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  • Negative Net Worth

    Posted by Carl from Chicago on March 15th, 2009 (All posts by )

    The Chicago Tribune business section has a series where readers write in with their financial issues and the columnists seek professional help and recommendations and publish the results. This column is titled “Law Degree on Her Side” and shows the plight of a woman under 30 who is a lawyer but is struggling under a mound of student debt and is considering bankruptcy.

    BALANCE SHEET VS. INCOME STATEMENT

    A big element in our economy’s struggle is the fact that the analysts and “experts” were focused on the income statement and not the balance sheet. An income statement view focuses on profits, or the difference between earnings (in her case, salaries) and expenses (rent, living expenses, etc…) and what remains each year. Companies often report earnings EBITA which stands for “Earnings Before Interest, Taxes and (depreciation) and Amortization”. In this model, you become a lawyer because you can make a lot of money (top line revenue) and use it to support the rest of your living expenses.

    However, this “income statement” model ignores the debt needed to finance education and expenses related to education. This debt keeps piling up and is a negative item on your balance sheet, which is the long term debt that you owe others, along with the annual interest that you need to pay to service this debt. In an analogy to the stock market, it is the debt payments, along with the fact that companies can’t come up with the cash to pay off principal (or roll-over debt) that is causing the liquidation of companies like Circuit City, Linens & Things, Mervyns, and soon to be many others.

    In this lawyer’s case, her balance sheet is “negative” meaning that she is insolvent or has a negative net worth. She has a tiny amount of assets (a bit of retirement savings, some cash on hand, and maybe equity in a car or something) which is all she can show to offset a mountain of debt.

    I don’t have exact statistics but I would venture that most Americans have a negative net worth nowadays. By this I mean that the value of their debts exceeds the value of their assets. I also run a site called “trust funds for kids” and I often tell my nephews and nieces that even the relatively small amounts that we put aside ($10,000 or so), as long as they don’t accrue debt, will make them better off than most Americans who have worked their entire lives, since they will have a positive net worth. Obviously some of this is tongue-in-cheek since you need a steady stream of income to pay minimal living expenses but there is much fundamental truth in that analysis in that if you pile up debt you will never accrue enough assets to offset this debt. And if you have a negative net worth, you can never stop working (retire) unless you have a guaranteed string of income high enough to offset your living expenses, interest costs and principal repayments.

    These debts cost money to finance, and this cost is in the interest rate. The woman in this article is drowning because $200k of debt will mean that interest payments of $14k ($200,000 * 7% or so) would be needed just to service the debt, without putting ANY sort of dent in the principal. Likely the principal is going to be due over a certain amount of years – let’s say 20 years – so she needs to pay $10,000 / year in principal plus $14,000 in interest (the interest will go down in future years as the principal is paid down) on the current balance. If her income is below certain thresholds (her income, at $75,000, is for now) then she can receive a tax deduction of $2500 based on the interest component (see IRS publication 970). Thus (using this relatively simplistic analysis) of her $75,000 / year salary, $24,000 (or almost 1/3) would go for debt principal and repayment (the tax deduction would likely offset this for about $1500 in cash, depending on her tax bracket).

    BANKRUPTCY AND STUDENT DEBT

    One very unfortunate difference between companies and this student is that companies can eliminate debt through bankruptcy (if they are cash flow positive on an EBITA base and can obtain interim financing), but the student debt can NEVER be discharged. I remember when I was studying for my CPA exam (20+ years ago, so maybe it isn’t an exact quote) that they had a section on bankruptcy and they mentioned that the discharge of student loans through bankruptcy was eliminated because

    Doctors, who require mounds of debt to pay for medical school as well as finance living expenses while they are interns and only modestly paid, used to accept the diploma with one hand and declare bankruptcy with the other. Tiring of this tactic, the schools lobbied and changed the laws so that student loan could not be discharged through bankruptcy

    Thus taking up student debt is serious indeed; unlike your house (which you can walk away from or short-sell to the bank) or auto, you can NEVER discharge this debt, and have to either pay it off or have this debt hanging over your head for the rest of your life (essentially meaning that you can’t accumulate any assets).

