Dealing with debt: Sonoma County consumers take advantage of endless supply of money to borrow

It used to be hard for a consumer to get a loan and go into debt.

Old-timers may remember the complaint, “You can’t get a loan unless you don’t need one.” You had to prove to your local banker that you’d have plenty of money to repay a loan before your banker would give you one.

Now it seems like you can get a loan as long as you’re breathing.

“BAD CREDIT CAR LOANS, Submit in 60 Seconds!” CarsDirect.com advertises. “Bad Credit? We can help! No Credit? We can help! Good Credit? We can help! Past Bankruptcy? We can help!”

Last year, Sonoma County households had debt levels that were almost double those in much of middle America and 30% higher than California as a whole, according to the Federal Reserve. Notably, local borrowing for houses, cars, credit cards and other purposes still was half what it was at the time of the 2007 to 2009 downturn, led by a big drop in mortgage balances.

“It seems like people just sort of go along and don’t really sit down and look at their budget. One reason is because it’s so easy to get credit,” said Craig Burnett, a bankruptcy attorney in Santa Rosa since 1988. “My grandparents would put money in different folders to budget it out. But it’s a consumer-driven economy we have now. It’s a different generation.”

What drives such borrowing? Low interest rates at times are one key reason. Laws to encourage homeownership, like letting homeowners deduct on their income tax returns the interest they pay on their mortgage, are another.

But an important reason is this: Shadow banking.

What’s that?

In the old days, banks approved a loan and held onto it until you paid it off. That was called banking.

Now banks pool thousands of loans together and sell pieces of that loan pool to investors. That’s what economists and financial analysts often call “shadow banking.” Not that it’s somehow suspicious, but because so much of the transaction happens outside banks and is hard to see. Others, worried that “shadow” is a pejorative word, prefer to call it market-based or nonbank finance.

In shadow banking, investors get the monthly payments consumers make on loans, happy to know they will probably keep repaying.

And the investors can also make even more money on loans by using the pieces of those loan pools to trade on Wall Street.

For example, some of them use the pieces, called securities, as collateral to get billions of dollars of loans for themselves. It’s like they’re taking their securities to a pawnshop for a loan. Many of these are overnight loans that must be repaid the next day, and the investors use the loan money to make overnight bets on Wall Street.

Put another way, every day investors borrow about $500 billion on Wall Street using pieces of loan pools as collateral, according to the Federal Reserve, and then they can use that $500 billion to place quick, overnight bets on Wall Street.

That means your loan can make lots of fast money for these investors. So they need consumers to borrow lots of money.

Who are the investors? They are financial institutions with money, lots of it. Sometimes they get their money from consumers.

They include: hedge funds, megabanks, large businesses, mortgage lenders, investment banks, money market funds, mutual funds, pension plans, insurance companies, states, municipalities, university endowment funds, certain community banks and others.

Seeing this opportunity, thousands of companies that are not banks, cleverly called nonbanks, have become lenders so they, too, can make pools of loans and sell pieces to these investors.

These nonbanks include lenders like Quicken Loans, the second-largest home lender in Sonoma County; SoFi, which makes online personal loans and has an office in Healdsburg; and Ygrene, a Petaluma company that makes loans in California, Missouri and Florida for homes and commercial buildings to become more environmentally sustainable. All three have been both praised and criticized for their lending.

Shadow banking now accounts for about 80% of U.S. lending, up from 40% in 1980, with traditional banking doing the rest, according to the Federal Reserve and the Securities Industry and Financial Markets Association. Data for Sonoma County is not available, but the global nature of 21st century banking suggests the profile is similar locally.

One more point about shadow banking: It has created an endless supply of money for consumers to borrow.

Here’s how: When investors buy the pieces of a loan pool from banks or nonbanks, the banks and nonbanks use that money from the investors to make more loans to consumers. And then they use your new loans to make more loan pools and pieces, to sell to investors, to get more money, to make more loans to you, to make more loan pools and pieces, to sell to investors, and so on.

And there you have it, a seemingly perpetual-motion money machine that defies the laws of physics to create wealth. No longer do consumers have to beg bankers or lenders for a loan. Now bankers and lenders beg consumers to borrow.

Lending machine

This machine, called a securitization machine because it turns loans into securities, has opened doors of opportunity for millions of people with lower credit scores who could never have gotten a bank loan. It provides money for people to buy houses and cars, pay for college, start small businesses and buy stuff they need and want.

But easier credit creates temptations that can destroy the lives of people who borrow more than they can repay. Especially vulnerable are people who don’t understand personal finance, haven’t learned to budget and don’t realize how saving can enrich their options in life, financial advisers said.

