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Those who grew up in the 1960’s remember the Outer Limits science fiction TV show. The Control Voice always introduced it with the following warning:

There is nothing wrong with your television set. Do not attempt to adjust the picture. We are controlling transmission. If we wish to make it louder, we will bring up the volume. If we wish to make it softer, we will tune it to a whisper. We can reduce the focus to a soft blur, or sharpen it to crystal clarity. We will control the horizontal. We will control the vertical. For the next hour, sit quietly and we will control all that you see and hear. You are about to experience the awe and mystery which reaches from the inner mind to… The Outer Limits.

For Americans running around like masters of the universe, the top news stories from 2005 are like an object lesson in humility, a reminder of the extent to which we are not in control.

Natural disasters

These include the tsunami off Sumatra, earthquake in Pakistan, and Hurricanes Katrina, Rita, and Wilma. These events are a constant reminder that both households and the country as a whole face capital calls that are beyond our ability to predict.

The total destruction of areas surrounding New Orleans has led to a chicken and egg situation where recovery won’t occur until the population returns, but the service businesses and employers who would attract the residents back won’t return before the return of the population. It’s clear that quick fixes to the situation are beyond the control of government. A mass infusion of money alone won’t work.

US government control over the level of long-term interest rates

Over the past several years the Federal Reserve has worked to keep short-term interest rates low to stimulate the domestic economy. American consumers responded by buying foreign goods, and foreigners responded by buying US debt obligations, principally treasury bonds and mortgage backed securities. These capital flows suppressed US interest rates beyond what was expected, and led to an unprecedented increase in US housing prices.

All other things being equal, the Federal Reserve would have preferred that interest rates drift upward to avoid the creation of a housing bubble. Unfortunately, with all these dollars sloshing around the globe, our policy makers are not in a position to fine tune the level of long-term rates. These are set in the open market by the supply and demand for capital.

China shopping internationally to lock up supplies of natural resources

US consumers have been busy shipping dollars to China in exchange for inexpensive manufactured goods. The Chinese, in turn, have been recycling some of these dollars by making investments in supplies of natural resources. When 1.3 billion persons start to turn into American style consumers, the market for raw materials will be fierce. With many of these commodities being primarily imported, future US control over raw material pricing will be limited.

Progress in combating the insurgency in Iraq

It‘s optimistic for policy makers to expect the world to function exactly as they would like. For those obsessed with making order out of chaos and doing it on a strict timetable, Iraq will clearly try their patience. Investment returns not living up to expectations

A generation of investors experienced high interest rates for much of the past 30 years, and has become frustrated with the low investment returns currently available in the bond market. Adequate investment returns are needed to fund up cash needs for retirement, and low returns will accelerate the drawdown of principal in retirement nest eggs.

When corporations have defined benefit pension plans, any shortfall in pension fund income must be made up by increased employer contributions. This results in a decrease in corporate profitability and a drag on stock prices. Businesses have responded by investing in the next holy grail of investment, the hedge fund, in an attempt to squeeze out higher returns in a low return environment.

Medical costs continue to escalate

Ford and General Motors are struggling under the financial burden of retiree medical benefits, with the possibility of following Delphi into bankruptcy. The only difference between these corporations and Medicare is that the federal government has the unlimited ability to tax to pay for the benefits.

One likely scenario is that Medicare will place more of the financial burden directly as retirees via co-payments, deductibles, and insurance charges. Imagine a portion of the Social Security benefits being channeled directly into covering Medicare costs. It’s like a game of retirement Monopoly. Pass Go, collect $200, then land on the Medicare square and pay back the $200.

The floundering of Social Security reform in 2005 (creation of private accounts) is an indication that the risk of relying on government benefits has increased. Individuals who hit retirement with a just home and government benefits are clearly not in control of their own destiny. Decisions will be made for them by others.

Trend following investment behavior conflicts with prudent risk management

Individuals are receiving confusing signals as to how to act in this environment. Highly leveraged real estate investors have recently been the big winners. The average price of a single-family residence increased from $139,000 in 2000 to $185,200 in 2004, as individuals responded to decreasing interest rates by bidding up prices to meet the available household income available to service the debt. (Americans like to live up their means.)

