Monday, April 28, 2008

What Does A Credit Crisis Look Like?

It's no secret: The 'credit crunch' is not contained to the subprime sector. Subprime, depending on who you listen to, was about 10-15% of the overall mortgage market up until the point when things started to crumble in January of 2007, and then really fell apart in August of 2007. For a while, the Fed, other economists, and certainly the mortgage industry was defiant about the idea that this little fire would be put out before catching the whole forest ablaze.

If 15% of the market is in peril, why are 75% of the banks "tightening" their guidelines, or in other words, making it harder to qualify for borrowing?

See evidence of this in the chart below.

Planning To Walk Away?

I wrote about an interesting trend/website a while back, and noticed this comment on a legal blog post. Even though the economic stimulus package included a provision for tax protection in cases of debt forgiveness, it appears that at the state level there still may be some exposure. Just as Julia says here, consult a tax professional for more details, especially if you are considering what happens when You Walk Away.

Tuesday, April 22, 2008

CMPS Proposal For Housing Crisis Reversal


I recently wrote about the negative feedback loop this credit crisis is causing, and how it causes a downward spiral in home values. You can read about it and the study referenced right here. Many economists are discussing ways that the government or the banking institutions can put up a backstop to help break this cycle. It's a complicated issue.

The CMPS Institute has issued a proposal designed to offer some ideas from the perspective of the mortgage industry. It's an interesting argument against some of Washington's proposals, which include a tight ratcheting down on the lending industry. This feels very threatening to mortgage professionals who know how to run an ethical business and use flexibility in creative ways for their clients. Read the proposal for more insight.

More on CMPS from their site:

CMPS is a training, examination, certification and ongoing membership program for financial professionals who provide mortgage and real estate equity advice.

You can be assured that a mortgage professional with CMPS credentials has met rigorous, peer-developed and reviewed standards endorsed by a national professional body. The CMPS Institute was formed as a joint effort by leaders in the mortgage and financial planning industries to raise professional standards among mortgage professionals and integrate sound financial planning advice into the mortgage process. Recognized for its preeminence within the industry, the CMPS curriculum represents the core knowledge expected of residential mortgage advisors, regardless of the diversity of specializations within the industry.

The CMPS curriculum incorporates the five essential CMPS skill sets related to integrating a client's mortgage, debt and home equity strategy into their overall financial plan:

  • Financial Market and Interest Rate Analysis
  • Cash Flow & Debt Analysis
  • Real Estate Equity Management
  • Real Estate Investment Planning
  • Mortgage & Real Estate Taxation Concepts
With such a wide range of subjects to be mastered, the educational process doesn't end once the designation is earned. There is a strong commitment among CMPS Members to continuing education through conference calls, seminars and self-study.

Monday, April 21, 2008

Six Proven Strategies For Managing Your Wealth Wisely

I don't think there is anything ground-breaking or new here, but this "special report" from the Wealth Management Exchange is the kind of reference that is helpful to read when thinking of your own financial planning or especially when looking for help from a professional. Its general, but comprehensive, and worth a read. If you are not working with a financial planner, or are looking for a new one, contact me for a referral.

Leveraged Losses. What Does Panic Feel Like?

One of the big deals about owning real estate, when it comes to financial motivations, is the concept of leverage. If you buy a 100 dollar asset with 10 dollars of your money, and 90 of borrowed money, when your asset increases by 10%, your return on investment is 100%. Thus, your leverage is 10x.

$100 * 110% = $110 ; Sell the asset and pay off the $90 loan, and you've doubled your money by owning an asset that went up 10% in value. That's leverage.

Real Estate appreciates on average at about 6% a year. Supposedly this is true dating all the way back to the 1626 purchase of Manhattan Island by Dutch settlers for a whopping $24 USD. I don't know if this is accurate (even wikipedia calls it a 'legend'), and I have not calculated the ROI on $24 USD in 1626 relative to the value of Manhattan today. In fact, I don't really know what Manhattan is worth today. This is just an anecdotal story I picked up somewhere. But 6% on average isn't a bad figure to use, on a very general basis.

