Coaching Tip: The Leadership Blog

Recessionary Storm Clouds

In the past 25 years, Americans have kept shopping through good times and bad.

In every quarter except one since 1981, consumer spending rose over the previous year, adjusted for inflation.  The main fuel for the spending was easy access to credit.  Banks and other financial institutions were willing to lend households ever increasing amounts of money.  Loans to consumers were viewed as low-risk and profitable.

Economists have been complaining about excessive borrowing and spending since the early 1980s.  But no matter how many times economists predicted the demise of the consumer, the spending continued.  The latest data from the Bureau of Economic Analysis show that the personal savings rate---the share of income left after consumption---fell from 12% in 1981 to just over zero today.  And debt service, which is the share of income going to principal and interest on debt, kept rising.

The subprime crisis marks the beginning of the end for the long consumer borrow-and-buy boom.  Standards for real estate lending have been raised.  Credit cards are still widely available, bit it is only a matter of time before issuers get tougher.  Research by economist Carroll suggests that every $1 decline in house prices lops about $.09 off of spending.  That accords well with calculations by BEA economists.  They figure that households took out $340 billion in cash from mortgage and home-equity financing in 2006.  That source of funding could largely disappear over the next couple of years.

What comes next could be scary.  Reduced access to credit will combine with falling real estate values to hit poor and rich alike.  "We're in uncharted territory," says David Rosenberg, chief North American economist at Merrill Lynch, who's forecasting a mild drop in consumer spending in the first half of 2008.  "It's pretty rare we go through such a pronounced tightening in credit standards."

Source: BusinessWeek, November 26, 2007

No Risk, No Reward

What risks should we avoid and which should we snap up?

Probably no one in American business has answered that question better than Sam Zell who amassed millions by looking at the same data everyone else has, and seeing what others don't.  He has invested in everything from radio stations to sports franchises to newspapers to cruise ships.  His practice of bypassing the blue chips for undervalued opportunities--often times businesses on their backs, even in bankruptcy--explains why he is known as "the grave dancer."

Zell co-founded, with Bob Lurie, Equity Group Investments in 1968.  Now, the Chicago-based firm controls a multi-billion dollar mix of private, public, domestic, and foreign businesses.  They made their names by viewing risk differently than their competition did.  Contrary to their public image, they were not riverboat gamblers throwing their money around with reckless abandon.  Rather, they invested in companies and industries that merely seemed excessively risky because others simply didn't recognize the underlying situation.

"One thing I know for sure: The assessment of opportunity is an art.  There have been many examples in my career where the information was available to everybody.  But why was I able to see that opportunity--and the rest of the world didn't--I don't know.  And by the way, the rest of the world didn't see it until long after we were up and running."

Example: Barges

In 1979, the federal government passed an investment tax relief to encourage the construction of barges with a 25-year lifespan.  "Well, as you might expect," Zell explains, "this resulted in too many 25-year barges being built, glutting the market.  So for the next 25 years the business was just horrible.  But we figured that 1979 plus 25 was 2004, when that huge glut of barges was going to be taken out of commission.  So if you could get control of that industry before the original supply finally shrank, you'd do pretty well.  So we got into the business when everyone else was getting out, and when 2004 came around, we were looking pretty good."

Source: LSAmagazine, University of Michigan, Fall 2007

Real Estate Competition

Consumers don't have enough understanding of the fee structures in the real estate industry and don't realize that they have negotiating power over fees.

Federal authorities ask state lawmakers to consider repealing laws that harm competition among real estate brokers.  The call came as part of a series of recommendations aimed at providing property buyers with greater information about the industry.

In a report released by the Justice Department's antitrust division and the Federal Trade Commission, the agencies said efforts are needed to ensure brokers act in a manner fair to consumers.  They pledged to continue monitoring the conduct of real estate broker associations, especially when they act in concert, and to bring enforcement action when necessary.

The report said the federal government will try to inform state lawmakers and industry regulators about the effects of state and local laws or regulations on competition.  And it urged state legislatures to consider repealing laws that limit choice and reduce the ability of new entrants in the real estate industry to compete.

Source: The Wall Street Journal, May 9, 2007

Mortgage Lenders' Implosion

The shakeout in the subprime area is the latest of the mortgage industry's periodic purges of dubious practices and weak lenders.

In the mid-to-late 1980s, savings and loan institutions moved into risky lending, sometimes to cover losses after interest rates turned against them.  Courts found that some executives looted dying S&Ls.  A 1989 government bailout ultimately cost hundreds of billions of dollars.

The collapse of many S&Ls, once the dominant force in home mortgages, opened the way for specialist mortgage-banking firms and commercial banks to take more of the business.  Today, Countrywide and Wells Fargo & Co. have a combined share of around 30% of all home loans originated each year, but the rest of the market is splintered among more than 8,000 lenders affiliated with banks, thrifts or credit unions, while those that don't take deposits are regulated by state agencies.

