A Rising Interest Rate Environment

If this is the actual long anticipated reversal in interest rates, what does that mean for you and me and what is a  good capital structure for future enterprises? (I believe that even personal finances should be thought out and well-structured. While individuals don’t have the tax situations that company’s have, they have plenty of capital allocation choices that are very similar to what a public enterprise would engage in.) The best place to start that thought is to explore what worked really well in the past. Let’s assume a hypothetical simplified business that makes widgets- Widgets R Us Inc. They require a small amount of cash on hand for day-to-day activities, maintain an accounts receivable and payable and take inventories of widget parts and turn them into full widgets which are then sold on the open market for a profit. We’ll assume some generic facts about the business and show two hypothetical simplified capital structures to illustrate the value of leverage in an inflationary environment and falling interest rates. Take a look at the simplified balance sheet and income statements below:

Widgets R Us Base Case
Widgets R Us Base Case Capital Structure

The terms at the top just govern the basic business structure and environment for Widgets R Us. The Revenue/Assets % is the annual revenue yield expected from total assets in this business and employing a standard distribution of assets for this business (i.e. the right amount of cash, A/R, PP&E, etc. to efficiently turn raw goods into a finished product). The COGS/Revenue is the total expense needed for the operation with the Gross margin simply being 1 – COGS/Revenue. The starting interest expense is the average interest ratio on all of the debt (i.e. Notes Payable and Long Term Debt) the company currently has on the balance sheet. The tax rate is the standard unmodified corporate income rate. We’ve assumed a five year compound inflation rate of 25% which breaks down to an annual inflation rate of 4.564%. Lastly, we assume since interest rates have been falling the company has the chance reissue its debt at a new and lower rate. For our example the 5 year expected interest rate is 8%, while the current one is 10%.

Next follows a very simple balance sheet and income statement. We start with both short term assets (cash, accounts receivable, and inventories) and long term assets (PP&E and Goodwill). Next is the short term liabilities (Notes Payable and Accounts Payable) and Long Term Debt. Finally, assets-liabilities=shareholder’s equity. Notes: Accounts Receivable is money owed to the company from outside sources, Accounts Payable is money the company owes to outside sources, and Goodwill is the excess fair market value over existing asset value).

After that comes a simplified income statement. We earn 40% of the total assets as an annual revenue (i.e. $6,100 is 40% of $15,250). We pay 75% of that as COGS and then pay interest expense leaving us with income before taxes. We then have to pay income taxes leaving us with net income.

The example breaks down the business into two hypothetical capital structures. The first example is with a low leverage ratio. Indeed the total debt $2,250.00 and the shareholders equity is $10,500 as compared to a total asset base of $15,250. The equity in this operation is nearly 2/3rds of the value in the business and very little of this operation is leveraged. In the second case the business is carrying $10,000 in long term debt and $1,000 in short term debt (and plans on maintaining this amount through the next five years). Now equity is a paltry $1,750 or a little over 1/10th of the total asset base of $15,250.

Columns three and four show the business in year five for both example 1 and example 2. IT IS IMPORTANT TO NOTE THAT THERE IS NO ASSUMED ORGANIC GROWTH FOR EITHER EXAMPLE. The businesses still need the required distribution of assets to operate and the only thing that has change is that inflation as increased both the price that goods can be sold at and the resulting price for the assets needed for this operation. We aren’t making the business bigger or changing products or anything else. We are just assuming that prices for everything went up! (The revenue earned increased by 25% from $6,100 to $7,025, the value of the assets needed to do that amount of revenue went up by 25% – Inventories went up 25% from $2,500 to $3,125, PP&E went up 25% from $5,000 to $6,250, etc.)

Once again we aren’t making the business bigger or changing products or anything else. Inflation has boosted our output prices and our required input prices. Nothing else. While most of the assets have gone up in value, some things have stayed the same. Goodwill hasn’t changed, since we really didn’t do any acquisitions, divestitures, etc. Our debt amounts haven’t changed. The low leverage business still carries a total debt burden of $2,250 and the high leverage business still carries a debt burden of $11,000 of combined notes payable and long term debt.

One other thing has changed. In five years we had the opportunity to refinance the debt at a lower rate due to falling rates. The interest we pay on the debt has gone from 10% to 8%; this affects our interest expense line item in the income statement. So what are the five year results for owners of this business solely due to disparate capital structures and an environment we’ve had for the last 30 years? Well there are two numbers that changed dramatically for the two businesses. The first is the amount of shareholders equity. The low leverage business (example 1) grew their shareholders equity from $10,500 to $12,187.52 for a 16% increase in value, but the high leverage business grew their shareholders equity from $1,750 to $3,437.52 for a 96.4% increase! Those shareholders made bank. In addition to the growth in equity, the net income changed due to inflation, but also due to the decrease in interest expense. We see the low leverage business growing their net income by only 21%, while the highly leveraged business grew their income by 106%!