    If you read the article, not only did the woman take on student debt, she also took a vacation and put it on her credit cards, which have a much higher interest rate (maybe 20% or so) and need to be paid off before she can make a serious dent in the student loans, unless she wants to declare bankruptcy. And even if she does declare bankruptcy, given her level of income, it is likely that the court will make her repay at least some of these obligations.

    VALUE OF A DEGREE

    When you incur tens of thousands of dollars in debt to get your degree (or $200,000, in this unfortunate case) you need to ensure that your degree will pay enough to not only support you going forward (and your family, if you intend to have one) but also to pay off the student loan debt and interest accrued on that debt.

    In the case of this woman, she has a law degree. However, one item that wasn’t advice in this article is that she has to leverage this degree to make a lot more money. She needs to work for a firm with high billing rates and she needs to put in a lot of hours. Traditionally law firm employees had to bill 2,000 hours / year – note that this is BILLABLE work so everything that isn’t billable has to go into the rest of the week (or weekend) after you are done with a full days’ work, including what shred of a social life you’d like to have.

    Given all the taxes and costs of living in Chicago (remember that the sales tax is over 10%, property taxes are high, and Federal and state tax rates are going up) if she increases her income to pay down debt effectively almost 50% of every dollar is going to be taken away from her between social security and taxes of all stripes. So she needs to increase her income by $50,000 to come up with the extra $25,000 which would allow her to pay down this debt sooner.

    My uncle (now deceased) was a man who fought for the little guy. He was a lawyer with his own firm and he represented the poor and often did death penalty cases for the state (as a defender). He summed it up to me that

    You can either represent poor innocent people or rich guilty people

    I suggest that she find some major companies with problems and burn up a lot of billable hours helping them. Her $75,000 / year job will never pay enough.

    RELATIVE RATES OF RETURN

    The other more subtle point in this article and overall in finance is that the implied rate of return for investments has been decreasing. Anyone who hasn’t been fully invested in gold and treasuries has seen the value of their investments plummet, possibly by as much as 50%. Various articles come and go about how the DOW is now back to 1992 or prior – although this is kind of specious unless you were heavily invested all this time – sadly enough most people bought into the market much nearer its peak, so they took big losses on actual cash put into the market (and didn’t just lose gains from prior years).

    If the markets are down 50%, it will likely take YEARS of sustained 15%+ growth, for instance, just to get back to where we were in 2007. Thus while those returns might be prominently featured in advertisements, essentially for the average investor those returns are needed just to get you back to zero, and then you need to make returns BEYOND this in order to increase your asset base.

    Why does this matter? Because while the implied return on YOUR investments has declined (is frankly negative) and banks are paying about 1% in interest (BEFORE taxes), a loan at 7% is very pricey. In the old days when people put in 10% / year return in their model, they figured that a 7% loan was cheap money. Now with negative returns or puny returns in the risk-free market, 7% means that your loans are outpacing your gains and that your problems increase every day that you don’t pay off that loan. I won’t even go into the impact of a 20% credit card loan (plus the fact that consumer interest isn’t even deductible).

    CONCLUSION:

    ANY students who are considering taking out debt to finance their education NEEDS to understand the gravity of the situation:

    1) these loans can NEVER be discharged through bankruptcy
    2) the interest rate you are paying is likely higher than the return that you will make on your own assets
    3) you need to earn enough money to pay off the principal and interest, as soon as possible
    4) as you earn more money and try to pay off these loans, high taxes and cost of living eat up the value of each dollar earned so that you essentially have to earn $2 to get $1 to pay towards your obligations
    5) you need to live as cheaply as possible and get this done as quickly as possible – in this case the woman worked as an unpaid intern which just let her interest accrue and she took expensive overseas vacations which caused her to add credit card debt
    6) based on all of the above items, it likely isn’t worth accruing debt for a degree unless your degree is extremely marketable (law, medicine, finance, engineering) – that doesn’t mean that you can’t follow your passion, but it does mean that you need to pay-as-you-go or find a way to do it through scholarships or at your local community college
    7) if you incur debt, you need to make money ASAP and forgo other social options, expenses and fun – else you will never escape the debt trap. You spent all this money for the degree, so now you have to leverage it to the hilt and make as much money as possible

