David Serchuk, 03.24.09, 06:00 AM EDT
Not all credit is alike. Investors should think twice about using plastic for discretionary items, but remember that all debts aren't bad debts.

This January saw Americans rekindle, in a small way, their romance with credit. As measured by the Federal Reserve, total consumer credit totaled $2.56 trillion, up 0.8% from December 2008. Prior to that, though, the consumer had been on something of a borrowing diet, as the fourth quarter of 2008 saw consumer credit spending fall 3.2% versus the third quarter. November, in particular, saw a steep 4.2% contraction in consumer credit; not coincidentally, November also saw the markets crash and market volatility skyrocket.

The catalysts for such savings are clear: market volatility and fear. When people are unsure about the future, they run for the banks. As measured by the Bureau of Economic Analysis, Americans' personal savings rates topped 3% in the fourth quarter of 2008, the highest its been since the third quarter of 2001.

Back in the third quarter of 2001, a few factors converged to motivate people to save out of fear. The obvious are the terrorist attacks of Sept. 11, 2001. But what most people might not know is that markets were afraid even before the bombings. On Sept. 10, the CBOE Volatility Index (VIX) was at 31.8, quite high, as anything above 20 is considered excessive volatility. By the time of the next VIX reading, Sept. 17, the index spiked to 41.8, and it topped out at 43.7 on Sept. 20, right around when the market experienced its bottom for the year.


Today we are experiencing similar savings rates, in addition to high levels of market fear. Until Jan. 9, the market bottom for the past five years has been on Nov. 20, 2008, when the VIX hit 80.9. Late 2008 also saw people running to the banks, despite the irony of a bank meltdown being one of the main factors in why people were so afraid of markets to start with.

But the multitrillion-dollar consumer credit market isn't going to truly shrivel soon. Indeed, it seems to move in lockstep with spending, as January saw U.S. consumer spending rise 0.6%, nearly inline with the increase in consumer credit. The consumer may be fearful, and they may even be saving, but the death of borrowing is premature.
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With this in mind, we asked the Forbes.com Investor Team how consumers should best use credit. After all, it can be enormously useful when it comes to financing homes and educations. But you might want to pay for that second flat-screen TV in cash.

Ken Shubin Stein, founder and managing member of Spencer Capital Management, says homeowners they should be prepared to put down 20% deposits; anything less and they shouldn't get a mortgage. He also advises against using credit to get a car. If you can't pay upfront, you should either get a cheaper car or buy it used.

Marc Lowlicht, head of the wealth management division at Further Lane Asset Management, recommends consumers use a credit card for financing purchases, but not as actual credit. He also noted that many of the people now being trapped by bad credit payments failed to plan. They didn't have enough cash and became overextended.

But P. Brett Hammond, chief investment strategist for TIAA-CREF Asset Management, sees things from a slightly different perspective. While it's commonplace to look at consumer credit issues from the demand side, he sees it from the supply side. During most of this decade credit was all too available to nearly everyone, leading to inevitable gorging. It couldn't happen any other way.

This observation lead to the most fruitful part of the discussion, as Shubin Stein, a medical doctor as well as an investor, noted that certain investment products are designed to act as the financial equivalent of high fructose corn syrup; i.e. a product known to create demand instead of sate it. What we ended up with, in a sense, was the monetary version of our national obesity epidemic.

One thing investors should know are the credentials of those pushing the credit. For example, mortgage brokers are pushing a product, not giving financial advice. Investors also need to know how their advisers and financial planners are paid.

Investors also need a good, healthy dose of financial self control, because even if credit is too easy, we allow ourselves to fall prey to it. Lowlicht says that telling investors "no" is often the hardest part of his job. "I think there are too many people in the business who give the client what they want, so they continue to be a client and they're placated," he says. "For the clients who are not going to listen, you are not doing them justice by giving them what they want. Because you're going to harm them more over the long term."

Credit Rules

Forbes: What should be the role of credit for the small fry? Should we borrow money for mortgages? For college? What about for investing? What are sound uses of credit for individual investors?