That’s a pretty big difference in 5 years for earnings and equity. And all it took was a serious amount of leverage. It’s also important to note that the low leverage business didn’t keep up with the rate of inflation in either equity growth or earnings growth. If the low leverage business was actually publicly owned (and possibly even if it was privately owned),  the owners would be having a very serious talk with the management team asking them why they were getting paid for sub-par growth. In fact, there probably would have been a distinct pressure to change the situation (by leveraging the capital structure) or by replacing the management team. The second way of righting the business is exactly how Bain Capital makes it money! If you understand that example, you can be as rich as Mitt Romney!

All joking aside, it’s important to see where inflation and reductions in interest rates affect a company’s prospects. Inflation primarily affects the balance sheet. If an enterprise can count on a steady and positive rate of inflation, it can assume a higher leverage ratio and wait for inflation to help juice the shareholder’s returns by counting on the increase in nominal prices for inputs and outputs. On the opposite side, a reduction in the borrowing costs for capital primarily affect the income statement, if the firm doesn’t take advantage of the lowered rates to raise the amount of leverage. In a realistic enterprise, they would definitely increase the amount debt on the balance sheet to maintain the present value of the tax shield asset (pre-tax interest expense reduction in taxable earnings). In our example the constraint was to not allow a change in liabilities; this was done to highlight the effects that have been in place for the last 30 years.

And the last 30 years, in general, have been incredibly good for businesses. The constant reduction in interest rates and the continuous positive rates for inflation have allowed companies to assume higher rates of leverage to increase their rates of return. This is the primary tactic for private equity enterprises. Buy a company with large amounts of debt that are then added to the company’s balance sheet and wait for the operational turn-around (plus inflation and reduction in interest rates) to juice up the equity and earnings so that you can quickly sell. But if the environment changes what happens to Widgets R Us Inc? In the follow up articles we’ll see what happens to the two different businesses when interest rates rise. After that we’ll conclude with some actual advice.



A State Transition in Interest Rates?

Just recently we have experienced what might possibly be the start of the reversal in a 30 year trend. For over 30 years, interest rates within the United States have been slowly but continuously dropping. From a cyclical high of a 15.8% yield on the 10 Year Treasury reached in 1981 to the incredible low yield of 1.63% reached earlier this year. While it was not a straight line and there were many counter-trends up, during the life of a 10 year bond you were guaranteed to not only earn a yield in interest, but to also earn a yield in principle. The constant and inexorable motion of the lowering of interest rates meant that it was always going to be easier in the future to pay of one’s debts- even if the only choice was to refinance the operation. Coupled with a constant and always positive rate of inflation, it made sense during the last 30 years to always try and leverage any activity as much as possible, continue operations until interest rates and inflation reduced the debt burden, and finally reap a return due to the equity growth in the balance sheet. The only issue that limited incredible rates of leverage was the ability to handle a short term reversal (remember Long Term Capital Management?).

30 yea10 Year Treasury Interest rate graph

That may have all changed earlier this year. The interest rate on the 10 year bond started rising from a low of 1.63% to just under 3%. And it seems that the positive change in interest rates, while large and quick, isn’t going to be stopping anytime soon.  In fact, this change might be the harbinger of a long 30 year counter trend where rates inexorably rise and there is a constant and continued reduction in operational viability due to ever increasing financing costs. (Note: The wording in the earlier sentences intone a strong sense of conditionality; this isn’t meant to imply that the result or effect is in question, but that right now no one knows if this is actually the start of a counter-trend or just a false uptick to lower overall interest rates. While people may say that there’s very little room left for rates to fall, a valid counter example is Japan where rates have fallen to well below 1%.)


Housing Affordability Index

One should always look for metrics that help to quantitatively assess the value one gets for the price one pays. Intuitively we all do this when we look for the next big ‘deal’ or when we employ a coupon to save money. The problem with financial purchases, as opposed to typical consumer purchases, is the time frame involved. Most food is good for a month and clothes are good for a couple years. Since people also tend to cycle in and out and make multiple purchases annually, the deals have to be acted upon quickly and no single purchase is detrimental to the long term value of the product being purchased. This isn’t the case with stocks, bonds, or real estate. One good purchase can disproportionately pay dividends for future years for as long as the asset is held.

The hardest financial purchase to get right is also the largest a family makes; the decision to purchase their family home. Research shows that the average length of stay at any one purchased property is 7 years. This means that the cost you pay is fixed for a fairly long time. So it behooves everyone to make sure that when they make this purchase they are getting the best possible deal that they could possibly get. So we’re back to the original need for a strong metric to help make this decision easier. One of the most common aphorisms in finance is that a ‘rising tide lifts all boats.’ The point being made (and hopefully remembered) is that when the market goes through periods of over-valuation and under-valuation relative to average all of the individual securities are influenced to some degree. Even crappy stocks get bid up and they become more pricey than when the market was undervalued.