Households have also supplemented their disposable income by monetizing real estate holdings through serial refinancings. This has led to a form of learned behavior, where there is an expectation of having your cake (tax-free gains) and eating it too (cash out refinancing). Households have considered these debt financed real estate purchases as a way of avoiding risk in the securities markets. Consider the increased concentration of risk in residential real estate, as its fair market value expressed as a percentage of disposable income has increased from 137% in 1979-80 to 204% in 2005.

Other winners have been investors practicing the carry trade, borrowing at advantageous short-term interest rates and investing long-term. Periods where the Federal Reserve is trying to stimulate the economy are particularly favorable to banks, which are highly leveraged.

The question that households have to consider is whether to hop on the leveraged investing bandwagon or chart another course. Legendary fund manager Peter Lynch warned against investing in the “next” of anything.

Franchise businesses are replete with examples of businesses following an established success formula, and then failing to live up to expectations. We may be in the same situation with respect to leveraged investing.

There has been a top to bottom leveraging of the economy, increasing our exposure to external shocks. We have the defense capital call (Iraq), the disaster capital call (Where’s FEMA?), and the retirement capital call (Medicare and Social Security). The intersection of higher leverage with higher uncertainty makes for an interesting exercise in risk management. See chart below:

Recent developments in mortgage financing are affecting tax policy

Current developments in the mortgage markets are combining to affect tax policy in ways that could affect the performance of real estate investments.

Growth of innovative mortgage loan products

Part of the growth in home prices has resulted from the availability of cheap credit with very liberal repayment terms. Mortgage options include adjustable rate, reverse amortization, and interest only loans. These allow borrowers to focus on their ability to pay the current interest rather than also considering their ability to repay principal. (This might be considered giving borrowers enough rope to hang themselves.)

Explosion of mortgage securitization through GSE’s

Fannie Mae and Freddie Mac, the government sponsored enterprises (GSE’s) have been at the epicenter of the leveraging of the US economy. Individual mortgages are bundled into securities that are then sold to investors, with foreigner investors making significant purchases. Consider GSE’s to be the faucet through which foreign capital flows to US households.

Use of monetary stimulus by the Federal Reserve

Alan Greenspan, the Fed chairman since 1987, has been criticized in some circles for contributing to a bubble in housing prices by pursing a low interest rate policy. Greenspan established his recession fighting credentials by forcing down short-term interest rates to apply monetary stimulus to the US economy. These episodes occurred during the recession of 1990 that was associated with the junk bond bust, and in 2001 through 2004 after the bursting of the tech stock bubble.

There is always a certain amount of tension between the government promoting borrowing to support full employment policies, and promoting the solvency of financial institutions. Low interest rates and liberal borrowing standards are two ingredients in transmission of monetary stimulus to the economy. A solid banking system and function securities markets are also needed.

Twice in Mr. Greenspan’s tenure (1989 and 2001), the Federal Reserve became so concerned with a reappearance of inflation that short-term interest rates were brought to levels that exceeded long-term rates. This phenomenon is called a negative yield curve or interest rate inversion, since short-term interest rates are normally lower than long rates. Both times the economy subsequently went into recession.

After these interest rate inversions, the Federal Reserve reserved course and lowered short-term rates significantly. The good news is that the resulting recessions were mild. The bad news is that borrowers learned that playing financial chicken with the use of credit was a winning strategy. The lesson learned is that government will always err on the side of full employment, easy money, and the solvency of the banking. There is small constituency for the enforcement of prudent financial management.

Solvency concerns move to center stage

Over the past two years there have been signs that the government has become concerned about potential instability in the economy because of the growth of financial leverage.

Fannie Mae and Freddie Mac have both had regulatory accounting problems.

There have been restatements of prior reported earnings and forced departures of key management.

