HOW YOU CAN HELP: DECREASE YOUR CREDIT CARD DEBT
The following is an explanation of what's happening for intelligent people who don't track this stuff -- in the form of an analogy:
There's a fictional town called "Carville", where the majority of people sell new and used cars. All the outlying towns come to Carville to buy cars, because the market is great for cars there -- since that's where everyone's selling their used cars.
Between 2002 and 2007, the five largest car dealers, Al's Autos, Bob's Beauties, Charlie's Cars, Diane's Diesels, and Eddie's Engines, were going gangbusters. They were expanding their inventory, buying up used cars left and right, and even loading a lot of these cars into trucks and selling them in lots to smaller car dealers; that was standard procedure -- the smaller dealers would buy these lots from the ABC dealers (that's what they were called) and the smaller dealers would turn around and sell these "wholesale" cars at higher prices.
Now the Carville town government had a requirement of all sellers. You could only sell cars if you kept at least 1 new car, or equivalent, per 100 used cars. The "or equivalent" was a rule our little town's mayor made that said any car worth $15,000 or more was considered a new car equivalent.
Based on that, the ABC dealers always kept a portion of their cars as new and equivalents, so that they could sell all those cheap used cars that were moving like hotcakes. The dealers even sold car lots to each other based on this sort of new car requirement -- so sometimes, overnight, Al would call Diane and say "Diane, I'm short two new cars for what I have on hand, will you sell me a pair of new cars at wholesale?", and she'd agree -- since Al had 98 new cars in hand for the 10,000 used cars he was holding. She'd charge him a small fee, and everyone's happy -- no problem there, standard business.
Now, someone realized that if you took apart 10 used cars and put the nicest pieces back together again, you'd end up with an "equivalent to new" car -- one that could be counted as part of your new car requirement. So the ABC dealers, since they had the most cars, started chopping used cars as they came in and making these higher value "equivalent to new" cars -- which was cheaper than buying actual new cars -- how great is that?!
Before you know it, they're not only making these "chopped new" cars for themselves, they're selling them to each other for equivalency headcounts as well, and selling them to smaller dealers as well -- there's a whole new kind of car here, and frankly since the value of a chopped new is so much higher than the pieces it's made out of, the ABC dealers were focusing on chopped new cars a great deal.
For five years, it's a wild ride. They realize that they can go after cheaper and cheaper used cars, chop them into just barely equivalent cars, and actually create MASSIVE inventories of new or equivalent cars, so they can go out and get tremendous amounts of used cars -- just vast lots -- Al went from 10,000 used cars and 100 new cars to 200,000 used cars and 2000 (!) "chopped new" cars. He was buying and selling car lots to folks as far away as Indiana -- making money hand over fist ... and nobody ever expected it to end -- because it wasn't some bubble, it was just a great way of doing business.
Then one day, there was a car accident -- and one of the drivers was driving a chopped new car. In the accident, the chopped new broke into pieces and the driver was severely injured. People at first didn't notice, until more chopped new cars started breaking apart in car accidents. See, chopped new cars were great for regular use, but they actually were terrible in a crisis -- they collapsed like a cardboard car, and people were getting hurt badly.
All of the sudden, nobody wants to buy chopped new cars. They're dangerous, they go bad at the worst possible moment and can't survive a crash. So the chopped new cars lost their value. Well ... that meant they were no longer equivalent to a new car -- heck, they weren't even equivalent to a used car. They were rolling junk, worth nothing.
So on a dark Monday morning, the ABC dealers went out and looked at their vast fields of cars, and realized they had a major problem. They had massive counts of used cars (remember Al's 200,000 used cars?) and only a handful of new or equivalent cars. So first, they called each other.
Al called Diane and asked if she had any new cars she could sell him at wholesale -- she replied that she was just about to call him and ask the same thing ... or would he like to buy a few lots of used cars so she can drum up the money needed to get the new cars she needed? Well, nobody had enough new cars. In fact, all of Carville had maybe 150 real new cars and close to 1,000,000 used cars on hand. Nobody was going to be able to afford the tens of thousands of new cars needed to keep Carville alive. Now what?
So -- here's the analogy explained:
* Carville is the Financial Industry
* Each of the ABC dealers is a major Investment Bank (Morgan Stanley, Goldman Sachs, Bear Stearns, Lehman Brothers, and Merrill Lynch)
* The new car or new car equivalents is "Assets on Hand" -- this is a requirement that the Government and lenders have for how much money you must have on hand before you can lend, or borrow money. Clearly, when you go to get a loan, the bank asks you what you have for collateral -- but what you may not know is that the Government won't let banks lend money unless they have a certain amount in cash or cash equivalents -- assets. These restrictions are lower for Investment banks -- but "regular" (or commercial) banks have very strict requirements for how much cash on hand they must hold. (See Reserve Requirements explained for more details)
* The used cars is the loans and other MONEY MAKING methods all these banks and Investment houses had out there. It's the equivalent of how many things in your house you've bought on credit vs. with cash. Imagine if most of your entire home is bought on credit (if that's the case, stop reading and fix that now) -- that's how "leveraged" the banks got. Well, that's how leveraged they tend to be in general -- but in this case the "ABC dealers" were basing it on these crazy "chopped new" cars ... which are...