The same process applies to real estate. As everyone now knows we just had a bubble in real estate with both good AND bad properties being priced at the higher range of the valuation spectrum. But how to know when is a good time and when is a bad time to buy real estate? Well the National Association of Realtors (bless their black little hearts…) actually do put together and track a housing affordability metric. It’s called the Housing Affordability Index and it’s actually very very useful. The metric is based on the median single family home’s monthly PI (Principle and Interest) cost as a percentage of the median family income. As a metric it gives you the actual monthly cost basis of real estate from a national perspective. This is a very valuable metric and can help anyone determine a good time (from a bad time) to buy real estate.

Zerohedge had an article that illustrated the thirty year affordability graph and is reprinted below. The zerohedge article talks about how housing affordability (due to the interest move on the 10 Year Treasury note) has starting plunging rather drastically. While it doesn’t mean that you shouldn’t buy real estate (as its price is always, first and foremost, a local phenomena) based on the housing affordability index alone, it does serve to highlight the broad trend and helps simplify the initial decision tremendously. And the signal coming from the market right now is, if you’re in the market to buy a house, to buy quickly; prices are going up.



Housing Affordability

30 Year Housing Affordability Trend


Rising Interest Rates and Capitalizing on Mortgage Shorting

Buying a primary home is one of the single biggest financial decisions that a person has to make in their life. The decision is further complicated by the fact that this is also one of the few moments where everyone has the ability to leverage 4 to 1 their purchasing potential. This financial situation, like many others, can be seen as an opportunity or risk. Depending on the property you’ve determined to purchase and the cost you’re willing to pay, you have the potential to make a decent return on your investment (or, at the very least, significantly reduce your inflation exposure).

About three years ago, I made the truly scary decision to purchase a property. I happen to live in California where the real estate boom and bust cycles are exaggerated compared to the rest of the country and buying real estate is not a sport for the faint of heart! I felt that I locked in a relatively nice property with development potential that was fairly affordable. At the time we were buying the property, I had a bunch of simple metric to determine whether we would purchase the place or not. Was the PITI (principle interest taxes and insurance) near neighborhood rental rates? If it was then the place was affordable and we could buy.

At the end of 2010 we ended up with our first property and started with an initial loan of 4.25%. To make a long story short over the next three years we did two no cost refinances to lock in a 30yr, 3.5% loan for the place.  These were fairly good deals and each helped me lock in a greater principal savings if mortgage rates rose in the future. Mortgages are like any other bond out there. They have a coupon payment associated with them (monthly PI payment), a term (typically 30 or 15 years), a face value (amount of the bond), and posted collateral (your house). The difference is that when you get a mortgage, you are issuing a bond to the bank against your house. If you invest in the bond market to any degree (by typically holding a bond fund) you are actually taking the role of the bank and acting as the lender/creditor and holding some other corporation/entity’s bond. It’s very difficult for an individual to issue bonds outside of a small business situation and this is one of the few times you get to do this. Locking in a low interest rate is advantageous for the issuer, because if the rate environment rises the lender takes the hit to the par value and you can consider the loss in par value as actual income. In fact, corporations can choose to report in their income statement gains or losses from fair value accounting of assets or liabilities and can record on their balance sheet assets or liabilities at fair value, as opposed to just at principal amount (FAS 157 covers these accounting rules).

What this means is that as interest rates rise, the face value of my mortgage declines and I have made money by locking in an interest rate below prevailing market conditions. Using a simple bond calculator and assuming a $500k loan, I can figure out the book value of my mortgage as mortgage rates rise. For a market rate of 4.5% (current) and a stated interest rate of 3.5% and 29 terms left, the bond calculator states that my $500k mortgage is only worth $420k. In one year and a 1% increase, I’ve made $80k if I was to buy this bond back. If interest rates rise to 5.5% by next year and assuming 28 terms left, the mortgage is only worth $361k. That means I have the chance of making another $79k by holding this mortgage. This is a significant earnings per $500k that a fair number of households will make over the next couple of years.