Marc Lowlicht: I believe that would be a client-specific question, depending on the client's circumstances, and you know, their liquid funds. And what they'd be using their other assets for. And the cost of borrowing for each individual. You know, I mean, obviously college loans, depending on whether they're subsidized or not, are fairly standard.

So, it's going to be across the board. You know, a mortgage is going to depend on your credit rating and the terms of the mortgage. So, I believe that if you're going to look at who should have credit, and who shouldn't, versus what--you really need to consider the client you're dealing with, the age, their income, their cash flow, their credit rating, the cost of credit, vs. other sources, uses, sources of capital. I would say that would be the first step in determining any of that.

Credit cards, I think, should almost never be used for consumer credit. Outside of that, the other forms of credit, I believe you should pay off the balance, obviously, immediately. But consumer credit, I think, to buy a TV on credit is ludicrous. If you can't afford it, wait.

Ken Shubin Stein: My opinion on credit is, if you need to use credit for your home, if you can buy a home and put down 20% and take a 30-year fixed rate mortgage, then that's an appropriate use of credit. I personally think people should try to avoid, unless they have to, buying a home that they can't meet that criteria for. Because if they need more lenient types of mortgages with earlier teaser rates or different structures that allow them to own the home, then they're essentially engaging in types of investing and decision making they may not be aware of, and putting themselves at risk for catastrophic outcomes they may think of as very improbable. But in today's environment, we've certainly learned, everybody's learned that very unlikely but severe outcomes do happen a few times over a lifetime.

So, credit for a home and for college, or other types of education, if necessary, seems perfectly reasonable. And I personally think people should avoid using credit in all other circumstances. I don't think people should finance cars unless they have to. And if you need a car to get to work, and the only way you can do it is to finance it, then you have to. But I would recommend to people that they buy a less expensive or a used car before buying a new car that's financed.
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I also don't think people should ever have credit card debt. You should have credit cards, because you need them for emergencies or for unforeseen circumstances. But I believe that's the purpose of credit in a day to day life. Try to have a great credit rating, try to have credit availability, so you have availability to borrow when you need it. But don't use it unless it's absolutely necessary. And then pay it off and get back to not having it. Because it's really a safety net.

Brett Hammond: Well, I could kick in a different perspective on this. These have been terrific comments from, in essence, a demand side. And they stimulated me to think about the supply side, as well as a macro view. From the supply side, I think that we have to add that in, in the sense that, the decision about credit is certainly up to the individual, you know, with advice. But the supply of credit does create demand. We've seen that happen in the last few years--the explosion of credit availability. And so, in many ways, the decision about credit is in the context of: Is credit tight or easy? And when it's easy, you can't necessarily depend on people to be their own best advisers.

And you can't depend on people to be able to hire somebody or to figure out how to get somebody who's going to tell the kinds of wonderful advice we just heard. So, I think that's sort of one aspect to it. You know, credit gets pushed, it doesn't just get pulled. So, the second thing is the macro question. Which is, that credit is great for the economy when times are good. The economy expands, etc., etc. And now we're seeing the other side of it in the sense that, as credit contracts the whole economy falls apart.

And so, in a macro sense, if everybody were to stop buying cars on credit, as they have, if everybody were to stop taking out credit card debt, which they should, I don't disagree. We have had a huge economic contraction and a bad economic situation for quite some time. And I think we're experiencing that.

So, I guess the summary of what I'm saying is, and I think I pointed out, that there are enormous dilemmas from the point of view of the supply side and from the macro point of view to taking a much more conservative attitude toward credit. Which many individuals should do.

Shubin Stein: Is that a version of sort of the paradox of the thrift concept?

Hammond: Exactly. What we've seen in the last few months is the savings rate skyrocket. I mean, in the American context the skyrocketing is now 3% to 5%. Whereas in the Chinese example, it's a 40% household savings rate. We all think that's great. Oh my gosh, we're actually saving again. Of course, the problem is that means we're not spending. And the consumer has been 70% or more of U.S. gross domestic product growth.

And so, if the consumer is spending less, then we're putting a big hit on our GDP. And that's basically the paradox. Individuals should save. Right now, in order to keep the economy going or to keep it from falling further behind, in a macro sense, we shouldn't be saving.

