Thursday, October 9, 2008

Thoughts on the “Bail Out” and Ways to Keep Your Money Safe

Last Month I mentioned that when market conditions deteriorate, fraud and scams will become more common. The mere fact that we will be doing a lot more short sales increases the opportunity for both deliberate and accidental fraud. Before we address that, let’s take a look at our current market conditions, and the potential effects of the bail out.
The first thing we need to get a handle on is the size of the problem, and how the size of the bailout relates to it. The numbers are so big that most folks just can’t comprehend them. This provides a fertile field for rumors, lies and scams to grow.
Here is a quick example: I have heard parts of several local and national radio talk shows where the following idea was being discussed as a serious solution to our problem.
Back when the Government was “only” putting up $ 85 Billion to bail out AIG insurance, the idea went: if we took the $ 85 Billion, and divided that amount between the 200 Million tax payers, each would get $ 425 Thousand Dollars. A man and wife would get $ 850 Thousand.
The argument went that each of us could pay off our mortgages (mortgage crisis solved), buy new Cars, Homes, Electronics…, and the economy would be stimulated.
At the times I heard these I was driving, and couldn’t do the math, but intuitively this didn’t seem like it could be possible. My first thought was that for the Government to have $ 425 Thousand dollars to give to each of us, they would first have had to take it from us in the form of taxes. It didn’t seem reasonable that we had each given the Government that much money in taxes.
While I was listening, no one ever called in and disputed the validity of this argument. In fairness, that may have happened after I tuned out, but I never heard it.
Then a couple of days later I got an email putting forth the same idea, and I did the math:
$ 85,000,000,000 Billion Dollars = $ 850 Dollars
200,000,000 Million People 2 People

Remember from Junior High math class how you can cancel out zeros on the top and bottom of a fraction?
The fact is that if the $ 85 Billion were equally divided between 200 Million people, each would only get $ 425 Dollars (Not Thousand). I think the fact that so many adults with a minimum of a high school education could get so caught up in this thinking says a lot about how we got here to begin with.
So, now that we are talking about another $ 840 Billion in bailout (700 Billion going to buy up bad mortgages), how much is that per person? If we stay with 200 Million taxpayers, it works out to $ 4,200 each.
In my mind, these are not the numbers we need to be looking at if we want to get a handle on this problem.
My question was: What does $ 700 Billion represent in terms of the size of the problem?
The best answer I can come up with, is that $ 700 Billion represents about 5% of the mortgages out there. Some sources have said (hopefully they are wrong) this represents only 5% of the delinquent mortgages. One of the big problems is getting to the correct information. There are so many sources putting out wrong information, as in the example above, that it is hard to be sure about the true facts.
In any case, let’s take the high road and assume that the $ 700 Billion represents 5% of all mortgages out there.
According to the Mortgage Bankers Association September 13th report, 4.39% of all mortgages on 1-4 family homes are delinquent, and another 1% are already in foreclosure!
According to Standard and Poors, last year (2007) sub-prime loans (421 Billion) represented 16.8% of all loans made (2.5 Trillion). Overall, they estimate that sub-prime mortgages represent 13.5% of all existing mortgages.
According to CNN Moneyline, we are seeing a spike in sub-prime defaults with 11.2% of the loans made in 2007 defaulting BEFORE THE FIRST INTEREST RATE ADJUSTMENT!
I will leave it to you to decide if you think the “Bail Out” will be enough to fix the problem. I am pretty sure the government knows this is just the first bite at the apple, as they raised the Federal Debt Ceiling by more than twice the amount of the “Bail Out” as part of the “Bail Out” package.