That’s all well and good, and I believe everyone understands that you will be making money off the bond as interest rates rise, but we might also be a bit more concerned in how much of a reduction in interest expense you gain by holding a lower than market rate mortgage as opposed to current rates. To figure this out I went to a mortgage calculator (http://www.mlcalc.com) and priced three $500k mortgages; one at 3.5%, another at 4.5%, and a third at 5.5%. I then calculated the total interest paid as a function of years for each loan and then calculated the interest expense saved by year. For the hypothetical $500k loan, you’re saving nearly $4k in the first year between the 3.5% and 4.5% loan and nearly $8k in the first year between the 3.5% and 5.5% loan. If you hold the loan to maturity you’ll save $83k on the 3.5% to 4.5% change and $170k on the 3.5% to 5.5% change. I also wanted to know how long it would take me to realize this savings and so calculated a rolling Interest Rate of Change for each rate change. The annual interest expense saved per year divided by the total potential interest saved is then plotted as a percentage over the life of the loan. After 30 years you’ve saved 100% of the potential interest expense and you can see (from the plot below) that they follow fairly similar rates of change. Also note you make 50% of your money back in the first ten years. So as rates rise, do your best to hold your mortgage for at least the next 9 years.



Interest Save RoC

College Signals and Networks

I recently wrote an article that talked about the difference between skills and talents. Skills represent learned mastery and functional ability within a specific discipline. Driving would be a skill, as would cooking or algebra. Talents on the other hand are basic inherent or developed aptitudes for specific disciplines. You could have a natural sport talent or math talent that allowed you to have a basic understanding and ability within that discipline. Skills typically don’t have such crossover.

I then talked about which is more useful. Tactically, skills are more useful. You have to have a specific skill to perform a job function. Being good and savvy at computers won’t get you a job that requires proficiency with Microsoft Word (i.e. skill with Microsoft Word). Talents are more useful strategically. They won’t ever qualify you for a job, but given a little time and ability they allow you to quickly pick up the skill needed to do something. More importantly, they grant you flexibility and the ability to grow into higher or different positions and roles. Said succinctly, being good at math isn’t going to get you an engineering job. Having an engineering degree will. That brings us to the point of this article, which is accreditation.

How do we know if someone is good at something and/or has talent and ability? Without personally observing the person and comprehensively measuring them , we can’t. This means that people (and companies) have an issue when thinking of hiring a new person. They can’t actually measure their skills and talents until they get them into the job, but they have to have some idea of what they can or can’t do. There are some tools available to help mitigate this issue such as resumes (which list skills) and references (to help validate and verify claims)  when it comes to skills, but neither are really helpful at assessing talent and long term potential. The resume is perfect for a tactical placement, but not very valuable for a strategic acquisition. In enters college degrees and their accreditation. Colleges’ primary responsibility is to impart an education sufficient in breadth and depth to make the student capable at performing in their chosen industry at an entry-level competency.

But college degrees also imply and grant another more important benefit. Due to the competitiveness and status of a college, they also grant some incite into a person’s talents. If you attend a premier engineering school (such as MIT or CalTech), people will know that you are a cut above the average engineering bachelor. These schools help impart some idea about a person’s talent. They grant the attendee the ability to signal to a prospective employer; “hey, look at me. I’m not just average at engineering, I’m really really good at it!” In certain disciplines, such as business and law, the professional degree also helps create networking opportunities with alumni who might be able and willing to help a junior graduate get their first opportunity. Both assets are strategically invaluable. It is also why students are willing to pay an ever increasing amount for schools with very good reputations.

The ability to signal talent and create networking opportunities doesn’t come cheap. Colleges charge a hefty tuition fee for this service. Yet lately, there are rumblings within the business world that the price being charged is over inflated. Peter Thiel, an entrepreneur and hedge fund manager, recently started a venture, the Thiel Fellowship, to help out young entrepreneurs. One of the first entrepreneurial ideas being suggested is an alternative to college for signaling talent. While the idea is in it’s infancy, it’s concept definitely has merit.




Ricardo and Comparative Advantage part 2

In an earlier post, I mentioned my need and fascination with financial blogs. I read them avidly and regularly to help understand the economic issues that are currently occurring. As a recent father and an employee during the Housing bubble and the current Great Recession, it seems that there is always an economic events in the news that impact me and my small universe. Understanding how that event will effect me is paramount to helping position myself and my family to weather the oncoming storm.

In trying to understand how the world works, I’ve found that some common economic principles helps one to understand the situation. One of my longstanding principles that I always seem to come back to is Ricardo and his concept of Comparative Advantage. Comparative advantage simply states that given more than one choice on how to produce a good the producer will choose the option that will cost him the least. If option A takes $5 to produce a good and option B takes $7, it makes prudent financial sense that the producer will take option A and save himself the $2 difference. This concept, while simple, has profound implications in the world and our increasingly globalized economy.

Once again I was reading Charles Hugh Smith, a blogger I thoroughly enjoy over at Of Two Minds, and found myself questioning one of his conclusions. His entire post can be found here:

In his post he states:

There is so much ideological, quasi-religious fanaticism around “free trade” (there is no such thing as “free trade,” there are only various permutations of managed trade) and “industrial policy” (every nation has one, explicit or implicit) that it is difficult to make any sense of the many intertwined issues.