    Cross posted at LITGM and Trust Funds for Kids

     

    17 Responses to “Negative Net Worth”

    1. renminbi Says:

      One point on EBITDA-it was used used to justify high equity prices on dot.com companies which otherwise could show no earnings, as if interest and depreciation (if you want to stay in business) and taxes were not expenses.

    2. Mitch Says:

      You are absolutely right. An education is an asset, and you should look at getting an education just as you would look at buying a business or a machine. If the cash flow you expect doesn’t cover the cost of acquisition, look for another deal.

      That said, most people are net debtors early in their lives, net creditors later. You acquire student debt expecting to pay it off out of your improved employment prospects. You take out a mortgage with the expectation that owning a house will sooner or later offer a better value than renting, and give your kids a place to dig holes and throw things without someone having a fit. This article looks only at a point in time. In reality, that point is only part of a process.

      Also, people tend to mentally “smooth” their income over time and adjust their consumption accordingly, which is why one-off tax cuts and one-time rebates do so little. Ms. Rimas needs to look more closely at the timing of her cash flows and put her expenditures more in line with her current earnings instead of borrowing so heavily on what she might make later.

    3. Andrew Garland Says:

      I wonder, what is the actual value of a college education, after correcting for these effects.
      (1) Colleges select for high IQ
      (2) Businesses select for IQ by requiring a college degree for executive-track training.
      (3) There is a cultural belief that a person cannot succeed without a college degree, limiting the success of non-grads.

      Employers and schools often dismiss the value of earlier college training, even in the case of future doctors and lawyers. The college education is regarded as an indication of dedication and interest. But, the employer or graduate school implies that the student should “forget what you have learned” and start to learn the real subject, if he can.

      So, a college degree may be valuable mostly because of cultural bias, the lack of a more efficient and cheaper alternative, or the prohibition against employers giving aptitude tests (via supreme court rulings). How much does the “learning” in college really matter?

      College is an Expensive IQ Test

    4. Brett_McS Says:

      Even if ‘college’ is a given, the question becomes ‘is an expensive college worth the price?’. The best teachers are typically not the top people in their field and vice versa. The top colleges hire the top researchers, not the top teachers.

      I didn’t realize there was some kind of prohibition against aptitude tests in the US. When I graduated (engineering) and went for interviews, more than half the prospective employers used aptitude tests. I sort of smiled inwardly at the opinion of University Degrees that represented.

    5. renminbi Says:

      Aptitude tests are legal,but it could leave you vulnerable to lawsuits. If I were running a small business I would hesitate to hire any member of a protected group, as a business decision. If you hire someone over 40, or other persons of protected groups,it becomes much more difficult to fire them; they can bring a completely meritless discrimination lawsuit and stand a good chance of winning it. Why be bothered? In fact why not just shrug, and tend your garden?
      All of the laws we have have made us a lawless society and have rotted the character of the public.

    6. Robert Schwartz Says:

      Here is the link to the story in the Trib.

      This girl is so screwed that she has no chance. $75K means she has a job, but it is not with a big firm, nor in a lucrative sub-specialty. Further, she can not find a more lucrative job as lawyer. Right now the market for young lawyers is bad and getting worse. Many big firms, the kind that paid young lawyers $150K+ in palmier days, are conducting mass lay-offs. A few have laid off more than 100 lawyers.

      It is possible, through the mechanism of contingent fees, for a lawyer to get lucky and rich, like John Edwards. But, it is very unlikely.

