They operated under basically the same process as the “CDOs”, or collateralized debt obligations or recent history – people took out mortgages from bankers to fund their land purchases.  Then, the bankers bundled up these loans and securitized them so that they could be re-sold.  The magic of securitization was that, if you could re-sell something, your liquidity was immediately bolstered and your perceived risk decreased simultaneously.  If you, as a banker, could convince a group of people to take out loans from you, and then you could convince a group of investors to buy the debt off of you, well – you had a nice opportunity to make yourself a profit.  Because the debt was no longer on your books, if the borrowers couldn’t pay back the money – too bad, so sad.  That was now the investor’s problem!

This situation is one of multiple issues that led to the crash and the Great Depression in 1929.  People got really excited because assets could be bought for a high price and then immediately sold for higher, and participation certificates were all the rage because the returns were “guaranteed”, by the houses that backed them.  Let’s think about the incentives here though, for a second.  How do you think the home builders responded to this investor thirst for mortgage-backed securities?  Why, they built more houses!  In fact, many of the homes built in the 1920’s were shoddily constructed and built en-masse so that the builders could quickly turn a profit, along with the bankers.

This rapid expansion also changed the minds of Americans about what was “good debt” and what was “bad debt”.  The notion of the time was that it was ok to get a mortgage on a property, namely because someone at the local bank said it was ok for you to borrow the funds.  Instead of evaluating loan risk solely based on the value of a person’s assets, banks started to look at risk based on the income of the borrower.  So, as long as you had a decent job with good prospects, you borrow for a home without a lot of money.

The paradigm shift from asset-based borrowing to income-based borrowing continued into the World War II and post-war eras.  Department stores really pioneered how America borrowed at this phase.  They invented revolving credit accounts so that shoppers could continually shop and shop, and as long as their minimum payment came in every month, all was well.  Department store heads shrewdly figured out that they could not simply re-possess a shirt or a blouse in the same way that a home or car could be repossessed, and they understood that because of the intense competition in retail, denial of credit would likely lead to customers simply walking out the door.

As the American economy flourished after the war, and the suburbs became developed full force, the department stores and the credit they offered went with it.  BankAmericard and MasterCharge (now known as Visa and Mastercard) were invented to allow for credit to be extended throughout a network of merchants and not just by a single store.  It took a little while for the idea to take off, but when it did, it took the country by storm.  Gradually, the offering of credit cards, which were initially just to well-off consumers, found their ways into the hands of everyday citizens.

By the 1970s and 1980s, credit cards were being massively marketed to people from all walks of life.  Because of the network that the credit card companies had created, a high amount of leverage could be employed to successfully boost profits.  To this day, it is a profitable business with high margins.  However, the credit crisis of 2008 and the return of the boom and bust of mortgage backed securities made our country think again about the dangers of unrestrained credit.

The book goes into a lot of detail about the 21st century economic system in America.  I learned a ton of history reading it, and would definitely recommend it for that reason.  Although I knew that debt had existed in America in different forms over the decades, I had not been aware of the nature with which it had evolved and of the nature with which our attitudes of it had evolved.  Before, debt was seen as a moral failing, whereas now people tend to see debt, as a concept, as having no moral underpinnings.  Also, the advancement of technology has allowed debt to be democratized in an amazing way, so that now the entire global economic system functions on the basis of credit.

This is a lot to think about.  I have been rambling a bit throughout this article, just kind of typing out the things that I remember from what I’ve learned.  I’ll have to read more about this topic in order to get a more thorough understanding of the things that Hyman goes over.

Lessons Learned From Reading The Snowball, Buffet’s Biography

I recently just finished The Snowball, one of the more recent biographies on Warren Buffet.  The guy gets a lot of attention because he’s rich and has consistently proven himself to be one of the best capital allocators of our time.  After finishing the book, I see why.

Mr. Buffet always worked his butt off, is really what I gathered from the book.  I mean, it seems like he never really stopped working.  Investing was always and always will be his passion.  It’s clear that ever since he was young, Buffet always enjoyed “the game” of money.