Ideological purity is not a substitute for knowledge, any more than a superficial admiration of machines equals actually knowing how to assemble, maintain and repair them.

As a background context, we might start by noting that Marx outlined how finance capital comes to dominate industrial capital, as industry comes to depend on the credit extended by the banks/finance capital.

The key takeaway: if you don’t control the banks, then they will end up dominating industrial capital. In the U.S., we have the worst of both worlds: a dominant financial Elite and various cartels (military-industrial, sickcare, agribusiness, etc.) that have captured what little of the Central State that isn’t already beholden to financial capital.

Moving production around the world to exploit cheap labor–also knowns as “wage arbitrage”– is not free trade: it is merely the consequence of free capital flows, and an extension of capital’s dominance of labor. If capital can reap higher returns by flowing elsewhere and abandoning domestic labor, then it will do so, and “lowering the cost to consumers” is the marketing propaganda issued to placate the captive home markets.

Consumers, after all, are not free to travel the globe seeking “higher returns,” i.e. lower prices–that privilege is reserved for capital.

The last sentence, and Charles’ assertion, got me thinking. Is this really true? Are consumers restricted from traveling the globe and seeking ‘higher returns,’ i.e. lower prices? While Ricardo’s comparative advantage only talks about producers, we have to remember the context of his life. In his life the world was shifting from farms to manufacturing and production and the Industrial Revolution was in full swing. The great forward thinkers were Industrialists and they thought in terms of factories, goods, and producing things. The principle has been most commonly meant to refer to capital accumulation, but there isn’t any reason that it can’t be applied to consumption. If you think of consumption (i.e. the purchasing of a good to meet an individual need) as an equal and opposite transaction to capital allocation, you come to realize that Ricardo’s theory of Comparative Advantage applies to consumption as well.

Consider a simple rewording of the earlier definition. Comparative advantage simply states that given more than one choice on how to purchase a good the purchaser will choose the option that will cost him the least. If option A takes $5 to purchase a good and option B takes $7, it makes prudent financial sense that the purchaser will take option A and save himself the $2 difference. And herein lies the value of global free trade common American households; the ability to purchase the cheapest option is slowly becoming available. We’ve all seen it in the last decade. Companies that used to be the sole provider of a good could impose a tariff on that transaction that the American households had no choice but to pay slowly, but assuredly, being eclipsed by companies that provide the good and service at a lower cost.

Take a long look at the record music business. CD sales have been falling every year for the last decade. Does this mean that people are consuming less music, or there are less people? No! It means that the record label monopoly that forced me to buy a CD for $16.99 for two or three good songs and a dozen crappy ones isn’t working anymore. People are free to find and consume music in different mediums for prices that are way cheaper. If you like a single song on an album, buy just that song for $1.29 on iTunes and save yourself the remaining $15.70 for other songs you’ll like. Do you wonder if you’ll like the song your about to buy? Preview the song before purchasing.

This trend in consumer purchasing power isn’t only applicable to CD music sales. We can see the same thing in movie purchases and rentals (Blockbuster vs. Netflix), books (Barnes and Noble vs. Amazon), medical supplies (Canada online drug stores vs. American pharmacies), Home Electronics (Best Buy vs. Newegg.com), and countless more. This is all thanks to the Internet. It has become the American consumer’s greatest friend in global markets. Apple wants to produce their phones in China and save on the cost of American labor costs. Fine! Go to Chinese websites and purchase the phone directly from there! I even have friends that went to India for hair transplant surgeries and surrogate pregnancies!

The options to buy goods from the cheapest global provider are multiplying every year. I recently bought a management textbook for class over the internet. The ‘American’ version of the text book was $180.00. My wife went online and within 15 minutes found and ‘International’ version of the text book for $52.00 ($58.00 with shipping)! What’s the difference between the ‘Amerian’ version and the ‘International’ version? The Indian website states that the material is exactly the same, but that the publisher might print the material in black and white instead of color and softcover instead of hardcover. Seriously! $120.00 for color and a firm outer binding? I know when I’m being ripped off and, trust me, I’m buying that ‘International’ version and applying Ricardo’s principle of Comparative Advantage to my benefit.

And so should you.


The Basics of Accounting Part Two

In an earlier post on accounting, I described one of the four basic accounting statements, the balance sheet, and the terminology of an asset, a liability, and owner’s equity. I also included an example of buying a car (well not just buying any car, but a 2010 Lamborghini Gallardo LP560-4 Coupe!!) to illustrate the difference between an asset and owner’s equity. This time I want to expand on that example a bit to help illustrate how accounting can help one make smarter financial decisions. These decisions might not be what the heart wants, but it will be what the pocketbook can afford!!