      Her best shot would probably be leaving the country, changing her name, and hanging out her shingle in some place where English is not spoken. Fishing boats in Alaska, truck driving in Iraq, and doing the horizontal mambo are dicier alternatives. Another possibility is joining a religious order and going to work in a convent in a third world country.

      If you want to read some student loan horror stories, try “U.S. Gets Tough on Failure to Repay Student Loans”, WSJ 1/6/05. One aids patient was having his disability payments garnished. Another case was a student who had studied cello in music school. He even found a job playing for an orchestra in New Orleans. His student debt was almost $100,000. He was working and making $20,000 and was the envy of his classmates because he was working. Now an orchestra job may only be 15 hours a week of playing and rehearsing, but he also has to put in 4 to 6 hours a day of practice to keep his chops up. The trial judge heard his story and discharged his debt. The Creditor Appealed! and the Circuit Court overruled the trial judge and told the debtor to take a third job!!

      Not the WSJ it is the first story on the page

      President BHO’s education plan, which seems to focus on making more student grants and loans, is, like the rest of his great ideas, wrongheaded. All he will do is drive up tuitions and make more students end up in debt slavery.

    7. Carl from Chicago Says:

      Thanks for the good comments.

      I think that the LEVEL of student debt has climbed overall and I think people are far too sanguine about their ability to pay off this debt. There should be alarm bells clanging in their heads every time they increase their pile of debt.

      This woman, from what I can tell in the story, wasn’t hustling or trying to land a top tier law job when they were available. I think that she wanted to live a reasonable life, working a regular job, and having a social life in the non 40 or so hours a week she worked. The problem is – as soon as she picked up that 200k in debt she should have been looking for a high rolling job instantly and working as many hours as possible to pay it down. If you read the article, she was an unpaid intern for a while and went on an overseas trip – not good.

      If you are going into a profession like law where you need to pile up debt you need to work like a banshee when you get out. Else you need to do it as cheaply as possible.

      The guy who took out 100k in loans for a symphony – what was he thinking? There was no way he could ever earn that back. And you can see that he can never escape his debt trap. All students taking these types of majors should fill out something in blood saying that they will die in bondage to this debt.

    8. david foster Says:

      The fundamental problem here is that we have allowed universities–especially “elite” universities–to become gatekeepers to career success to a far greater degree than is necessary or appropriate. The gatekeeper role also allows them to become de facto tax collectors, and to sweep an ever-increasing part of the GDP into their own pockets. Even more importantly, the dominance of universities is acting as an inhibitor to class mobility and to the full use of America’s human resources.

    9. david foster Says:

      Also..see MaxedOutMama on the MBA degree.

    10. Paul Says:

      I’m wondering why construction workers like myself, truckers, waitress, general working shlubs are taxed to subsidise college for others, like Queer Theater, Lesbian Studies, Parks and Recreation, and in the case of law and medicine services we can not afford with remnants of our after tax income.

    11. Cousin Dave Says:

      Interesting. I know that the value of an engineering education declines over time, due to the advancement of the field vs. the snapshot-in-time nature of the education. It doesn’t go to zero, but it does decline. When we hire junior-level engineers, we look a lot at how they did in school. Senior-level, not so much. Career accomplishment matters a lot more.

      The only thing I can add to the student-loan story is that many universities have priced themselves out of the market, or would have if it weren’t for those seductive “easy terms” student loans. I thought I was horrible for graduating with $7500 in student loan debt. But my income right out of school serviced the debt without much trouble, and inflation was definitely my friend, to the point that about halfway through the 14-year term of the loan, I paid it off just to be rid of the nusiance of mailing the payments. The difference is: My 18-hour-workdays occurred during school, not after. I worked part time to pay my tuition, plus a full class load; I went over the summer, and I graduated in 3-1/2 years. Thus, I didn’t need wads and wads of student loans, just enough to bridge some rough spots. That’s the other lesson today’s students need to learn. Four years of partying isn’t worth it if you have to pay for it the rest of your life.