Since the holdings in their investment portfolios are principally mortgage-backed securities, and because of the leverage of these companies, any significant increases in long-term interest rates would have resulted in insolvency. Bankruptcy risk of GSE’s creates a situation with a significant rise in long-term rates would create a financial panic.

It appears that GSE bankruptcy risks have been a factor in the Federal Reserve not increasing interest rates. The Federal Reserve and the Treasury department have forced a significant shrinkage in the size of the portfolio of investment owned by these GSE’s. This will give the Fed greater latitude to fight inflation and deal with escalating real estate prices through higher interest rates.

There have been discussions about limiting the use of creative mortgage financing.

To a certain extent, the Federal Reserve can make the use of adjustable rate debt uneconomic by increasing short-term interest rates. The real target of regulation would be interest only and low down payment mortgages.

Proposals have recently been made by a legislative committee in Congress that would limit the tax benefits of home ownership.

One proposal is to replace the mortgage interest deductions with a tax credit, but limit the amount of mortgage on which the credit would be based. The idea here is that if Americans can’t borrow and create tax deductions, they will change their behavior and reduce mortgage debt. The committee also proposed eliminating the interest deduction for second homes.

Refinancings have allowed homeowner to skirt the intentions of the Tax Reform Act of 1986

Tax law changes enacted in 1986 were designed to eliminate tax deductions for debt-financed personal consumption. The deduction for personal debts (mostly credit cards and auto loans) was eliminated. Deductions for mortgages interest incurred in connection with the purchase or improvement of primary residences was limited to loans up to $1 million. Interest deductions related to increases in additional debt on a primary residence was limited to loans up to $100,000 (home equity indebtedness).

The dollar limits were sufficiently high that virtually all home purchasers had 100% deductible interest expense. However, the real action was with home equity loans and refinancings as households have extracted equity from their homes to finance consumption expenditures. The regulations under Section 163 require that taxpayers track the use of any increase in loan balances above the amount of existing acquisition debt plus $100,000 (the home equity limit). The nature on the interest expense on this amount of loan increase is based on the use of the loan proceeds.

This is mouthful, but it works like this:

As you pay down your acquisition loan, acquisition debt decreases.

  • If you refinance up from the current balance of your acquisition debt, you get mortgage interest deductions up to a maximum of a $100,000 debt increase.
  • If you refinance up over $100,000, you have to track the use of the cash above that amount and determine the nature of the loan. If you use the cash for business purposes, it’s business debt (100% deductible). If you use the cash for vacations and consumer electronics, it’s personal debt (not deductible).
  • A cash out refinancing can result in portions of a loan being treated differently for tax purposes, producing a combination of home mortgage interest, business interest, investment interest, and personal interest.

The Internal Revenue Service is totally incapable of monitoring the deductibility of mortgage interest. Lenders report the total amount of interest paid, but the government is clueless as to what portion relates to original acquisition debt, home improvements, or trips to the Caribbean. Auditing these deductions on a taxpayer-by-taxpayer basis is not an economical proposition.

Under these circumstances, the attitude of Congress is to simply throw a brick at the problem. This will come in the form of drastically reducing the amount of mortgage debt that qualifies for tax benefits. It’s no problem for mortgage lenders to report mortgage interest separately for loans about and below $300,000, as an example. The precedent for this is the deduction for meals and entertainment. The IRS got tired auditing M&E, so they just made them 50% deductible.

No deduction for real estate taxes?

A second proposal is to eliminate the regular tax deduction for state and local taxes. These are already not deductible under the Alternative Minimum Tax, so in determining your Alternative Minimum Taxable Income, these taxes are added back to regular taxable income. Elimination of the state and local tax deduction amounts to dealing with the AMT by increasing the regular tax.

Personal exemptions are also an AMT addback. As regular tax personal exemptions have increased through inflation indexing, and the AMT exemption has remained constant (it’s not inflation indexed), the combination of the personal exemption and real estate tax addbacks have combined to put more people in an AMT position. This has been recognized as a problem, even for the middle class, but with the government running chronic deficits, they are hooked on the AMT tax revenue.