First a quick recap: the actual goal of accounting is to help you realize and correctly determine out of the many things and claims you have for and against you what is an asset, what is a liability, and what is owner’s equity. You’re using the accounting statement to help clearly visualize each category and to help quickly determine the best financial option given your current financial situation. This is the balance sheet’s primary purpose. There are three other accounting statements- the income statement, the cash flow statement, and the statement of owner’s equity that comprise current accounting principles.

We will still concern ourselves mainly with the balance sheet, but we’ll talk briefly about the income statement in this post. So what is an income statement? Wikipedia has a great article on the specifics of what an income statement is which goes into far greater detail than we’re currently interested in, but it’s worth a look if your curious. If you only want the quick bare bones summary, an income statement is a statement generated to help an individual determine his top line revenue, all associated costs incurred to earn that revenue, and the final residual income (or loss!!) associated with the aforementioned revenue activity. For individuals, the income statement is pretty straight forward. You have your job’s earnings at the top, you then subtract of all mandatory expenses needed to perform the aforementioned job (i.e. taxes, gasoline costs required to get to and from work, car maintenance, etc.), and then you’re left with the residual income which you can then use at your discretion (hopefully, though, food, clothing, and shelter are at the top of that discretionary budget). For our purpose we’re not really going to explore the ins and outs of the income statement; we’re only going to borrow a single line item from it- the expense line. We’ll need this to help track our overall expenses we incur from buying that Lamborghini with a loan.

We’ll also be making some assumptions that we’ll try and hold throughout the example- car loans are financed at 4.67% new, 5.02% used for a 60 month loan, which was found from Bankrate.com, you can invest money in a 5 yr CD at 1.55%, and that a cars’ intrinsic value is fairly constant over a five year time span. This would mean that five years from now that 2010 Lamborghini should be priced in equivalent dollars to a 2005 (or currently 5 year old) used Lamborghini would be priced right now. While we are playing a little fast and loose with model changes and possible issues with inflation (or deflation), hopefully they’re relatively static across all cars and these issues represent only a small amount of error in the calculations. We could try and find sales data for the same model over five years, but that would be a lot of work that probably isn’t worth the effort. With these assumptions out of the way, let’s look at our car example again. Using a new car loan to purchase our Lamborghini we can see that the monthly car payments would be $3,706.64.

At the start of the purchase our Balance Sheet would look like:

The expense line item would be $0.00.

We’ve just bought our care signed up for a car loan and added the car to our balance sheet. We’ll be paying $3706.64 per month and track the value of the Gallardo on the balance sheet. Let’s assume that we make our payments diligently for three years. We’d like to see how we’re doing at this point. Our total expenses (for three years of payments) is $133,439.04. We also want to know how much the car is currently worth. To figure this out we’ll estimate the value of our Lamborghini Gallardo by seeing how much 3 year old Gallardo’s go for.  Using AutoTrader.com I found a used 2008 Gallardo with 4,700 miles on it selling for $155,000. Assuming we actually drive our car a bit, we’ll conservatively assume that our Lamborghini will sell for $145,000. So our new Balance Sheet would look like this:

On the left side, the asset side, we have the market value of the Lamborghini Gallardo ($150,000.00). On the left side we’ve estimated the remainder of the car loan on a linear scale (which is 2/5 of the original balance). We’ve done this because we’re assuming we’ll pay of the entire car loan on time without missing a payment or refinancing. In reality it’s a bit more, since interest is paid upfront and not principal.

On the bottom right side (liabilities) you’ll see that we have a value of $150,000 also. This has to equal the value of the asset (Gallardo). To figure out the owner’s equity we just subtract the loan amount from the liability balance; our current equity in the car is $70,800. That’s not too bad. The last item we need to remember is our expense line item, which is $133,439.04. This just reminds us that we’ve paid approximately $133k to have a car worth $70k. Owning a Lamborghini for three years has reduced our net worth by $63k. This happened even though we only “lost” $48k on the face value of the Gallardo (from $198k brand new to $150k used). Loan expenses ate away another $15k. This is important to calculate and remind ourselves.

Hopefully this example helps show the usefulness of basic account (which isn’t too involved). I know I didn’t explain how I came up with the monthly payment for the Lamborghini, but I don’t know if that’s overtly necessary to know. Bankrate.com has a great free calculator that you could use at anytime to find that number and maybe, if there’s interest, I’ll show the formula I used (which gives the same result). Next time I’ll expand this example by showing an alternative investment option.


