Finding Yourself Financially Upside Down

    

Insolvency:  According to Black’s Law Dictionary, the definition of insolvency is "Such a relative condition of … assets and liabilities that the former, if all made immediately available, would not be sufficient to discharge the latter."

Cutting through the arcane language, Black’s definition of insolvency (financially upside down) simply means that a person is effectively bankrupt (declared or undeclared) if he or she cannot pay off all debts owed, even if all assets owned were liquidated.  That is, you may own a home (that is worth $20,000 more than you owe on it), a 401k account worth $20,000, and a $5,000 certificate of deposit, but you would be financially upside down, or insolvent, if you also owed $50,000 to a combination of credit cards and student loans.      

According to the Uniform Commercial Code, an authoritative document that standardizes commercial law among the several states, defines insolvency two ways.  A person is insolvent who has either ceased to pay his debts… or cannot pay his debts as they fall due. This definition of insolvency is less hypothetical than the first one; in the housing meltdown, it is not difficult to imagine people who cannot pay their debts as they fall due.  This type of insolvency, which afflicts individuals and businesses alike, is typically referred to on Wall Street as a "liquidity crisis"

If you cannot pay debts as they come due, then it does not matter whether you can say, "my house is WORTH $X00,000"!  Banks foreclose on the large and the small; and they often do, even if the owner falls behind on just one payment.  Here is the upshot of a liquidity crisis:  the bank will foreclose and you not only lose your house (your shelter and home)… but possibly tens- of, or even hundreds- of thousands of dollars in home equity that has accrued over time.  The first and foremost rule to take away from this is that your home is not a savings account.  Unfortunately, hundreds of thousands of American households have treated their homes exactly as if they were savings accounts.  The financial ignorance (unwitting or intentional) that leads to such home-abuse is deadly for themselves; and it may just sink us all.

Looking at the liquidity crisis itself that reflects a state of insolvency, most people have extremely few options.  They are often left with only one of four possible sources from which to pay debts as they fall due:

1) Panhandle/seek charity from friends or relatives
2) Borrow money to pay your debts
3) Pay debts from your current income
4) Tap accumulated wealth

Option 1: is an absolute anathema to the overwhelming majority of Americans. Most people would rather go hungry and homeless than beg for money.  Option 1 is out.

Option 2:  Borrowing money to pay debts is not much better than a dog chasing its own tail. Option 2 doesn’t get you anywhere. Most often, option 2 will actually lead to a greater set of problems than the original debt problem that set off the crisis.  Option 2 is outright foolish.

Option 3: Current, job-based income is an odd duck. When you have plenty of it, you never think there’s enough; but when you don’t have any, you would be extremely grateful to have a little. Income depends on having a job (investment income falls under option 4).  Keeping a job, even for highly skilled professionals, is not easy; and the difficulty is not centered on a lack of skills.  Instead, specific positions in specific companies are often re-located, down-sized, out-sourced, or simply eliminated. Of course the mid- and high-salary earner is employable… but how long does it take to find another job?  How do these people pay their debts as they come due, when they are looking for work (possibly in another city with much lower pay scales)?

For too many Americans, debts are looked upon as if there will always be a good-paying job to cover all the expenses that their debt incurs.  From the Black's Legal Definition, this may be true . . .  but from a UCC perspective, the one that really matters when a job is lost, the central problem is that of  liquidity.  No matter how employable a highly-educated person is, that individual has to meet debt payments as they come due.  For those who cannot rely on both universal and un-interrupted employment,  then relying on Option 3 is dubious in a stable or falling economy.

Option 4: If you have accumulated wealth, then you have the opportunity to keep the bank away while you manage and rectify employment/income problems. Option 4 buys you precious time to get Option 3 back-on-track (if you became unemployed for awhile). Accumulated wealth can be likened to financial insurance.

Accumulated wealth comes in many forms: it might be $10,000 sitting in a savings account; it might be held in mutual funds or individual securities that you hold outside of a retirement plan; it might be in the form of Government savings bonds; and it might be held in investment real estate (specifically not your home). 

Accumulated Wealth, however, is not found underneath your house.  This truism has been illuminated brightly throughout The Great Mortgage Debacle of 2007-2009; and it continues to be true in 2010 under the new (actually traditional, pre-1992) mortgage lending standards.  That is, if you lose a job, don’t expect a bank to lend you money against your home.  Banks got burned (see FDIC bank failures) during 2007-present; and they will now strictly verify income before lending against a home.  No job, no loan.   Today, banks stare very hard at  a person's documented and verified income.

Option 4 is the only reliable way to ensure that you are never insolvent.