How to Keep Your Money Safe
Over the last two weeks I have been inundated with calls from students and others wanting to know what they should do with their money. Primarily, they seem to be concerned about money in their 401Ks and similar retirement accounts which are heavily invested in securities. They are also concerned about whether they can depend on FDIC insurance, and if it is safe to keep their money in the banks.
I don’t consider myself qualified to answer stock market questions as I do not invest there. FDIC insurance is probably not my strongest subject either. I do have the feeling that if the Government fails to back up the banking system we will be in a total financial collapse and the word money itself will no longer have the same meaning.
What I can do is share with you what I have done with my own money and why, leaving it up to you to make your own judgments about where you want to go.
My money was invested in residential real estate. I liquidated a substantial portion of my portfolio, starting in early 2006, with the last property sold in July of 2007.
I did this because I felt that we were at a market top, and that values had a good chance of declining from those levels. Said another way, I converted these assets to cash, because I felt that cash had a higher potential to hold its value than Real Estate.
Many who have called over the last few days now feel that the stocks held in their 401Ks (or other retirement accounts) are at risk of further decline from present levels. If you agree with this line of thinking, you can convert your stocks to cash by selling them on the open market.
If your money is inside a 401K, you probably have the option of a guaranteed interest fund or government security fund inside the 401K. You can immediately instruct your 401K administrator to move your funds from their present investment into the safest, most guaranteed fund they have, still inside the 401K. All with no tax consequences.
This will end your risk with regard to stock market declines as selling my real estate ended my risk with regard to its decline.
Now the problem is, we both have money sitting in a LOW INTEREST (1% to 3%) account. This not being a satisfactory long term rate of return, our next goal should be to reinvest that money into something that is both safe, and provides a “better” rate of return.
If your money is in a 401K, you will have very limited options as to what you can invest in. Most 401Ks have only a few stock, bond, or guaranteed interest funds in which you are allowed to invest.
You can rectify this problem by “Rolling Over” these funds into a Self Directed IRA. This can be done with no tax consequences.
The two IRA custodians I know of in Albuquerque that will allow true self direction of an IRA are: Sunwest Trust and Zia Trust.
Once you move your funds to a truly self directed IRA, you may want to “park it” in a guaranteed interest fund until you can make a Real Estate Secured investment as I am about to explain. Or, you may decide that you prefer to be invested in the stock, bond gold stocks or other securities.
Even if you prefer to invest in stocks etc. you will have a wider range of choices inside a self directed IRA than you will in a typical 401K plan.
Now, the thing that may be confusing at this point is the fact that I sold Real Estate because the risk of price decline was too high, and am now going to explain that I reinvested in Real Estate Secured investments.
In fact, what I have re-invested my money in would rightfully be classified as SUB-PRIME MORTGAGES. I think at this point looking at the specifics is the best way to clear up the confusion.
One of the properties I liquidated in 2006 was a single family residence, held by my self directed IRA. That sale netted my IRA approximately $100,000 (net equity).
The position my IRA had in the house was such that a 10% decline in market value would have resulted in a 20% decline in my net equity. Said another way, I had a 50% equity position in the property. If it was a $ 200,000 house, then I would have owed $ 100,000 on it. If we ignore closing costs (as I will do for the remainder of the examples), selling a $ 200,000 house would pay off our $ 100,000 loan, and leave us with $ 100,000 cash.
A 10% reduction in the value of a $ 200,000 house will make it a $ 180,000 house, which will leave me only $ 80,000 net equity after paying off the $ 100,000 loan. If I had $ 100,000 in equity, and now only have $ 80,000, I have suffered a 20% loss due to only a 10% decline in market value.
For comparison to the next section on re-investment in Sub-Prime mortgages: A 50% decline in market value of this house would have resulted in a 100% loss of my net equity.
Remember, leverage cuts both ways: it makes you money in an appreciating market, and it costs you money in a depreciating market.
The $ 100,000 netted from the sale of the above property was used to Purchase an existing $ 95,000 Real Estate Contract, and to create a $ 25,000 2nd mortgage. Both situations involved homeowners who were then being foreclosed on. Both parties paying on these notes had, by any definition “bad credit” therefore I refer to them as Sub-Prime loans.
The $ 95,000 Real Estate Contract bears interest at 8.5% per annum with monthly payments of $ 970, and a balloon payment in five years. It is in first position on a NE Heights home that had a market value of $ 250,000 at the time my IRA purchased it. Because my IRA paid only $ 75,000 for this Real Estate Contract, it will receive a 15.14% return on invested funds if the contract is paid as agreed.
Of course, the payments may not be made as agreed, and I may be forced to take the property. If that happens, I will have $ 75,000 invested in what was a $ 250,000 property.
Now to compare the market value risk of this situation to that of the house discussed above, let’s consider the 50% decline in market value that would have totally wiped out our equity in the earlier example.
If this house went down 50% in value, it would be worth $ 125,000. Since I only have $ 75,000 invested in it, I stand to make a $ 50,000 profit even after a 50% price decline.
So, with this investment, I have moved money from a position where a 50% decline in value would have entirely wiped out my equity, to a position where it will still be safe even if prices decline by more than 50%.
The $ 25,000 second mortgage I created is in almost the exact same situation. In this case, there was a homeowner who was in foreclosure. She owed approximately $ 80,000 on a property worth about $ 250,000. She needed $ 25,000 to make up her back payments and pay some other bills. I directed my IRA to make her a $ 25,000 second mortgage at 12% interest, $ 250 per month payment, and a 5 year balloon. When you throw in Origination fee and discount points, the loan should yield about 13% if paid as agreed.
Again, however, the payments may not be made as agreed. If this happens, I will have $ 105,000 invested ($ 80,000 first mortgage + $ 25,000 loaned) and will own a house that was worth $ 250,000.
Using the same math as the first example, if prices fall by 50%, this house will also be worth $ 125,000. Since I only have $ 105,000 invested in it, I stand to make a $ 20,000 profit even after a 50% price decline.
Up to this point, we have only been dealing with the risk of market value decline. Investing as described above provides some additional risk reduction as well.
First, I don’t have to worry about whether FDIC will come through or not. I have made my bet on the value of those houses not going below what I have invested in them. Everything is in my hands, win, lose or draw.
Second is the concept of protecting your money from external liability such as Legal or Medical liability, creditors etc. Think of how much money people spend in Attorney and CPA fees setting up and maintaining Private Trusts to protect their assets. Did you know that money inside an IRA is as well protected as it would be in a trust for only a small percentage of the cost?
Finally, let’s think for a moment about some of the fraud and theft that occurs in any down market. I realize that this is very unlikely to happen to any of us as individuals, but it is almost certain to happen to some among us.
Consider for a moment how much harder it would be for a dishonest person with evil intent to steal a mortgage, than it would be cash, or securities that can be sold and moved with the push of a button.
Transferring a mortgage, real estate contract or real estate itself, requires notarized signatures and recorded documents, as compared to the push of a few buttons for cash or securities.
And if someone with truly evil intent and talent does fraudulently transfer a mortgage or other real estate instrument, at least you have a chance to try and recover the asset. Real Estate and Mortgages don’t just vanish, the way cash does.

We will be covering all of this and more in the upcoming class: Real Estate the IRA solution on the 23rd of this month. Zia Trust will be providing space for the class in their office which will be passed on to the student in the form of a 25% price reduction on tuition. Also Zia Trust will have trust officers on hand to answer questions about the services they provide. Seating is limited to 15, so make your reservations early by giving me a call.
Until next month,

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