Economic Stress and the Middle Class, Part III

July 2014
Ivan Obolensky

Previously (in Part I and Part II) it was determined that a family must receive an annual income in the top 20% of the population (minimally over $105,000) to be part of the middle class.¹

One of the reasons cited for this was the fact that real wages (the buying power of the money after inflation has been factored in) have remained virtually unchanged since 1972. This means that in spite of increases in salaries, the amount of goods those salaries could buy remained the same while expenses, in general, and education and medical in particular, put the squeeze on the middle class quality of life.²

Although significant, these factors do not make up the whole story. One key expense that was not present in households of the 1970s but is widespread today is the cost of borrowing per household. Family debt levels are far higher today than at any previous time. The problem with debt is there is a cost to borrow and that has been a deciding factor for the middle class family of today.

Let’s do the math:

With real wages virtually unchanged for some forty years and all expenses increasing, is it any wonder that:

It takes a higher income today to afford what was easily afforded twenty or thirty years ago.

Households that are not able to increase incomes resort to one of two solutions:

Cutting back on expenses and lifestyle.
Going into debt to support a lifestyle that can no longer be afforded.

Many chose 2.

The two major interest expenses a typical family has are mortgage interest and credit card interest.

Credit card interest has been particularly egregious and to understand why this is so, it is necessary to understand some further banking history.

One of the byproducts of the inflation fighting actions of the eighties (US inflation having peaked around 15% in 1980) was the Savings and Loan Crisis. Banks had lent long term at 5 and 6% but needed to pay out at 18% to retain deposits. The result was squeezed banks and numerous bank failures.

After the debacle, many banks retooled their processes by supporting the formation and creation of new markets for mortgages and other interest creating products. By using these avenues, banks were able to manage their risks and balance sheets. Selling their mortgages meant they could mitigate the risk of owning assets that went down in value when interest rates rose as they did in the late 1970s (interest rate risk).

Secondly by selling the mortgages for cash they replenished their balance sheets allowing them to make more loans.

In addition, “financialization”, the placing of a value on tangible and intangible assets, created many new places to park funds and further avenues to transfer risk away. (A credit default swap is one such device. See article The Story of Modern Finance.)³

Further, banks lobbied for and got reforms in the banking laws that allowed them to invest in any financial instruments they wanted which meant they could gather better returns from their deposits.

The end product of this process was a banking system that was in better shape and able to take on far more leverage than ever before.

In summary: Banks were able to reduce one type of risk (interest rate risk) by selling loans which allowed them to take on and increase another type of risk, (default risk) by investing in riskier assets with their deposits. Ultimately this led to the 2008 crisis; but prior to that, as the banks made more and more money, the question of what to do with all of it became a greater and more difficult problem for them.

Interest rates rise when there is a scarcity of money. With banks flooded with funds, interest rates continued to go lower. (Think of money as a commodity. If there is a lot of it around, it costs less at the store, just like tomatoes in season.) The consequence was that banks had to spend more and risk more in order to get the same returns they had the year before. It is one thing to loan out a billion dollars at 10% and quite another to have to loan out 3.3 billion at 3% to make the same amount of income.

In addition to this, banks had a new and extremely lucrative means of making money: the credit card and this meant that banks which were already in good shape financially struck the mining equivalent of a bonanza.

In 1980 with inflation at 15%, loan rates of 20 and 25% were not uncommon and were justified by the high inflation component that determined the interest rate level.

Loans usually come in two forms: term, having a fixed time to pay, and revolving. Revolving loans allow one to borrow up to a set limit. There are no particular time limits as to when it will be paid back. One simply pays interest on the principal for the privilege of borrowing. Revolving credit, because it is open-ended, has a correspondingly flexible interest rate structure and was the basis for the credit card.⁴

The first modern credit card system was developed by Bank of America in 1958. In 1977 it changed its name from the BankAmericard to Visa. MasterCard was formed in 1966 by a group of banks that decided to compete with BofA. MasterCard received a boost when Citibank merged their credit card in with them. ⁵

It took years to put the credit card infrastructure in place, but once it was there almost every bank discovered it was possible to create their own credit cards using either the Visa or MasterCard system. The result was a nuclear blast of credit expansion.

By the 1980s credit card interest was in the high twenties. By the 1990s, inflation had peaked and was on its way down to 5% and by the year 2000 inflation was under 3%.

For various reasons, the fact that it was revolving credit with no set term limit and perhaps that credit cards were marketed as a privilege, interest rates on this debt were not adjusted down to reflect the drop in inflation. They held constant at the high inflation level.

In addition to the interest charged to customers, merchants were also charged anywhere from 1-4%.

With each delay in adjustment and the more cards that were issued, credit card debt became the most lucrative instrument possible given the amount of risk taken.

To put this in perspective, by the 1990s many AAA customers were paying rates that historically would be paid by only the worst subprime customers (well over 20%). In any other time it would have been called fleecing..

Credit became easy to obtain. It is my view that when economic historians look over the credit card boom of the 1980s and 1990s and the regulatory changes to the financial industry, they will conclude that the excess liquidity generated by these actions fueled the Internet bubble, the housing bubble, as well as China’s “miracle”. The latter might seem a stretch but how else was the demand for goods that was unleashed by all that liquidity able to be fulfilled without prices rising astronomically? Remember the credit card boom was not restricted to the US; it was worldwide.

