R.C. Lim, Attorney and Counselor at Law

Why Smart People Make Big Money Mistakes

There are two things that I have noticed in speaking to clients contemplating bankruptcy.
1. They are exceedingly intelligent and well-educated, and
2. They are exceedingly honest and good people who are concerned about the ethical implications of bankruptcy.

Here, I only mean to tackle the first issue. There is an issue, which is hard to understand, which is how very intelligent folk can arrive at money trouble. Perhaps this is not such a hard question.

But there is a book, inspired by the work of recent behavioral economists, that seeks to understand “Why Smart People Make Big Money Mistakes,” by Gary Belsky and Thomas Gilovich. It’s a great read and worth a few hours of your life.

The key points of the book:

• Every dollars spends the same.
• Money that’s spent is money that doesn’t matter, or the sunk-cost fallacy.
• It’s all in the way that you look at it the decision, or “code it” in your brain.
• It’s hard to admit mistakes.
• The trend may not be your friend.
• You can know too much.

These points, copied exactly from the language of the book, are the take-homes, but as you can see, they mean very little without the explication they receive. The book proceeds from the history of economics to the work of Tversky and Kahneman and their insights into how people really make economic decisions. That is, why do people make irrational — non-wealth-maximizing — decisions? And how do those patterns affect common personal finance mistakes?

The personal finance take-homes, however, are perhaps even more valuable.

They are as follows:

• Raise your insurance deductible. (Because you should plan on never needing your insurance!)
• Self-insure against small losses. (Because insurance companies are for profit businesses!)
• Pay off credit card debt with emergency funds. (Why? Because 30% is usurious is why.)
• Switch to index funds. (Because a monkey could do better than your mutual fund manager. Okay, okay that’s mean. I mean to say only that the monkey who passively manages the mutual index fund charges less than the monkey who actively manages your mutual fund.)
• Diversify your investments. (It’s your free lunch, remember.)
• Max out on retirement plans. (Taxes.)
• Set up a payroll deduction plan. (Well, if you don’t, are you sure that you will really make the deposits?)

Two Kinds of Insolvency

There are two different types of insolvency.  There is cash flow insolvency and there is balance sheet insolvency.

Insolvency is usually defined as not being able to meet one’s debts as the obligations mature. If you have debts that are due and are unpaid, a company may find itself in Chapter 11, even though it has assets and even cash flow to pay the obligations.

An example of this has recently occurred with General Growth Properties (GGWPQ), one of the largest owners of malls in the United States. General Growth Properties had financed a lot of its debt with commercial mortgage backed securities (CMBS). When the CMBS market disintegrated, General Growth Properties was unable to roll forward its maturing debt into a new CMBS securities because the market simply did not exist for this to occur. Unlike most home mortgages, commerical mortgages often do not amortize or pay down over the life of the loan and so they need to be refinanced at their termination.

After filing for bankruptcy, investors did not analyze the balance sheet properly and sold off the company to below a dollar. Clearly, all were anticipating that the stock would be canceled in the bankruptcy process. However, as has been made fairl clearly from Ackerman’s presentation, it is unlikely that the stock will be canceled in this case.

This example is a good illustration of the many ways that the moving pieces can come together in bankruptcy. What all bankruptcies share is a liquidity crisis. This, however, does not necessarily also mean that the company’s debts exceed its assets, particularly when many of the assets are illiquid.

Cram Down Redux

Evidently, the defeat of the cram-down provision several months ago doesn’t mean that it’s actually dead.

To summarize the issue briefly, a cram-down occurs on filing for bankruptcy when an undersecured asset is split into two portions - one secured and one unsecured.  As an example, if a house was purchased for $600,000 several years ago with a first mortgage and still has a half a million owing on it, then a bankruptcy court could change the mortgage so that only $500,000 was treated as a secured debt, while the other $100,000 would be treated as unsecured debt, like credit cards. This matters because it means a bank could be paid back less than it is owed on a house, which might occasionally happen through foreclosure but does not happen in Chapter 13.

Many are surprised to learn that this is the general rule in bankruptcy proceedings and can be done with all other assets — cars, boats, helicopters. First mortgages are treated different for some reason. My cynical guess here is that it is largely to do with lobbyists. Mortgage companies usually argue that it is a necessary to keep borrowing rates low and that if such a rule were to be changed, then borrowing costs would rise for all future borrowers.

The issue that perhaps all of the legislators are thinking about but not actually discussing: what would such a rule change mean for our already weakened (crippled) banking system. Last week, bank failures reached a record high of 109 for the year. The FDIC is now closing in on insolvency itself and has raised its fees to banks. And now there is a new storm brewing over toxic drywall to eat at the banks’ limited reserves and assets. Perhaps if home prices have really bottomed out, it will seem less risky to Congress.

Middle-Class Bankruptcies

Certainly this has proven true from my experience, that the latest economic collapse has reached up and down the socioeconomic strata. The WSJ Blog recently did an interview with Leslie Linfield from the Institute for Financial Literacy.

Some key points:

• You only get one bite at the apply because you can only file once every eight years. This makes the decision of whether or not to keep a home important. (Although arguably, it’s less important in California.)
• Even though it’s a matter of public record, as it turns out, few are really looking at the public record.
• Most people feel some relief after filing for bankruptcy.
• The racial composition of who has been filing for bankruptcies has changed so that there are fewer African-Americans and more Asian-Americans and Whites.

Blame the Bankers

My friend Mark Gimein writes in Slate that strategic mortgage defaulters should not be blamed or feel blameworthy.  An obvious point perhaps, but worth making nonetheless.

Too many facing bankruptcy and foreclosure feel “guilty” and “blameworthy.” This is obviously wrongheaded thinking.