A late night TV commercial, in the 1980s, showed sad people, sitting around their kitchen, with no money to buy a new home entertainment center. Then a friend suggested, “Why not take a home equity loan?” The next scene showed the happy couple, not only enjoying their new home theater, but also fanning themselves with hundred dollar bills. The announcer came on and said, “Don’t just sit there on all that cash. Take a home equity loan and live the life you deserve.”
This commercial basically suggested that people put their home ownership at risk in order to finance the purchase of consumer goods that they didn’t absolutely need. It was just one of many easy-credit programs which used to be targeted only at the poor, but have steadily been creeping up and up the American social ladder, infected both the middle and the upper income groups.
Back in the early 1990s, when I was essentially homeless and working construction, my coworker, Red, told me about coming home and finding a check for $1,500 dollars in the mailbox. Basically, these checks were sent out by “banks,” shady credit institutions, who lured the poor into debt slavery. The back of the check, the part you had to sign in order to cash it, was actually a loan agreement, locking you into some horrible repayment plan, with high interest, origination fees and late penalties.
I think it is no longer legal for companies to send these checks out, unsolicited, to strangers. But, if these guys had already borrowed through this company, then they were considered existing customers, and it was okay. I once borrowed from a company like this, and noticed that what I thought was a loan agreement was actually a credit account. This meant, even if I managed to pay back the principal plus interest, I could just draw it out again, without going through an application procedure. What was worse, at any time during the repayment process, you could call up — no internet in those days — and check your credit balance. Any cash in the account could be drawn out and the debt started over from zero again.
It took me three years to pay off a $3,000 loan.
“I was so tempted to cash that baby,” said Red, a hard drinking, semi-employed brick carrier, with a wife, several children by other women, and a trailer to support.
“Why didn’t you?” asked Jason, who was probably thinking of the big meal they would eat at a Mexican chain restaurant, sharing Red’s windfall.
“Darleen said she’d leave me if’n I got further into debt. Every Friday when we get paid, I gotta go give most of it over to the Quick ‘N’ Pawn so’s’n I don’t lose the TV.”
Pawn was another scam. Red had been $30 short on the rent for the space where he parked his trailer, so he took the only thing of value he had left, his TV, down to the pawn shop. His intent had been to borrow $30 and pay it back, plus the vig, but I think they call it interest in semi-legitimate credit institutions. If he missed a payment, he would lose the TV. The strategy of the pawn shop is to try and push the guy to borrow more. This way, the guy would be more likely to miss a payment a few weeks down the road, and he would lose his TV. The pawn shop then had all of his payments, up to that point, plus they would sell the TV, price which they would make sure was higher than what they had loaned him.
The pawn shop had talked Red into borrowing $100. He paid his rent, then used the rest for a big Mexican meal, complete with nachos and beer, and invited Jason and me. The rest he used to buy an answering machine for his wife. The next week, when he couldn’t make his interest payment, he gave the pawn shop his answering machine. Now, he was in danger of losing his TV. And a check for $1,500 had arrived in the mail.
Fast forward nearly ten years: I was working as financial consultant for a European investment bank. They sent me into consumer banks to invest money for the regular banking customers. At one point, I was responsible for seven bank branches in Manhattan. Depending on which branch I was in, I handled investments for the UN, and used all my various languages in the meetings. I handled investments for politicians, entrepreneurs, mom and pop, you name it. And I saw the whole gamut of personal finance, from top to bottom, which families made good decisions and which made bad ones.
One of the branches was in the garment district, and while I was called into handle investment for factory owners, I would see the workers lined up to cash their checks. I always avoided going near that branch on the first and fifteenth of the month, because the factory workers scared me. They would be lined up around the block, hundreds of them, waiting to cash their checks, because they didn’t have bank accounts. Because it was payday, a lot of them had been drinking. Occasionally, violence would erupt. The bank actually had to hire extra security guards for those days.
At other times, I was at a branch by Wall Street, where the patrons, mostly traders, had more money and education. But, on Fridays, there was also a line out the door, and around the block, with very well dressed men, holding briefcases, waiting to cash their enormous pay checks. Unlike the factory workers, who would clear less than $200 a week, these checks were sometimes in the tens of thousands of dollars. Ten thousand dollars a week! That was more than a factory worker made all year. This branch also had to have extra security because they would have millions of dollars on hand that day.
Why were these well paid men cashing their paychecks rather than depositing them?
Because they bought stock several days earlier and had to pay for delivery of the stock on Friday. The stock they bought was speculative. In the late 1990’s it was very possible that in the three to five days it took until you absolutely had to pay for the stock, it would go up enough that you could sell it, without having paid for it, and clear a profit. Or, you could borrow money, pay for the stock, and then sell it. If the stock didn’t go up, then you needed to pay out of your pocket, and sit and wait and sell it next week. Hence, the need for tens of thousands of dollars.
But, it gets better than this. These men were also using the financial concept of leverage, whereby they could borrow money, depending on the stock, and could get credit worth several times the value of the stock. Why did they do this? To buy that much more stock, and earn more money.
If you buy 100 shares and they go up by a dollar, you made a hundred dollars. You would then sell the stock and pay for it, and pocket the difference. But wouldn’t it be better to buy 1,000 or 10,000 shares? Then, if they go up by one dollar, you made $10,000. If your friend made $10,000 and you only made $1,000 wouldn’t you feel foolish?
At that time, there were technology securities which had growth rates of 100% or even 190%. So, if you break that down to how much that was per day, it was a huge growth in the three to five days until you needed to pay for it.
