Wealth Tip: Three Reasons Why Foreclosure Rates Keep Climbing

REASON ONE: Changing mortgage underwriting guidelines.

There was a time four decades ago that in order to get a loan to buy a home the borrower needed a 20 percent down payment, strong credit, and stable income that was at least three times as high as the mortgage payments. But the world has changed, and so has the lending market.

Today home buyers can get zero down loans with adjustable rate mortgages that cause their loan balance to actually increase every month (called “negative amortizing loans”). In fact, lenders today have loosened up their requirements on credit standards (witness the explosion of “sub prime” loans) and income levels (with many lenders requiring only twice the income of the total home monthly payment).

As you can imagine, this loosening of the financial requirements means more borrowers will default on their loans. They have less equity. They have a smaller cushion to make the monthly payments. And in many instances they have lower credit scores.

Just to be clear on this, I personally think many of the mortgage industry changes are good ones. I love the idea that more people than ever are able to get access to financing to purchase their home. To me this gives ordinary people the chance to build wealth and enjoy the freedom of owning their own home.

But there is a downside to this too, when you add in the societal push to buy the “most expensive home you can qualify for a loan for”. This influence I think causes many homeowners to get in way over their heads. Hence the need for investors like you and I to be there to bail out many of them for a fair profit.

In many cases the lenders themselves make this profit possible by accepting less than what’s owed (aka: “short sale”). Now don’t go feeling to bad for the lenders since most loans are bundled up and sold on the secondary market (i.e. wall street) in such a way that the risks are spread and investors make a high enough rate of return to cover the cost of the defaulting loans. In fact, this financial flexibility and growth of the mortgage industry to source off the loans in collective bundles is what has allowed the lending world to offer so many more potential loans for would be borrowers. Again, in and of itself I think this is a very good thing—for borrowers, for lenders, for investors, and for the country as a whole. It’s just when you add in the other element I just talked about along with poor financial fluency that so many borrowers get into trouble.

REASON TWO: Toxic Mortgages

A recent Business Week cover asked, “How Toxic Is Your Mortgage?” (September 6, 2006). In the 14-page feature article the Business Week reported on the alarming rise in “option ARM loans”. These are adjustable rate mortgages that offer several payment options to the borrow, including one option, called the “minimum payment” that is less than the cost of the interest so that the loan grows bigger every month. According to the article, up to 80 percent of all option ARM borrowers make only the minimum payment!

In 2005, Countrywide Home Mortgage (the nation’s number one mortgage lender) had a 500 percent increase in “option ARM” loans! According to the article more than 20 percent of all option ARM loans in 2004 and 2005 were worth less than the outstanding loan balance! And if the real estate market fell by just 10 percent that number would double to 40 percent!

Are you getting a sense of why in earlier wealth tips I suggested that prudent real estate investors would be ready to buy with cash? There will be a lot of properties that are in need of saving. Shortsales, as a technique to buy properties in foreclosure where the lender accepts less than what is owed just to get the defaulting loan off its books and make the best of a negative situation, will be one of the most important buying strategies for investors to master.

And if that wasn’t enough, in 2005 lenders gave 43 percent of first time buyers loans for 100 percent of the purchase price (National Association of Realtors) leaving these homeowners vulnerable to the slightest economic quiver.

REASON THREE: A Shift in the Real Estate Market

The headlines are everywhere. The cover of The Economist read, “Has America’s Housing Bubble Burst?” (August 26, 2006). USA Today reports about the declining real estate market. What’s happening?

The answer is that another market cycle is playing out in the real estate market. The huge growth of real estate (from 2000-2005 the total value of American homes skyrocketed from $9 trillion to $22 trillion) was drastically slowed and in many parts of the country, especially the Midwest, is declining in value.

When you add this decline in the real estate market to the loose lending trends of the past decade what you get is a recipe for a massive increase in opportunities for foreclosure investors.
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I hope you enjoyed this week’s tips. Please take us up on the opportunity to join us in January!

My best to you all,
David

P.S. Remember to mark your calendar for January 20-21st, 2007 for the Maui Millionaire Wealth Weekend. This powerful, life-changing workshop is being held in Las Vegas and ALL proceeds—gross not net—go to charity! My suggestion? Come to both this and the “Financially Free” workshop (the events are back to back.)

P.P.S. Don’t miss out on the Financially Free: How to Become Financially Fluent and Build Level Three Wealth Workshop January 22-23, 2007 Las Vegas. For full details and to register, just follow the above link!

Wealth Tip: Get ready to buy for cash!

I want to talk to those of you who are real estate investors out there (or those of you who want to be investors.) With the shifts in the real estate market in many areas of the country I have a word of advice for you—get ready to buy for cash!

According to the Mortgage Bankers Association of America, 4.41 percent of all residential housing was in various stages of pre-foreclosure or foreclosure by the end of August 2006. This number has doubled over the past several years. That rate is even higher when you look at sub-prime and FHA loans which both had delinquency rates of roughly 12 percent as of the first quarter of 2006! Twelve percent! And these rates are climbing.

The next time you drive to your local supermarket to shop, you’ll probably pass 1,000 homes. Of these, statistically speaking, 44 are in pre-foreclosure or foreclosure. That means in your neighborhood within a few minutes’ walk, four to five of your neighbors are delinquent on their loans and in danger of losing their home to foreclosure. These people need your help. As you help them, you’ll earn a healthy profit.