The Slowly Declining Housing Market

It is interesting how things can change within the span of a couple of months. Two months ago, the housing market was seen as just slowly stabilizing and the housing industry being able to eek out a small change in price over summer over last year. Unfortunately, with the summer selling season and tax rebates over, the lack of sustained buyer interest has caused house prices to restart their inexorable downward decline.
At first it seemed that the lack of a tax rebate would only limit the upside potential in house prices. The Case-Shiller Home Price Index (which is one of the most respected and accurate) is a rolling three month average that is published a full month later. At the end of  August (the end of the summer home buying season), the Case-Shiller HPI actually only shows data for the July index point, which happens to be an average of the change in prices for the months of May, June, and July. There are many valid and applicable reasons that the Case-Shiller index does this, but it tends to delay the ability to see sudden price changes due to external events (like tax rebates). To get a truly accurate picture of price momentum after the rebate (which maxed out positive price momentum) in July you’d have to wait till at least October (which would have July, August, and September data), with the November report accurately  portraying the correct downward slope. Unfortunately at the end of November another disastrous event might have potentially started that guarantees even greater declines in the following year: the increase in interest rates.

For the last two weeks, interest rates on the 10 year and 30 year bond have been slowly trending upwards. This is seen as positive news for the economy since higher interest rates imply growth and increased inflation. Why higher levels of inflation is good for the economy is a topic for another post at a later date; it is sufficient to understand that our current government sees it as a good thing and something they have actively been trying to promote. One consequence of higher government interest rates though is higher mortgage rates. And higher mortgage rates are never good for nominal home prices. I tried to capture the issue in an earlier post, but at that time it seemed more of an academic argument than an actual issue. (The fact that the article was only published a week ago is more due to my class and work schedule and not a factor to when I started thinking about the issue. I started the original draft for the post in the middle of November). With the move in interest rates becoming concrete, there are a number of other bloggers that are starting to sound the alarm on what is to be expected for next year. If mortgage rates move 1%, the average potential decline in home prices is nominally 10%. From the bottom in October, we’re already seeing a 0.75% increase in mortgage rates. That means that for 2011, we can expect a nominal decrease in  home prices of roughly 7 to 10%. On a country-wide basis we had a 1.7 trillion loss this year, and we can expect around a 2 trillion loss next year.

I’ll leave my readers with links to other great posts. For those that are interested and need more information, they can help shed light on the big issue we’ll be seeing in 2011.

Why are home mortgage interest rates rising so quickly?

Higher Mortgage Rates Could Kick a Down Housing Market.

Mortgage-Bond Slump No ‘Fun’ for Housing as Rates Increase.


Mortgage Rates and Their Impact on Homeownership

I was reading a fantastic article over at Dr. Housing Bubble Blog about how now isn’t the time to buy a house in Southern California.  I won’t argue one bit with Dr. Housing’s analysis, because I agree with it entirely. No sane person would be looking to buy a place in southern California, and definitely not within any of the neighborhoods Dr. Housing has honored as a “Real Home of Genius” neighborhood. These ‘featured’ neighborhoods are a great synopsis of neighborhoods where a person can ‘invest’ and lose a lot of money. His main thesis is that there are multiple signs that should warn anyone about when is and isn’t a great time to buy real estate. One of the more interesting graphs he shows is from the US Gov. and details the average mortgage rate in America. The graph is shown below:

Source: Article by Dr. Housing Bubble Blog.

One of the real reasons that this graph is so valuable is due to how people in America buy Real Estate. They buy a fixed monthly payment that lasts for 30 years. This allows them to amortize the cost of the house over an extended period, while paying an interest rate commensurate with long term inflation risk. Many people think that they’re getting a good deal, because the payment stays fixed and inflation helps to ease the burden in the future. What they don’t realize is that the bank’s mortgage rate more than compensates for inflation and still charges a premium for the money loaned. (Ex. current conforming mortgage rates are around 4.35%, 10 yr T-bond is at 2.75%, and the current annualized inflation rate for the US is around 1%. There are decent margin spreads on the mortgage rate over both comparable indices.)

More importantly, when people buy a house they have two things they have to qualify for to actually buy the place. They have to have an adequate down payment (which is usually 20%), and they have to afford the monthly payment on the note. Each and every month for 360 payments they have to come up with the amount that they’ve signed up for. This is no mean feat and figures hugely in the affordability of the house. Typically, the home buyer allows the bank to do this calculation for them and present them with the amount that they can afford. What most people don’t realize is that the interest payment for a mortgage note is a huge factor in how much house you can afford. The amount of the note moves inversely with the interest rate. Consider a typical house with a price of $250,000, a down payment of $50,000 (20%), and at the long term average of 9% in interest rate. The average monthly payment is $1,500. This is a reasonable amount per month. What would that monthly payment be if the interest rate was say 7%, or 5%? At 7% it would be only $1,166.67 a month and at 5% it would be $833.33. At a 5% interest rate you can nearly afford a house that is twice the principal (or $500,000). Does this mean that you can buy a house twice the size? Not really. In the real world, the typical price for a house rises and the monthly payment stays the same. The main reason for this is that as interest rates go down, people realize they can afford more (per month) and they then tend to bid more per house which raises the overall price of housing.