One of the key insights I got from the book is that Warren Buffet has always, in a way, been wealthy, or at least very clearly on the path to wealth.  As a young boy he rented out pinball machines, flipped Coca-Colas to his friends, and even bought stock in companies (in those days the barrier to entry for direct stock ownership was much higher, you had to know someone in the business and have a decent amount of capital to invest.  Now you can just go online and buy $10 of McDonald’s on Loyal3 in 5 minutes with no commissions.)

After piling up a decent amount of savings, he worked for Benjamin Graham, the legendary value investor, for a time, and then he began his own investment partnership.  This allowed him to leverage the assets of other people and get a nice cut of the profits he made that were above a pre-established benchmark.  I like this incentive system.

Most people’s work is not like this – they show up, put in a set amount of time to do a set amount of work, and then go home and collect their paycheck.  By establishing himself as the owner in a business with a scalable earnings model, Buffet was able to structure his affairs so that the better he got at investing, he benefitted in a multi-faceted manner.

1. By investing his own money well, Buffet’s portfolio grew quickly while minimizing risk.

2. By investing other people’s money well, Buffet got an ever-growing cut of the profits he made, which he then re-invested in his personal pile of assets.

It’s awesome because Buffet was able to focus intensely on developing a single skill set – investing in businesses – and reap rewards at different levels that exponentially grew his pile of assets.  When he invested well for himself and his clients, he was able to attract more clients.  When he invested well for his clients, he was able to take a larger profit for his personal investments.

Another important lesson I learned is that having the right partner will greatly accelerate your journey toward your goals.  Buffet’s relationship with Charlie Munger demonstrates that two brilliant minds working together can indeed achieve extraordinary things.  Both men knew a lot, and they acted as checks and balances on each other in order to avoid making big mistakes.

Charlie Munger was instrumental in helping transform Buffet’s mindset from buying “cigar butt” companies – simply looking at assets on the cheap – to buying companies of excellent quality that pounded out cash year after year.  Although Benjamin Graham was Buffet’s earliest mentor and influencer, Munger’s friendship and partnership greatly added to his success.

To this day, Buffet works hard to build Berkshire Hathaway and increase its value.  From interviews of him and reading about him, it really does seem like he “tap dances to work” and loves the game of investing and making money.  By discovering what he wanted to do relatively early in life, and then devoting himself wholeheartedly to it, he achieved a level of success that few ever dream about.

I learned from this book that it is not enough to simply be smart and have a high level of knowledge about any particular area (such as investing), but to be able to continually grow your knowledge in many different areas and then execute well over long periods of time.  Buffet got to where he is by applying sound investing principles over time, and gradually adding more and more money to his investments through the power of compounding.

The New Elite by Talor, Harrison, and Kraus

The New Elite is a good profile of "the 1%".

The New Elite is a good profile of “the 1%”.

I just finished up reading The New Elite, a book that details the habits, characteristics, upbringings and attitudes of “the truly wealthy”.  I almost shied away from picking this title up because I’ve already read a few works from bestselling author Thomas J. Stanley (The Millionaire Next Door and The Millionaire Mind), which pretty much profile who the typical millionaire in America is.  The typical millionaire:

-is in his or her 50’s

-lives in a home worth less than $300,000

-drives used cars, such as Toyotas or Lexuses

-owns their own business (mostly small businesses) and is a big part of their local community

The New Elite goes a step further, which is why I like it so much.  The authors mention the Millionaire Next Door types, but the primary focus is on the 1% in America – those who have net worths in the tens and hundreds of millions, and annual incomes in the half million to multi-million dollar range.  Although, from Stanley’s research, higher-paid professionals such as lawyers, doctors, and CPAs make their way into the millionaire/affluent category, the 1% is made up almost entirely of business owners with some highly paid corporate executives sprinkled in.  Either way, the message is clear that these people primarily obtained wealth from businesses that they either built from the ground up or, in less common cases, existing businesses where they climbed the rungs of the proverbial corporate ladder.

There are two chapters of the book in particular that enjoyed.  One discussed the journey of wealth, and how the attitudes of the 1% change over time as they become more used to having money.  These are classified as Apprentices (0-5 years of being wealthy), Journeymen (6-14 years), and Masters (15+ years).

