Brrr! Tuesday’s news that the average price of a Twin Cities-area home in August was 4 percent less than a year earlier sent chills down homeowners’ spines. For most households, their home is their most important asset and constitutes most of their net worth. A fall in house prices affects millions who ignore stock price declines.
But the degree of alarm, and true financial harm, varies greatly from one family to another, even if they own identical homes. It depends on how highly leveraged each is. “Leverage” is a word that gets used a lot these days, though it’s not well understood. Yet leverage is vital to understanding housing markets right now, and is equally key to the unfolding drama on Wall Street.
Consider four households, each of which owns a house that was worth $250,000 in August 2006.
The Andersons are a retired couple who moved into their house in 1962. They paid off their mortgage in 1982 and owe nothing.
The Bakers, in their 40s, bought in 1987, refinanced in 2000 and still owe $125,000 of the principal on that mortgage.
The Cleavers, also in their 40s, did not buy their house until 2004. They made a small down payment and have paid off some principal. They owe $230,000.
The Dilberts just squeaked into their home in late 2005. They had no down payment and barely qualified for a loan. They took out an adjustable-rate mortgage for the full $250,000 that is interest-only for the first two years. In January 2008, the interest rate jumps 2 percentage points and they must begin making payments on the principal, which is still $250,000.
A 4 percent decline means each house is worth $10,000 less than it was a year ago. This dollar amount is identical for all four families. But the declines in equity or net worth are not the same.
The Andersons see their equity in the home drop from $250,000 to $240,000. That is 4 percent.
For the Bakers, the value also declines to $240,000. But when you subtract the $125,000 they still owe on the mortgage, the value of their equity drops from $125,000 to $115,000. That is an 8 percent drop.
The Cleavers’ house also is now worth $240,000. Subtract the $230,000 principal left on their mortgage and they now have $10,000 equity in the house instead of $20,000. Their equity fell by 50 percent, even though the decline in the house value was only 4 percent.
The poor Dilberts started with zero net worth. The principal on their mortgage equals what they paid for the house. But now the house is worth less and they are $10,000 in the hole. Moreover, their monthly payment will increase sharply in January. Bankruptcy looms.
The Andersons are not leveraged at all, the Bakers somewhat, the Cleavers a lot and the Dilberts are off the scale.
Note that when prices are rising, leverage can be good. The Ellis family bought a $250,000 house in 2003 with $10,000 down and a $240,000 mortgage. A year later, the house was worth $285,000 – a 14 percent improvement. They added $35,000 to their net worth, at least on paper.
This is the story of all housing booms or even periods of high inflation. Nominal prices rise sharply. The net worth of highly leveraged people soars. Suddenly, everyone is a financial genius.
Buying stock “on margin” worked the same way. Some shoeshine boys really did own stock in the summer of 1929. If they had $50, a broker might lend them the other $950 to buy $1,000 in stock. It was a safe loan; the stock that served as collateral would increase in value right along with the market. If the shares went to $1,200, the shoe shiner could sell out, repay the broker and have $250 where he had only $50 a couple months earlier. Or he could use his gains to now buy $5,000 in stock.
But if he bought in October of ’29, all of his net worth, and then some, was gone by mid-afternoon on Black Thursday. The collateral no longer even protected the broker.
Some hedge funds borrow 97 cents for each dollar their clients actually have in the fund. Take in $15 million, get a loan of $485 million from a large bank and buy a half-billion in securities issued by Skinnem Financial Services, a sub-prime mortgage originator. If the annual interest rate to the bank is 6 percent, you will owe the bank $514.1 million after a year. If Skinnem’s securities yield 8 percent, you will get $540 million for them after a year. You started with $15 million and you end up with $25.9 million. That 73 percent increase allows you to pay yourself a hefty fee and still awe your clients at Whatsamatta U with your wizardry as their endowment fund manager.
But what if Skinnem suddenly discloses that it cannot pay off its securities? You quickly unload them to a vulture fund at 70 cents on the dollar. You are left with $350 million – far less than the principal and interest you owe the bank, not to mention anything for your clients. That is how some envied funds go broke from one week to the next. Or maybe the bank that had lent to them slowly rolls over, belly up.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.