* The "Chop New" cars are the CDOs (See Collateralized Debt Obligations for more details) that the Financial Industry ("Carville") was slinging around as if they were real assets ("new car equivalents"). The CDOs basically are an armful of debt - and the big monster in this case is consumer debt, in the form of crazy sub-prime mortgages (Mortgage Backed Securities aka MBSs) wrapped up with a bow and treated basically like money. That's great, until we start seeing...
* The car crashes are when individuals started defaulting on their consumer debt. These defaults were getting more frequent -- which forced the Financial Industry to review the MBSs and realize that these MBS "chopped new" cars fell apart in a financial crisis -- individuals with low credit ratings had been scooping up vast amounts of debt, being put into these CDO/MBS securities -- which were then sold to the major banks. When all the bad consumer debtors started defaulting on their crazy loans (those "half-caff with a twist" super sub prime ARM cheater mortgages that sane people avoided), those individual loans made the CDOs that had them bundled, into garbage. All of the sudden...
*The major investment firms realized they had massive amounts of loans out there, and their assets were next to nothing -- they had no capital, they couldn't match Reserve Requirements (where applicable) -- and all they had were giant piles of these useless CDO/MBSs filled with defaulting debt.
So what happened?
Well, to date of this post -- the mayor and government of Carville realized they had to buy all these "chopped new" cars from the dealers, or all of Carville would fall. The hope is that the Mayor's people can fix the chopped new cars, or at least hold them long enough for the good ones to be worth something again.
"But that's going to cost the town $700 Billion", someone shouted.
"Well,", said the Mayor's banker, "if we don't do something, there won't be any more cars to sell, and frankly, without cars, nobody can drive, and if you can't drive, the farmers can't sell their goods, people can't get to the store, and the whole sky will fall. Folks will be trapped on their own farms, living off the land. We gotta do something."
...and where it stands right now is that the Mayor, his banker, and the town elders are all sitting down to figure out how to get this money available to the car dealers so they can get back to selling cars, and unwind this mess.
What happened to the ABC dealers?
* Lehman Brothers (let's say that's Al), failed. They've filed bankruptcy protection (they're not closed, they're just saying they can't pay any of their creditors and need protection until they recover, you'll see them again)
* Merrill Lynch (Diane) found a neighbor, who never got a big piece of the "chopped new" business. See, that neighbor is a truck dealership -- and they're required to have many more new trucks per used truck (let's say 10 new trucks per 100 used trucks vs. 1 new car per 100 used cars). Since they have stricter requirements, they were less exposed, and tended to act more conservatively (usually). Coincidentally, since they're kept in a more strict position and act more conservatively, the town of Carville lends them money at a lower cost (The Federal Reserve System). These are the "real" commercial banks. That neighbor bought her for almost nothing. That neighbor is Bank of America
* Goldman Sachs and Morgan Stanley (Bob and Charlie), went to the mayor and said they'd like to become truck dealers -- primarily in the hopes of getting their hands on that cheaper Carville town lending that truck dealers get. That's helping, but not a given solution. "Old Jack", the smartest man in Carville, sauntered in from his ten million acre ranch and told Bob he'd give Bob some of the money he needed if Old Jack could have a whole bunch of things from Bob (including a 10% dividend, which pays essentially $1.3 million a day). Of course, "Old Jack" is Warren Buffett -- what a great dealer :)
* Bear Stearns (Eddie) died early and was sold to JP Morgan months ago (not to be confused with Morgan Stanley)
But the saga continues -- as the Mayor and his people determine how to deal with this -- Washington Mutual, a "truck dealer" found itself so massively extended in these CDO/MBSs, that they couldn't meet the strict requirements, and the Government seized them and sold them ALSO to JP Morgan
What does the future hold? It's gonna be more expensive to buy a used car for a while (get a loan), because everybody's gotta make money and the prices will go up -- and if the Government does nothing, Carville will go bust and we're all living in our farms alone. How's your farm?
Your Farm:
Your farm is your personal financial status. You should be primarily as debt free as you can be -- your mortgage, if you have one, should be very traditional and the lowest rate you can have -- get out of your credit card debt, period.
Another thing about all of this is where it can get worse. See, there's a LOT of Credit Card debt out there -- and it could make things worse. If consumers are defaulting on their mortgages, then they're also going to default on their Credit Card debt. That's going to create ANOTHER burden on the banks, and make the heavy lifting even heavier.
HOW YOU CAN HELP: DECREASE YOUR CREDIT CARD DEBT
How much credit card debt should you have? (None, but...) If the cash you have can't pay the debt you carry, you've got too much. Stop investing, stop buying, pay off your cards now -- it's how we got here. You want responsibility? Yes, the ABC dealers are responsible, but the extreme credit card debt of consumers is the cause.
To do that is going to take an emotional shift. When you look at your flat screen TV, enjoy it -- don't then look at mine and say "Well, his is bigger, I need a bigger one too." -- stop looking at your neighbors and comparing; just look at yourself and be happy, in other words -- live off the land on your own farm, live within your means.
Bottom line? $10,000 cash is better than $20,000 and $10,000 in debt -- for you, your farm, and our country.
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