Apprentices typically exercise extreme financial caution with their investments and moral caution with their relationships.  They do not want their newly created wealth to disappear overnight because of reckless speculation, and they do not want to attract unwanted attention from family members and friends asking for a piece of the pie.  Journeymen start to grow into and accept their role in society as a wealthy person, and begin to be a bit freer with their spending.  Masters are mostly comfortable with their financial status and many spend lavishly on status symbols such as fine art or rare watches and jewelry.

I like this classification of the top 1% because it exposes the nature of human behavior.  Sometimes when we get something really coveted by our peers or surpass a significant milestone of personal achievement, we can feel guilty even though we rightly earned all of the fruits of our labor.  Over time, however, the guilt and bad feelings associated with the accomplishment or newly achieved status starts to wane, and acceptance and pride take their place.  It is one thing to feel entitled for things that you have, but it is completely different to reward yourself for a job well done.  This behavior pattern lines up with other data on the wealthy, as 90% of millionaires in America are self-made.  It makes sense that a natural shift occurs in the 1%’s attitudes about money the longer that have it and the more it grows.

Another one of my favorite chapters is about the varying personalities of the truly wealthy.  This method of classification brings light to the fact that not all wealthy people are stereotypical John D. Rockefeller types – stern old men who are ruthless in their business and personal dealings.  In fact, that stereotype appears to be completely inaccurate.  The authors classify the wealthy into a few categories based on habits, interests, and personality.  Here’s a summary:

Neighbors – These are the “Millionaire Next Door” type.  They typically continue to live a middle class to upper-middle class lifestyle, and practice stealth wealth.  They typically enjoy maintaining involvement in their local communities – primarily via their businesses.

Wrestlers – These folks tend to wrestle with their wealth and what to do with it.  They typically worry about their children developing good money habits and not having a sense of entitlement.  Wrestlers tend to spend a lot on lavish items.

Mavericks – This is the Richard Branson type.  These millionaires often have high-energy, sometimes quirky personalities.  They often pursue a variety of interests outside of their business and live more on the wild side.

Directors – Think of a CEO-type of personality.  Directors feel that money should serve a very intentional purpose and seek to appropriate it responsibly.  They are the most concerned with retaining their wealth and passing it down to future generations in the best way possible.

Patrons – These are the people whose names are etched in stone at your local art or history museum.  Patrons feel it is their duty to share wealth with others (with good judgment, of course), particularly with those who help the community at large in civic pursuits.  They tend to describe themselves as content and happy, but they also like to spend on luxury items.

Wealthy people are not all the same, just like folks in the middle or lower classes are not the same.  Personality influences how you spend your time and money, regardless of how much of either you have to give.  Reading this section of the book really made me think and remind me of the fact that wealth is simply a means to an end – it is not an end unto itself.  Having more money at your disposal simply amplifies your personality.  The way you treat $100 is the same way you treat $1,000,000.

OK, this is not strictly the case.  After a certain level of wealth, spending on luxury items can go relatively uninhibited without recourse (think: superstar music artist or professional athlete with a long career).  This is the super-minority of wealth in America (top 0.1%).  However, this does not change the fact that habits are habits.  If you always give some of your income to a charitable cause even though you are a member of the middle class, you will likely keep up that practice when you become wealthy, the numbers on the checks just get bigger.

The book did focus some chapters on the spending habits of the wealthy, which was OK, but I was not particularly interested in this data.  The authors have a firm that markets to wealthy individuals, so I can see why they spent a fair amount of time on this subject.  Also, the book discusses other interesting topics, such as how the wealthy are more and more becoming “globizens” (global citizens), due to the increasing globalization of the business world.  There’s also a chapter on the children of the wealthy and their attitudes about life and money, which is interesting.

The New Elite makes for a good read if you are interested in the 1%.  If you haven’t read Dr. Stanley’s The Millionaire Next Door or The Millionaire Mind, I would recommend reading those alongside this book.  In my opinion these three books do a great job of explaining the origins, lifestyles, and attitudes of the affluent and wealthy in America.