Shubin Stein: But don't you think, as a follow-on concept, clearly we've had a very abrupt transition. Kind of like, we were driving a car at 100 miles an hour and then we slammed on the brakes. And the car at 100 miles an hour represents people borrowing a lot of money to buy things they couldn't afford, and not saving for inevitable, but unexpected, problems.

For instance, significant health care costs. And unexpected health care costs are one of the big contributors to people going bankrupt in this country. Unexpected job losses combined with health care costs lead to people losing their homes and other sort of very uncomfortable and painful things that are occurring now. But if the car never got to 100 miles an hour, because we didn't finance so much of our consumption with debt instead of saving it, do you think it would've been easier and a better long-term policy in any case?

Lowlicht: I agree with that. I mean, I feel that we had this conversation at a roundtable not long ago. People don't plan. They're reactive more than anything.

So, you change the way you handle it. You know, there are certain figures that are utilized that determine what's an appropriate amount of credit based on your net worth or your income. And they've been standards for years. People treated them almost with disregard when credit got cheaper. If people had planned for this, people wouldn't be suffering as much. The massive unwinding you're seeing is for people who didn't have enough of an emergency cash cushion, overextended themselves and didn't prepare properly.

Shubin Stein: Well, in fairness, those people got bad advice, too. Because people thought mortgage bankers were actually giving them advice, as opposed to selling them a product. And you know, famously, mortgage bankers don't have any duty of care to the consumer, right?

Lowlicht: Yeah, and I'm noticing this in the current environment. In environments like today, even though you're providing advice that's appropriate for the client, you receive a good amount of resistance. Because they feel like it's not working currently. And it isn't. But what tends to happen with a lot of people in the business is--because a lot of people in the business are compensated by commissions rather than fees--there are a lot of people in business who are trying to just hang on for whatever they can to keep the business alive, and instead of doing what's best for the client, they do what the client wants. And that's not always what's best. It's almost like going to your doctor, and your doctor saying, you should do this. And doing the opposite, because you don't want to.

Hammond: I think the medical analogy is really a good one. Because when you were talking, it made me think I completely agree with you. It made me think about obesity in America. You know, most of us are not as fit as we'd like to be. And we all know what we'd like to be. But when we see the availability of things that we shouldn't eat, and the not just the types of things but the amount of things. Some of the theorists have, in the medical field, been talking about how it isn't just willpower. It's the fact that there's so much stuff around, compared to you know, 50 years ago, or compared to other countries. That we gorge ourselves. And we've gorged ourselves on credit because it was so available.

Shubin Stein: We did. And I think a very fair analogy between the medical world and the obesity, specifically the obesity argument and the lending argument, I think are really good analogies. Because our brains are wired to crave certain things, right? So, if there are certain types of chemicals in foods, that will stimulate overeating. We know that. Like, high fructose corn syrup directly stimulates overeating. And similar to your argument about, you know, pushing credit vs. pulling credit; if we offer people lots of credit with terms that are opaque at best, they're going to use as a group, as a population, we will use that credit. And probably unwisely, right?

So, I think one of the most helpful things we can do as a society, because we don't want an Orwellian society where people dictate precisely what we're doing, but I think truth in lending is a really important concept, right? Having people really understand the impact of the difference between an adjustable rate mortgage with the teaser rate, and a reset pause vs. a fixed, certain payment over 30 years.

I think the No. 1 way to judge human behavior is to look at incentives. Where are the incentives in the system? And part of the trouble with finance, part of the problem people are having interacting with the financial system is, incentives are often not clear to people.

We could, as a system, make it much more explicit. Where people know when they're interacting with a mortgage broker, or a real estate agent, or a wealth manager of some type, you know, exactly how do we get paid. And I think if we make it very clear to people exactly how we get paid, they can make better decisions, because they'll at least understand where the incentives lie.

Lowlicht: The hardest part in our business is to consistently continue to provide advice, especially during stressful times. And for the clients who are not going to listen, you are not doing them justice by giving them what they want. Because you're going to harm them more over the long term.

Forbes