Wealth Tip: You’ve got to be smart enough to look behind the easy answers the wealth industry hands you

The wealth industry has grown rich by providing ever expanding financial services for its clients. While many of these services can be useful, unless you as a wealth consumer actively and intelligently take control of your own wealth building, you are virtually guaranteed to get sub-par results.

Take the example of how the wealth industry lays out your financial information on performance. Since the most common investment via the wealth industry is publicly traded securities let’s start there. My friend showed me his Merrill Lynch monthly statement which had column after column of “results” for his portfolio. But all of it was laid out in such a way to impress, especially to impress upon my friend how much he needed them to keep track of all this complicated information.

The truth is that they report actually hid or ignored the two most important markers to measure the performance of his portfolio: the real rate of return and each investments performance against an appropriate benchmark for that risk category of investment.

Let’s look at each of these in turn. First there are the returns that his statement showed. The return did not share the AFTER TAX, AFTER FEES rate of return on the investment, but rather the pre-tax, pre-fees rate of return. Empowered wealth builders know that they need to look at the real rate of return on their investments which means the after tax, after fees view of how well their investments performed.

Second, his statement never compared his returns to a suitable benchmark that was appropriate to the risk category of the investment. He had no way to know how well he was doing in an objective way, instead, all he saw was his isolated performance with no way to see how well the market as a whole was doing.

Without this information it is impossible to know how much his results were augmented by the financial services he was paying for, and how much was just passively driven by the marketplace.

And if this wasn’t enough, there was the area of “asset allocation” which on his Merrill Lynch account was neatly represented on a pie chart in three distinct sections: Equities, Dividends, and Other Assets. He was given a wealth plan which said he should use these three categories to determine the ideal composition of his portfolio. This is woefully inadequate and in fact is very misleading.

First, the above divisions treat all stocks as if they were the same risk category, and treats all “dividend” investments as if they too were of the same risk category. This is fatal to your wealth building. A stock like Coca Cola is much less risk than some specialty stock in a focused niche about which you have no real expertise or advantage, even though both are equities. A short-term AAA rated bond cannot be compared to a junk bond, even though both generate dividends.

When you lay out your asset allocation you need to consider which risk classes you want what percentage of your net worth first. Then it is your job as a savvy investor to find the highest return possible per each of those risk categories.

(For the moment I will just let go of my personal bias to any wealth plan that doesn’t take into account real estate or businesses except those you invest in via publicly traded securities, but I think you all know where I stand on that issue. I won’t even mention that it is a bit strange that my friend’s wealth plan that he paid a lot of money for via the financial services industry never seriously looked at anything other than securities it could broker the purchase, management, and sale for him. Aren’t I on my best behavior here?)

Second, his portfolio was being run for him in a way that over time put him at great risk. What do I mean by this? He had professional management that he was paying for coming, going, and on every layer in between. He had his “wealth advisor” being paid to manage his choice of investments, including many government securities that needed no real active management, and his mutual funds that he was already paying the for his fractional proportion of management costs.

As Warren Buffet shared in a recent letter to the stockholders of Berkshire Hathaway, the FRICTIONAL COSTS of all this management eats away at the real returns most investors get (these frictional costs also include the turnover costs of actively trading securities in your portfolio.) As Buffet suggests, and I agree with, for those investors who want to invest in securities but don’t want to invest the energy to become skilled themselves, and would rather pursue a passive strategy of investing and holding, they would do much better to invest in the market via index funds that have so much less expense associated with them.
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I hope you enjoyed this week’s tips. I’ll do my best to write to you from Maui as the Maui Mastermind event is going on.

My best to you all,
David

P.S. Remember to mark your calendar for January 20-21st, 2007, for the Maui Millionaire Wealth Weekend. This powerful, life-changing workshop is being held in Las Vegas and ALL proceeds—gross not net—go to charity! My suggestion? Come to both this and the “Financially Free” workshop (the events are back to back.)

P.P.S. Don’t miss out on the Financially Free: How to Become Financially Fluent and Build Level Three Wealth Workshop, January 22-23, 2007 Las Vegas. For full details and to register, just follow the above link!

Wealth Tip: Annually fine-tune your Wealth Map™.

Each of us, whether we realize it or not, has a Wealth Map™ -- our individualized action plan to create wealth. For most people this plan is simply the default plan that is given to them by our society.

For the poor this default plan is to be dependent, upon the government, or active income from a job, or relying on family or other people to cover their basic needs.

For the middle income, this default plan is to work, earn, save, and invest via “retirement accounts” and pension plans so that when they retire, this “nest egg”, combined with their Social Security income will be enough to take care of their living expenses.

And for the wealthy, this default plan is to buy and build assets that generate passive, residual income so that they are financially free as soon as possible.

I think each of us at a minimum needs to sit down and assess our own Wealth Map™ at least annually (personally I do this quarterly and have found this to be a powerful catalyst to building wealth.)

The reason this is so present on my mind is that two days ago I sat down with a very close friend and doing him a favor—looked over his personal financial situation and Wealth Map™ and gave him my perspective and feedback.

He shared with me the “individual” wealth plan that his “wealth manager” had created for him and the latest statement from his Merrill Lynch portfolio.

We went through and created a quick list of his balance sheet (everything he owns less everything he owes), his “S-Factor™” (his annual cost of living), and finally his passive and passive, residual income sources.

After going through all of these with him I gave him five suggestions for him to fine tune his wealth building portfolio. Now while these suggestions are specific to him and his personal situation, there are several suggestions that I will share with you in next week's Wealth Tip.