    12. ElamBend Says:

      Actually the worst perpetrators are mid-level and lower schools, particularly professional schools (I’ll focus on law though). Professional schools are often a cash cow for their greater universities, even the lower and mid-level ones charge an arm and a leg. The credit bubble of the last 15 years has meant that virtually anyone could get the loans. The schools have lured in students with the enticement of the first year pay of the ‘big’ firms which start at $150k. Unfortunately, that is just 10-15% of all lawyers. Meanwhile, the legal profession has two ‘means’ in its salary scale, one in the mid $100ks and the other around $60k. Law school has become vastly overvalued for the payoff. I encourage anyone who tells me that they want to go to law school to avoid it and if they really want to practice go to a state that allows the apprenticeship route (for instance Virginia).

    13. Carl from Chicago Says:

      The other element with regards to law isn’t just the fact that there are only a relatively few $150k / type positions – it is that to get and excel at one of these positions (have it for any amount of time) you need to be COMPLETELY FOCUSED on it and really can’t do much of anything else with your life, except sleep and eat.

      If you ask a law student who is piling up with debt what type of life they feel that they will have after they graduate, unless their answer is “no life whatsoever, will put my entire life in the job” then they are missing the point.

      It is analogous to “don’t do the crime if you can’t stand the time” or whatever they used to say on those old cop shows.

      Not a lawyer just my 2 cents from coming in contact with hundreds of lawyers over my professional life, many quite wealthy and successful. They put their lives into it.

    14. Cousin Dave Says:

      Carl, that’s a good point. I wonder to what extent the totally unrealistic portrayal of the law profession that the mainstream media (particularly TV) conveys is responsible for that. Every lawyer you see on TV is either Saving The Planet, or covered up in bikini babes. By contrast, engineering schools aren’t graduating enough students to meet the demand, and except for a period in the mid-’90s, they haven’t for decades. I’ve got to think that part of the reason for that is the mass-media portrayals of engineers as either socially inept or just plain evil.

    15. K.J. Webb Says:

      I’m a lawyer myself, and have seen many young lawyers enter the profession in our middling firm (24 lawyers), including my own son. I don’t hold any particular brief for lawyering, unless it happens to suit your talents and character, which ought to include powers of writing and analysis, a sturdy hold on common sense, an interest in the human comedy and what I can only call by an old-fashioned name – integrity.

      Lawyers like to moan and groan about the killing hours they put in and the superhuman stress they’re exposed to. Take those tales with a grain of salt. They’re often told by the kids in the bottom half of the class, who would have flunked out in an earlier day but now are allowed to coast through law school, pile up debt and discover after a year or two of work that they can’t cut the mustard. The system is crueler in that respect than it once was.

      Good lawyers make it look easy. But, then, being good isn’t as easy as it looks.

    16. ElamBend Says:

      I have to kwibble with K.J. a bit. I no more than a few top of the class attorney’s who work the long hours at good firms and constantly disparage their profession. (though some like it). Either way, a certain kind of law practice (think big firms) requires huge hours and like it or not that equates to less family time.

      There are so many different tracks of legal profession, but law schools (mostly) sell themselves on a particular kind of track which conveniently allows them to justify big fees.

      There is a need for lawyers in this world, for businesses and individuals, but I think a lot of young lawyers and legal students feel cut off from so many tracks due to the debt they incur and the encouragement of their respective schools.

    17. Carl from Chicago Says:

      My only experience has been with “big firm” lawyers who clock in the hours. In my experience they typically put in long, long hours.

      A good friend of mine was involved in an IPO back in the boom days, working literally day and night. When it was done they were all going out to celebrate but the lawyer that helped them just went right to the next client. It was crazy.

      Similar to the investment bankers – if you go out with them to a sporting event (i.e. a Cubs game) in a quasi-business situation afterwards they all go back to the office and do a bunch more work.

      Many of them are scooping up all the billable hours they can in the bankruptcy area now, too.

      I can’t generalize beyond my experience, though. Or at least not too much, else I wouldn’t be much of a blogger :)