But leverage can work against you as well. If that $100 asset lost 10%, you still owe a bank the other $90, so if you sold the asset, you pay the bank off, and you have zero. 10x the loss = 100% of your investment. That's also leverage.

Leverage isn't just a game played by homeowners with mortgages. It's the concept behind borrowing on margin to purchase securities. And it's a major component to investment strategy employed by commercial banks, investment banks, hedge funds, and pretty much anybody in the investment game.

When it comes to mortgage dollars, it can take a lot of leverage to make a big profit. The interest rates banks receive on the money they lend is pretty low. So they borrow more money to lend, and keep a few nickels on the "spread". The more they can borrow and lend out, the more nickels they collect.

Well we all know by now that the mortgage market came to a screeching halt last summer, a few months after home values started to come down, and loans at the shakier end of the spectrum started to default. As illustrated above, just a 10% asset value decrease can lead to 100% investment loss when you're sitting at 10x leverage.

A new report out of the University of Chicago offers quite a lot of insight into the anatomy of this bubble, explains how the negative feedback loop of dropping asset values in mortgage bonds and real estate create a web effect that has worked to assure that this "subprime meltdown" would NOT remain contained, and goes on to illustrate how 400BN in bank losses equates to an estimated 900BN in business contraction, and corresponds to an estimated GDP reduction of 1 to 1.5%. The role of leverage is central to the paper. Its a long read, but critical if you wish to understand this market.

Wednesday, April 02, 2008

Exploring The Liquid Value Of Real Estate - SF Federal Reserve Study



If you have not heard me preach in the past about the value of liquidity, and how defining that value might impact your borrowing strategy, now is a good time to listen-up.

When a millionaire buys a million dollar home, they typically don't pay cash. They use a mortgage, because they want to maintain liquidity. Would you rather have a million dollar home, and no cash, or a million dollar home, a big tax-deductible mortgage, a million in other investments, and a monthly payment?

Liquidity preserves options, and builds control and safety into the financial picture. It has a cost (the mortgage interest) and its up to each consumer to figure out where the benefit of liquidity out-weighs the cost of interest. This is what we can help you evaluate.

Real estate, in general, is illiquid. We are seeing this realized on a whole new level, as sellers are dropping prices to entice buyers, and the time required to sell a home has skyrocketed. If you need to sell a home, and you are not liquid, how long can you wait for a buyer?

The Federal Reserve Board of San Francisco recently published a brief letter discussing the relationship between falling prices, days on market, and liquidity, and the message is noteworthy. The author (John Krainer) suggests that real estate values should be adjusted for their lack of liquidity, and in doing so, we see a different picture.

Think about this. If you are selling a home, and its worth 100k, but it costs 1k per month to pay the bills, and you are facing an average time on the market of 6 months, you face a decision of carrying for 6k to sell in 6 months for 100k, and net 94k in your sales price. Why not drop the price to 94k today, and sell it right away?

If you are holding the asset, you also hold the risk of market deterioration. What if in 6 months, the present value has dropped to 90k? Now you've spent 6k and will be selling at 10k below what you could received 6 months ago. Not to mention what you could have done during the past 6 months with the cash in-hand!!! Time. Is. Money. Case in point.

In fairness, if you hold the asset, and the value increases by 10k over the 6 months, you also own that. But who wants to bet on this market getting better over 6 months? If buyers believed that were going to happen, the average time on market would not be 6 months!!!

The tricky part about markets is understanding where psychology intersects with economics. Sellers typically try to hold out for the top dollar when they are selling their former home, but there are some cases where sellers are trying to hurry. These are auctions and foreclosure sales, typically driven by builders, banks, and other business entities. They want to cut to the chase, while the homeowner doesn't want somebody to take their home on the cheap. But they have to compete against non-homeowner sales in their market, especially when there is an imbalance of buyers and sellers!

So be careful. Real estate is liquid enough at a low enough price, but when sellers outnumber buyers, that price is likely far lower than what your concept of value is in your home. And this brings us back around to why its important to maintain liquidity outside the home; if you want to sell your home, and want top dollar, you better be prepared to wait. You'll need savings to carry the cost of owning. There are a lot of reasons why this may work better in the long run, but each case is subjective.