It seemed at that time, that everything you bought went up. People were doing anything they could to buy stock and get in on this cash cow that all of their neighbors were doing so well with. In the commercial banks where I worked, I saw the customer come in, and take out a home equity loan, drawing every penny of available equity, and then come over to my desk to buy stock. Once, and I swear this is true, a man came in, filled out all of the necessary paperwork, told me how much and what he wanted to buy. Then, he walked over to the ATM machine and drew out a cash advance on his credit card to pay for his stock trades. As I was in a more conservative end of the business, we weren’t even allowed to accept cash. So, he wrote me a check, said, “wait a minute on that.” He walked over to the teller window and deposited his ATM cash. When he got his deposit slip, he waved and smiled at me, as if to say, “Okay, go ahead and process that trade.”
He left the bank without even stopping by my desk again.
Many of my trader friends told me they used their American Express cards to buy stock. With Amex, you don’t have a credit limit, as such, and if you pay in thirty days, you don’t pay interest. So, they would buy stock, and hold it for thirty days, sell it, and pay off the bill when it came in. But because of settlement rules, it was possible to hold the position for 33 or even 35 days.
Picture using a $10,000 cash advance on a charge card to buy $50,000 worth of stock, that you can’t afford to pay for, because you are hoping that it will go up in the next 34 days. I don’t know about you, but that would be a long sleepless 35 days for me. But for these guys, this was their normal routine, month in and month out.
I heard stories, although didn’t actually see it with my own eyes, of guys taking cash advances of tens of thousands of dollars, buying hundreds of thousands of dollars worth of stock they couldn’t afford, and holding it for thirty days.
In addition to being insane about trading stock and “leveraging” their position, one commonality between all of these educated, well-off men was that they sneered at the “jerks” who fell for the home-equity credit scams on TV.
“Can you imagine someone being that stupid and using their home equity to buy a stereo?” They would say.
The late 90’s and into about 2000, Wall Street was experiencing what financial experts call a bubble. It is a time when the market goes up and up. Prices and returns inflate until, eventually, like a bubble, they burst. And then you are left with a soggy, deflated balloon, and no house.
When Charles Edward Merrill, founder of Merrill Lynch, coined the phrase, “Bringing Wall Street to Main Street,” he didn’t mean that normal people should be leveraging their kid’s college fund, their retirement monies, or their home. He was trying to level out the playing field, and give the regular Joe a chance to participate in the stock market. But somehow, the concept became perverted and blown out of proportion on a scale that would probably have sent Merrill spinning.
Everyone was focused on “let your money work for your you.” But, as comedian Jerry Seinfeld pointed out, “What if my money gets fired?”
In addition to leveraging assets and salaries, people in New York, and elsewhere, decided that they, like big corporations, should hire accountants, who knew how to “work the system.”
“Why should the government be making money on your taxes?” was a common phrase that was thrown about, as people sat in Starbucks, drinking a $4 latte and swapping tax avoidance strategies.
A friend of mine, a Wall Street trader, earned $800,000 in one year. His accountant used aggressive, but legal strategies to postpone all of his tax payment until the following year. And why did my friend want to do this? So that he could use his tax money to buy stock.
His plan was brilliant. Use the $250,000 in his tax account to buy stock, fully leveraged, of course. And when the stock went up, he would sell it, and use the profits to pay last year’s taxes and this year’s taxes. Or, maybe he would look for another loophole to push the tax debt further one more year.
Since a technology mutual fund could gain 190% per year, my friend, and others like him, saw their debts as decreasing in value at a rate of 190% per year.
Unfortunately, for my friend and others like him, a basic rule of both physics and finance is, what goes up, must come down. The bubble burst.
If you use leverage in a stock account, the stock is essentially the collateral securing the loan. This method works great in an upward market. But now, let’s say that your stock drops in value by 10%. You no longer have enough collateral to secure the loan. The loan comes due in the form of a margin call. This basically means, you have to repay the loan, or put enough money into the account to make up the shortcoming in your collateral.
But money — cash — was the one thing none of these guys had. Cash was stupid. Cash was for losers. Cash prevented you from “leveraging,” from maximizing your returns.”
So, how did they make up the deficit in the face of a margin call? They sold stock. But they were now selling it for less than what they had paid for it. So, they had to sell more than what they lost. For some of these guys, the credit card bills, home-equity loans, or whatever crazy credit bills also came due, and now they were in serious trouble.
My friend, the trader, who postponed his $250,000 income tax payment, lost everything. On Wall Street, if you wind up in trouble with the IRS or have any personal credit issues, bankruptcy or foreclosure, you generally lose your license and your job.
The tax debt which my friend believed was decreasing at a rate of 190% wasn’t. Those gains in his portfolio were “paper gains,” not real. But his tax debt was real. Suddenly, he had no money, no job, and a $250,000 tax bill staring him in the face.
Like a recovering alcoholic who could never go near a bar again, my friend needed to find the simplest, most secure, quietest job he could. He started working at the post office. His new salary was $40,000 a year. And he will be paying off his tax debt for the rest of his life.
This would be a good place to end this article. We saw how crazy the bubble was and how stupidly people used credit in America. But sadly, it doesn’t end here.
When technology stock blew up, people went to small cap. When the stock market more or less imploded, people ran to real-estate.
“I can’t believe how stupid we all were with stocks before,” a friend of mine told me. “But I learned my lesson. Real estate is the way to go. It’s safe. You can see. You can touch it. And it always goes up in value.”
This particular friend used his house as collateral to invest in as many condominiums as he could. When last I checked with him, they were still unrented. And in the face of the current trend of foreclosures and lack of consumer credit, I don’t see how he could sell them.
If I had a chance to pull him aside at a cocktail party I would tell him, “I got a hot tip for you, the new, new thing.” Then I would look over both shoulders to make sure no one is listening and tell him the financial secret handed down to me by the film, “The Graduate.”