What to do with all that debt?
As the amount of money Americans borrow increases, it raises questions – big and small – about what you should know and do.
Debt seems to be everywhere these days, from a now-ebbing tide of home loans to last year's record wave of personal bankruptcy filings. So perhaps it's not surprising that an organization called the Chicago Debt Exchange is launching its first official auction this week.
Think of it as something akin to the New York Stock Exchange or the Chicago Mercantile Exchange, except what's for sale isn't stocks or wheat contracts, but loans.
Wednesday's auction focuses on debts that have gone bad – more than $500 million in all – being sold off by the US Bankruptcy Court's Northern Illinois district. Buyers will try to collect enough of the debt to turn a profit.
In itself, that's nothing unusual. In today's economy, good debts and bad alike often change hands from the original lender to a range of investors. What the debt exchange hopes to be is a new venue for such trades – using a transparent format familiar in financial markets worldwide. "It creates excitement. It creates urgency," auctioneer and exchange founder Joel Langer says of the open-outcry system. Just as in a commodity trading pit, he says, "something sells for what it's worth."
The fledgling debt exchange may never rival the scale of Chicago's commodity markets, but it hints at a conspicuous fact: For better and for worse, America has an increasingly expansive culture of debt.
As credit has become more liquid – easily transferable from one party to the next – it has also become cheaper and more available to a wide range of consumers. That has helped a record 69 percent of families become homeowners in the US. It's also helped fuel a housing boom and resulting rise in family wealth in recent years.
But the availability of credit has also lured millions of people into a debt trap. Some have borrowed on credit cards to pay basic expenses. Many have bought homes using exotic mortgage setups that could backfire – some of which have already done so – in today's environment of higher interest rates.
All this raises three important questions for ordinary Americans who spend, borrow, and invest: Is the nation in danger of a debt-induced recession? How can you avoid becoming a statistic in a bad-debt sale? Does rising debt present new investment opportunities?
Here's what some experts say about these credit quandaries:
With about $9 trillion in outstanding home loans and $2.2 trillion in other consumer credit, a key issue for the economy is how much the squeeze of rising interest payments affects household spending – which makes up more than two-thirds of the nation's economy.
"You will have a weaker economy" as some of the debt-driven consumption of recent years unwinds, says Christian Weller, an economist at the Center for American Progress in Washington. "I wouldn't go so far as to say there will be a recession, but some economists definitely do."
He points out that rising home values allowed consumers to cash out $430 billion worth of spending power from home-equity loans in 2005.
Most forecasters see the economy merely downshifting, not heading into reverse as the housing boom ends. Many say that America's credit culture is more an economic strength than a weakness. "Well-developed financial markets, and thus ample consumer and business credit, is one of the big reasons why the US economy is so strong in comparison with other economies around the world," says Gina Martin, a Wachovia Corp. economist, in an interview by e-mail.
For all the growth of borrowing, household net worth has been rising. The median family's assets exceeded its liabilities by $93,000 in 2004, up from $71,000 in 1995, according to Federal Reserve data released this year. Debts are up, too, but people are generally borrowing to buy homes or pay for college educations – both of which can be long-term sources of wealth.
Nearly 1 in every 100 US households filed for bankruptcy last year, as debtors rushed to avoid a new law that makes it harder to win protection from creditors. Meanwhile, the percentage of home loans that are past due has been edging up for several years, to about 12 percent of all FHA mortgages.
Debtors' prisons are a thing of the past, but financial and legal hardship for the overly indebted isn't. Experts say the first line of defense is to curtail spending on credit. Build up some savings for financial emergencies. Understand the fine print on loans.
"Compare rates," urges Mr. Weller. "A lot of people don't understand that the credit-card market is extremely competitive."
If you do fall behind on payments, state and federal laws may help you resist abusive collection efforts. Debt collectors are not allowed to contact you at unreasonable times and places, such as between 9 p.m. and 8 a.m. The federal Fair Debt Collection Practices Act also provides that a collector may not use threatening or obscene language. The collector must send written notice of how much you owe, to whom, and how to dispute the amount if you believe it is incorrect.
"There are small investors that have gotten into the debt industry," says Langer, the auctioneer. But buying and selling loans on his exchange would require a good bit of homework. "You want to know what you're buying," he says, "and you want to know who you're buying it from."
Many of the bidders will be companies or investors who specialize in nonperforming debt.
For those not interested in starting their own collection agency, there are other more common ways to invest in debt.
The most tried-and-true way is buying bonds – generally the debt obligations of governments or corporations. Debts sold by the US Treasury have yields ranging from 4.7 to 5.1 percent, depending on their duration. Corporate bonds can pay 6 percent or so, but with higher risk of default.
Investors can also tap into household debt – mortgages. Mortgage-based mutual funds have outperformed intermediate-term government bonds this year. And for all the volatility in the housing market these days, analysts say these funds can be surprisingly stable. That's because the payment of their mortgages is often guaranteed by the Government National Mortgage Association, or Ginnie Mae.
"These funds tend to hold up pretty well in rising interest-rate environments," says Scott Berry, an analyst at the investment research firm Morningstar Inc.