“Sometimes debt is an investment, for an education, for the right house. It can help push your life forward. But make sure it’s a maintainable, manageable amount, and (you) have savings,” said David Lawrence, an investment adviser with Willow Creek Wealth Management in Sebastopol. “It’s so easy to go into debt and suddenly there you are, and it’s tens of thousands of dollars, and you’re stuck for years. Debt is unrelenting.”

And there are other problems.

• When your loan is put into a loan pool and sold to an investor, it can be hard for you to negotiate lower payments when you’re in danger of default. Calling your local banker that used to hold loans won’t help.

• Shadow banking, which involves multiple financial transactions, worldwide institutions and traders on Wall Street, is a key reason financial crises today engulf whole economies instead of just a few banks. For example, the 2008 worldwide financial crisis was triggered when some big investors like Lehman Brothers could not pay back their overnight shadow loans.

• Shadow banking can drive up prices and costs. Homes, vehicles, college tuition, all have seen costs soar in part just because people can get the money, economic studies have shown.

Shadow banking has existed in the financial markets for decades. But it dramatically expanded to Main Street America in the 1990s when advanced computers made the complex transactions possible and Congress and the states deregulated banking.

Because bankers and nonbanks want to attract investors, they make loans that can favor investors over borrowers. Here are some examples:

Student loans: Most loans to college students are made by the U.S. Treasury and the American taxpayer. That federal program is losing money and it’s cutting back on lending. But student loans made by private companies and shadow banking are profitable and booming, up 42% in the past five years while federal loans fell 16%.

The increased private lending has helped many students reach their dreams. But at the same time, the number of students graduating with debt and unable to make payments has “soared,” according to the Federal Reserve, especially at for-profit colleges.

That’s a key reason Congress decided in 2005 that private student loans cannot be forgiven in bankruptcy, with a few rare exceptions. Congress wanted to protect lenders from student defaults and encourage lenders to do more student lending.

The result is that unpaid student loans are usually a lifetime burden that will never, ever go away.

Vehicle loans: Auto lending has risen steadily since the financial crisis, from $353 billion in 2008 to $612 billion in 2019, according to the Federal Reserve. About a quarter of the 2019 loans were pooled and sold to investors, the Wall Street Journal reported.

One reason for the surge in auto lending was the rise in popularity of the seven-year loan. About a third of loans for new vehicles approved in the first half of 2019 had terms of longer than six years, according to the Journal. A decade ago, that number was less than 10%.

Some car buyers prefer the longer loan because it lets them get a more expensive vehicle with lower monthly payments than traditional five-year loans. Investors like the longer loans, too, because longer loans have higher interest rates for a longer time, including an even higher-rate variety for borrowers with impaired, or subprime, credit.

But borrowers have to pay thousands of extra dollars over the seven years. And as cars depreciate for seven years the owners can end up owing more than their car is worth.

Credit cards: Investors are also happy to finance credit card debt, in which the average interest rate was 16% in mid-August for consumers with a good credit score and 24.4% for consumers with lower credit scores, according to CreditCards.com. By comparison, interest rates on a home loan hovered around 3%.

Opportunity and risk are rising

The securitization machine drove the mortgage mania in the early 2000s. Then, for a decade after the financial crisis in 2008, lenders and borrowers were cautious.

But in the frothy economy just before the COVID-19 pandemic hit early last year, some of the Wild West lending reemerged.

Yes, the mortgage market is more subdued than it was 15 years ago, said Ann McGinley, a retired Santa Rosa mortgage broker who teaches continuing education classes for real estate agents. Home lenders are actually verifying incomes with the IRS before making a loan. Borrowers still remember the financial crisis and don’t want to repeat it. Regulators are tougher.

But the number of subprime borrowers is rising, though still low compared to mortgage mania days. By the end of last year it was almost double what it was in 2013, according to National Mortgage News. Risky loans with balloon payments, negative amortization and no income verifications are creeping back.

McGinley is taking precautions. “When I teach real estate agents, I like to tell them that the very last part of the sales transaction is to be at the signing table and pay attention to the terms of the mortgage,” she said.

It all reminds her of the worst day of her life.

In 2005, a Latino couple chose a loan offered by another broker over the loan McGinley urged them to take. The loan they took was a negatively amortized, adjustable-rate mortgage with low introductory payments. It allowed the couple to make small monthly payments for a while, but their loan amount went up every month.

“They were making minimal, less than interest-only loan payments and did not understand their loan balance was increasing each month,” she said. By 2008 their mortgage payment had nearly doubled, their loan balance had increased and their property values had fallen.

“’Señora, we should have listened to you,’ they told me, and I couldn’t help them,” McGinley said.

Mary Fricker is a retired Press Democrat business reporter. You can reach her at mfricker@sonic.net.