While companies are free to lend through branch offices, Websites or call centers, their main way of reaching customers has been via independent mortgage-brokerage firms, generally tiny local outfits.  Mortgage brokers find customers, advise them on which types of loans are available and collect fees for handling the initial processing.  There are more than 50,000 mortgage-brokerage firms and they are involved in 60% of all home loans, up from 40% a decade ago, says Tom LaMalfa, managing director of Wholesale Access, a mortgage research firm in Columbia, MD.

But by outsourcing much of its direct contact with consumers, lenders also lost some control over the screening of borrowers and the presenting of loan choices.  Some lenders and industry consultants say subprime lenders' dependence on brokers partly explains the industrywide surge in mortgage fraud.  Fraud appears to be one reason for a recent rash of defaults occurring within the first few months of subprime loans.  New subprime loans made in 2006 totaled about $605 billion, or about 20% of the total mortgage market, up from $120 billion, or 5% in 2001, according to Inside Mortgage Finance, an industry newsletter. 

Wall Street is deeply entrenched in the entire mortgage market, including loans to more creditworthy borrowers, on which defaults so far have remained low.  Last year, banks and brokerage firms pocketed $2.6 billion in fees from underwriting bonds that use mortgages as their collateral, nearly double 2001's figure.  Wall Street banks also extended billions of dollars of short-term credit, called warehouse lines, that allowed lenders to fund mortgage loans.

Source: The Wall Street Journal, March 12, 2007

Your Home Loan

Most people pay less attention to their home loan than they do to their investment portfolio. 

Some have adjustable-rate loans that offer cheap payments for the first few years.  Those loans have enabled some families to stretch and buy the new home they loved but didn't think they could afford.

If you have any kind of mortgage where the payment terms change over time, you should be asking yourself: How likely is it that you'll get hit with a big jump in your monthly payment that would mess up your personal finances?

The easiest way out:

Switch into a 30-year fixed rate.  The national average is currently 6.27% according to consumer-loan data provider HSH Associates.  That's low by historical standards, and better than most rates available in past 18 months.

Source: The Wall Street Journal, March 10, 2007

Real Estate Tax Gap

Full-time real estate professionals, defined as someone who spends more than half of his or her working hours in real estate activities, can fully deduct losses---including depreciation, interest expense on loans and property taxes.

But those who don't fit into that category are typically considered to be "passive" real estate investors with a limited ability to deduct their losses, says Alan Weiner, a CPA and tax partner at the firm of Holtz Rubenstein Reminick LLP in Melville, NY.

Robert Marvin, a spokesman for the IRS, said the tax agency can't comment on individual taxpayer cases.  However, he indicated that the agency is paying more attention to real estate activity because it is one of the areas where research shows there is a large tax gap, meaning taxpayers are underreporting income to the IRS.  The tax gap in income from rents and royalties is about $13 billion and $11 billion for capital gains.  (Income from real estate activity is included in, but not exclusive to, both categories.)  Mr. Marvin said that several thousand returns of real estate professionals have been audited since last year and approximately 3,000 are under audit now.

Real Estate Professional or Passive Investor?

The IRS advises its auditors to do the following when trying to discern whether a taxpayer is actually a real estate professional:

* Determine whether the taxpayer materially participates in one or more of such real estate trades or businesses as rental, construction or leasing.

* Determine who is the real estate professional: husband or wife.

* Request and closely examine the taxpayer's documentation regarding time.

* Scrutinize other activities the taxpayer is engaged in to determine whether claimed time makes sense.

Sources: IRS's Passive Activity Loss audit-technique guide and The Wall Street Journal, February 28, 2007

Real Estate Goes Online

Just like newspaper classified ads have shrunk due to Craigslist, eBay et all, local real estate agents are becoming less important in finding the house of your dreams.

The real estate industry has been based on what economists call information asymmetry, which simply means that one party (typically the seller and seller's agent) knows more about a product than the other (the buyer).  It's an opaque market that encourages obscurity and leads to flawed pricing.  But now through the Internet technology, entrepreneurs are making real estate more like a stock exchange, a transparent market where all information about every property is readily available, and as a result pricing is perfect.

For example, Zillow Inc., based in Seattle, operates a Web site (www.Zillow.com) that offers free estimates and other online tools for real estate buyers and sellers.  It draws revenue from online advertising. The two men behind Zillow are a pair of former Microsoft executives named Richard Barton and Lloyd Frink.  Their company is trying to create a perfect market for real estate.  Mix E*Trade, Craigslist, and the Multiple Listing Service together, and you begin to get the idea.