In addition, the Federal Reserve ensured that the spread between long term rates and short term rates was large so that banks that made loans were able to lend at high rates and pay out low rates to depositors.

The amount of money coming in was almost too large to spend.

As an aside, it is worth wondering where all this money came from.

It may sound odd but this money came from the future of the middle class.

By taking cash out of houses and spending it on the present. By taking on revolving debt in the form of second mortgages and credit cards, the future value of assets such as homes and the future income of wage earners was tapped into the present and spent. Is it any wonder now that the middle class is shrinking? It has disappeared into the past by taking away its future.

By the year 2000, markets for mortgages had been well established so that it was possible to offload them as fast as they were created. All that was needed now was a way to ensure that there was a simple means to determine credit quality to simplify the process further.

The two pieces of the puzzle were the rise of the credit score which was aided immeasurably by the use of the Internet, as well as a financial device called a Tranche. Tranche is a French word for slice and is a now a mainstay of what is called structured finance.

A Tranche is one of a number of securities that are offered as part of the same loan. Tranches make up a deal’s capital structure.

Suppose I decide to borrow $10,000 from my bank. (Deals are usually quite complex and for much larger amounts.) The bank gives me the money but decides it wants to reduce its risk. It can do this this by selling the loan it made to me to someone else.

An alternative is to break up the $10,000 into four parts called Tranches labeled A, B, C, and D.

Each month I pay $100 on the loan. The owner of each Tranche, therefore, should receive $25.00; however, the new security created by the bank stipulates that Tranche A gets first dibs on any payments followed by Tranche B, C, and D in that order. It is like a waterfall and the section of the loan agreement that outlines this part is called the Waterfall section.

If I make a partial payment of only $50 then only Tranche A and B get paid. Tranche C and D are out of luck. If a second month goes by and I make only half a payment, Tranche A and B get paid but not C or D.

This means that Tranches A and B are higher quality than C or D and because these Tranches are considered lower risk, the bank can stipulate that the buyers of Tranche A or B will receive $15 and $20 each month. Correspondingly, Tranches C and D are riskier because they are last in line and the buyers of this paper need to be compensated more by receiving a higher payment of $30 and $35 respectively. When all is said and done the same amount of money that I pay in is paid out to the four tranches but not in equal measure.

The bank has taken my loan and created four smaller ones that it will sell to customers each paying different amounts of interest depending on whether it is Tranche A or Tranche D. The bank will take care of the breakdown of my payment to the new owners of my loan so I do not see this but chances are in the fine print I signed to get the loan there is a clause allowing the bank to sell my loan to another party.

The Tranche structure has created a higher credit quality instrument as well as a lower quality loan. With this new loan structure, my bank can sell Tranches A and B to those needing higher quality investments (like another bank or retirement fund). They can also sell Tranche C as a higher risk loan but make it enticing by making it pay more and keep Tranche D, the riskiest of all, in its own portfolio and have it pay the most.⁶

If the bank did a proper loan review, the high interest portion they retained will not be a problem; however, it was realized that this type of capital structure was an excellent way to tap into substandard or subprime loans en masse. The thinking was how likely is it that all 1,000 of a batch of 1,000 loans would default at the same time?

Remember banks can’t simply hold cash. They have to use it and in a low interest rate environment it is necessary to take on risk in order to earn anything at all.

Of course if this is done many times over, there will be a large number of Tranche D’s tucked away somewhere and it is easy to understand a bit more about the crisis of 2008 and why the Feds had to take large amounts of bank paper and return US Treasury bonds instead.

Perhaps it is easier to see at the end of this series that what trapped the middle class into compromising its future by spending in the present was an endless campaign to get people to take out credit lines and use them.

We can also understand a bit more clearly why it takes more income than ever before to live comfortably.

This phenomenon is not restricted to the US alone, but is likely present wherever the middle class finds itself shrinking and under pressure.

As to what can be done?

Understand credit and how to use it effectively. There are times to use it and times not to. Supporting a lifestyle that is increasingly under pressure is not one of those times.
Understand real income and what it means. If possible work to increase it.
Understand that eventually rising fixed costs can tip over even the most balanced and prosperous apple cart.
Reducing fixed costs means more spendable income and an easier life.
Becoming more efficient can reduce fixed costs.

I hope you found this helpful.

1. Table HINC-06. Income Distribution to $250,000 or More for Households: 2011. Retrieved on May 12, 2014 from http://www.census.gov/hhes/www/cpstables/032012/hhinc/toc.htm.

2. Thomas, K. (2012, March 12), Basics: Real Wages Remain Below Their Peak for 39^th Straight Year. Middle Class Political Economist. Retrieved on May 12, 2014 from http://www.middleclasspoliticaleconomist.com/2012/03/basics-real-wages-remain-below-their.html.

3. Turbeville, W. (2013), Financialization and a New Paradigm for Financial Markets. Retrieved 13 June 2014 from http://www.demos.org/sites/default/files/publications/Tuberville.pdf.

4. Mayo, H. B. (2008) Investments: an Introduction, Mason, Ohio, South-Western Cengage Learning

5. Simon, J.M. (2007) Visa: A short History. Retrieved 13 July 2014 from http://www.creditcards.com/credit-card-news/history-of-visa-1273.php.

6. Coval, J., Jurek, J. and Stafford, E., (2008) The Economics of Structured Finance. Retrieved 13 July 2014 from http://www.hbs.edu/faculty/Publication%20Files/09-060.pdf.

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