As long as interest rates fall and price goes up as a result, it’s a virtuous circle because people gain equity due to their initial leverage when they purchase. When interest rates rise and price goes down as a result, it can easily wipe out home buyers equity and help speed along the possibility of default. I built a quick and dirty table in excel to help visualize the reduction in home prices IF a mean reversion in interest rates occur. I fully expect some sort of mean reversion within the next five years and this table helps determine how much I can lose when purchasing real estate. In the table I’ve listed three interest rates- 4.35%, 6%, and 9% and a home price of $600,000.00, with 20% down. These interest rates represent the current mortgage environment, a rate we’ve seen just within the last five years, and the typical average. The calculation is shown below:

The calculation lists the effective home price for a house with a similar monthly payment (called ‘monthly nut’ in the spreadsheet). Using this spreadsheet calculation, I can see that a house currently worth $600k currently is only really worth $290k if interest rates move. This represents over a 50% loss if one was to purchase a house at the current prevailing interest rates. That is something to seriously consider if you’re planning on buying.


Note: The reason the monthly nut isn’t the same in all three lines is because the imputed down payment in the following rows is held constant. If one was to reduce the down payment to 20% of the effective house price we would have a table that looks like this:

Another couple of points: The rate listed is the annual percentage rate (or APR), the term is the number of months of the loan (so 30 years at 12 months per year is equal to 360 total months), the effective rate is the monthly interest rate (i.e. for the 4.35%/year rate it is just 4.35%/12 months or 0.36%/month) the cashflow is the monthly expenditure required for the loan (both principal and interest amounts) PER EVERY 1oo THOUSAND DOLLARS (which is the present value column). The house price is the full purchase price that the house would retail for if the monthly payments (aka monthly nut) stayed constant, and finally the down payment is the amount put down for the loan.

Update: Since I actually put this article together (two weeks ago), interest rates have turned in the market and a slew of articles by other bloggers have appeared also detailing the same issue I bring up. Namely, as interest rates turn, house prices will fall.

Mortgage interest rates hit five-month high by IrvineRenter  on Irvine Housing Blog and

Mortgage Rates Go Parabolic by Tyler Durden on ZeroHedge

If mortgage rates keep increasing, you will probably see a decent uptick in articles about the drop in house prices because of it and widespread pressure on house prices in 2011.

Current Home Sales in the US

I don’t bother to update or revise other blogs’ financial data sets because I usually see very little value in rehashing what everyone else is already doing a fine job of posting. Unfortunately, sometimes other people don’t  express a data set in a method that is consistent with seeing a bigger picture. When presenting disparate units it is of the utmost importance that the ranges employed have the same spans. If you use different spans, you can end up not understanding the data set completely. In the chart below, I’ve made sure that both data sets’ bottom range is 50% of the top listed value and that both sets starting point is close to each other. This allows one to gauge the relative percentage change visually as opposed to numerically.

The chart below is for new and existing home sales within the US for the last twelve months (the data set currently available from the National Association of Realtors and the US Census Bureau).

While the graph is similar to the one posted by Dr. Housing Bubble *on his blog, I think the above graph which has been smoothed for data ranges expresses a better picture of the current situation than his does. The range on the left side has a max value of 6.6 million homes and a min value of 3.3 million homes, while the range on the right side has a max value of 450 thousand homes and a min value of 225 thousand homes. Both data ranges have a min value equal to 50% of the max value. This allows the above data sets to “experience” the same percentage result when plotted on the same graph. If existing home sales fell by 10% and new home sales fell by 10% you would see the same amount of decline in the graph. This is a very valuable technique. It allows you to eyeball very quickly which data set is moving at a faster pace. If you’re also skilled enough to line them up closely you can also tell immediately their relative percentage changes. From the above graph, what we’re starting to see is that both sales are approximately suffering by the same amount percentage-wise from last year. This is sobering news. It means that while we have more existing home sales than new home sales (which we always have had) we have the exact same decline in sales for both types of housing. Over the last year, it hasn’t mattered whether the house was new or not, sales have declined for both properties by the same percentage. If you’ve been following housing related news, they’ve all been talking how new homes have been pounded while existing home sales haven’t. Absent some manipulation by the federal government due to the home buyer tax credit, they’re both suffering the same amount this year. The housing malaise has finally caught up with existing home sales.


*btw – Dr. Housing Bubble is an excellent blog and I highly recommend him. His blog, with a couple others, is my main source of information on the US and California housing markets. He has an incredible wealth of real estate information and was partially responsible for me not losing my shirt to the current housing bubble. I’ve probably been reading him religiously for at least two or three years. Also he’s been tracking this data set for longer than I have and his graph is a better picture of the housing market over a longer period. I just wish he did what I did for the graph so that the reader would get a better understanding of the current situation. That’s the only real reason I’m posting this blog article.