In the year since its launch, Zillow has made millions of Americans familiar with the computer-generated estimates of home values, created a new online addiction and become a staple of dinner-party chatter.  The Wall Street Journal recently looked at transaction prices recorded for 1,000 recent home sales in seven states, using data from First American Real Estate Solutions, a data provider in Santa Ana, CA, and compared those prices with Zillow estimates, which didn't yet reflect the sales.  The median difference between the Zillow estimate and the actual price was 7.8%.  The estimates were about equally split between ones that were too high and those below the mark.

Zillow came within 5% of the price in a third of the transactions studied by The Journal.  It was more than 25% off target on 11% of them.  In 34 of the 1,000 transactions, Zillow was off by more than 50%.  Like a four-bedroom five-bath house in Fall City, WA where Zillow's estimate was $661,756 but sold for $2,690,000.

Real estate agents and appraisers tend to sneer at Web site valuations and insist that consumers still need their local expertise to get a true idea of values.

Sources: The Wall Street Journal, February 14, 2007 and FORTUNE, February 19, 2007

Impact of Vacant Homes

A large number of homes for sale in the U.S. are unoccupied.

In the third quarter, there were 5.7 million vacant housing units for sale or rent, accounting for a record 4.6% of all U.S. homes.  The average in the 1990s was about 3.5%.  To get this ratio back to normal, 1.3 million vacant homes would need to be occupied.

High vacancy rates have other effects, points out Credit Suisse analyst Ivy Zelman.  When an occupied home gets sold, the seller has to buy or rent another home.  That sets off a chain reaction that ripples through the housing market.  When a vacant home gets sold, the seller doesn't have to do anything.

The good news is that trouble in housing hasn't spelled trouble for the rest of the economy......yet.  And low interest rates give households more buying power.

Source: The Wall Street Journal's AHEAD OF THE TAPE, January 8, 2007

Your Wealth Myth

The myth: Americans don't need to save because they are wealthier than ever.  Just look at the roof over their heads and the cars in their driveways.

Most Americans believe that if they can afford the monthly payments for a house mortgage, the house will appreciate over time and the larger the house, the larger the appreciation.     This real estate appreciation belief is one of the main reasons, the U.S. savings rate has fallen sharply since the mid-1980s.  In fact, last year, it was negative for the first time since 1933.

This may have been true during the recent housing boom with the increased building of McMansions---but it isn't likely to be true over the long run.  Since 1975, home price appreciation has been modest, averaging just two percentage points a year above inflation.

Americans don't save in favor of increasing their housing and transportation expenses.

Our housing expenditures have climbed fairly steadily over the past century, and our homes now claim a third of our spending.  More families are buying houses, more folks are purchasing second homes, and houses are getting bigger.  According to the Census Bureau, over the past 25 years, the number of second homes has jumped 95% and the size of the typical newly constructed single-family home has ballooned 40%.

The number of passenger vehicles has leapt 270% since 1960, far ahead of the 86% increase in the adult population.  We now have one vehicle for every adult.  Transportation spending jumped sharply in the 1960s and has remained high ever since, accounting for more than 19% of spending in 2002-03.

"The trend has been to buy the most house you can afford, rather than the amount you need," notes Sophie Beckmann, a financial-planning specialist at A.G. Edwards in St. Louis.  "It's the same thing with cars.  You see a lot more luxury cars on the road.  While you can get by with a $20,000 car, people buy the $40,000 vehicle with the leather seats and the TV.  There's a lot there that's discretionary."

The bottom line: By reducing what you pay monthly for your houses and cars, you could amass far more wealth by sinking the extra money into your 401(k) plan.  This strategy may be critical to fund your retirement years.

Source: The Wall Street Journal, June 21, 2006

Shift to stable mortgage options

The recent decline in adjustable-rate mortgage ("ARM") demand marks the end of an era in which new mortgage products made it easier for borrowers to afford ever-more expensive homes.

The declining popularity of ARMs comes as short-term interest rates have risen and some lenders have raised prices on these loans for new borrowers.  As a result, fixed-rate mortgages are regaining popularity and some borrowers are becoming disenchanted with their option ARMs (where teaser rates of as low as 1% gave borrowers multiple payment choices but can lead to a rising loan balance).  Some borrowers are moving to hybrid ARMs where the rates on loans remain fixed for as many as 10 years before adjusting annually.

The housing market continues to signal that the boom of the past five years is bursting as sales of previously owned homes fell by 2.7 percent in October.  "This signals that the housing sector has likely passed its peak.  The boom is winding down to an expansion," said David Lereah, chief economist for the National Association of Realtors.  Click here for more on the housing market bubble.

Source: The Wall Street Journal, November 29, 2005