The existence of federal budget deficits may have as much to do with these proposals as addressing solvency issues. If marginal income tax rates are to be kept at moderate levels, then the government may have no choice but to eliminate or restrict key deductions. Interest deductions on McMansions make attractive targets because the owners can’t cry poor. The elimination of the real estate deduction will be a more difficult sell.

The interplay between the value of real estate and the foreign exchange value of the US dollar

One of the most widely advertised predications in the financial community has been for a significant dollar decline to occur in response to the chronic US trade deficit. During 2005 US interest rates increased relative to foreign rates, and the dollar strengthened significantly vs. the Euro. The US dollar can be supported, but at a price. The negative aspects of support via interest rate policy are withholding monetary stimulus, and pricing mortgage credit at a higher level.

Ben Bernanke, currently a Federal Reserve governor, has been nominated to replace Alan Greenspan. In a speech prior to his nomination, he voiced support for “micro regulation” as an alternative to interest rate policy. This can be translated as showing reluctance in using credit tightening via an interest rate inversion to control indiscriminate credit usage in the mortgage markets.

It doesn’t take a soothsayer to realize that a combination of paring back tax benefits of owning residential real estate, tightening lending standards, and increasing borrowing costs will have a negative effect on prices. A similar episode occurred with respect to tax shelter investments with deductions that were restricted starting in 1987. We may be reaching a transition point where the old model of leveraged investing doesn’t work on a mass scale.

(For a more complete discussion on the history of tax policy with respect to real estate, go to our web site at www.RubCPA.com and download our year-end 2002 newsletter.)

How should households respond to these changes in the environment?

The investment community never tires of pointing out the superior long-term return on stocks. Investors shouldn’t be surprised. These are organizations that are subject to market disciplines and do things like:

  • Engage in business planning
  • Invest to develop new product and lines of business
  • Engage continuously in controlling costs
  • Look to maximizing the return on invested capital
  • Practice risk management

Businesses are not successful all the time, and those that don’t react to changing circumstances disappear. However, there has been enough success in US businesses through periods of uncertainty that households should look at business practices and apply those things that make American business successful.

On the table at the end of this newsletter, Comparison of Business and Household Financial Management, a number of the attributes of successful businesses are listed, along with examples of good and bad business management:

  • Anticipatory attitude
  • Attention to continuous improvement
  • Focus on most profitable activities
  • Diversity in sources of income
  • Management of known risks
  • Low fixed costs
  • Control over variable costs
  • High rate of investment
  • Efficiency in the use of invested capital

The table also shows applications of these attributes to households. The point here is that same practices that make businesses successful can also be applied to households. A number of these practices relate to the ownership of real estate. For example, loading up on personal use real estate does the following:

Reduces investment income by placing capital in non-earning assets

Without a stream of rental income, carrying costs such as real estate taxes, maintenance, insurance, and utilities offset price appreciation.

Increases financial risk

Borrowing by a household with three sources of income is obviously less risky than borrowing done by a household with a single wage earner and no investment income. Default risk increases when employment is in cyclical industries, or a large portion of income is incentive compensation.

Risk also increases when households borrow using adjustable rate debt. The Savings and Loan industry engaged in borrowing short-term and lending long-term in the 1970’s and 1980’s, and it didn’t work. What makes anyone think that it will work in now for the masses?

Increases fixed costs and lowers the savings rate

If the ownership of personal use real estate results in cutbacks in tax-deductible retirement plan contributions, then a condition exists where the carrying cost of the real estate may be over 25%. This is higher than financing the home with a credit card.

Uses capital unproductively

The objective of all households should be to replace wage income with investment income. A key component of this strategy is maximizing income-generating assets. If this is done, personal use assets must be minimized or kept at reasonable levels.

Increases exposure to variable costs

Governments looking for tax revenue go where the money is. Real estate taxes are a stable form of revenue that doesn’t fluctuate with the state of the economy. Homeowners in the hurricane belt are likely looking at significant premium increases for flood and homeowner’s insurance. Hurricane Katrina was the warning shot for higher natural gas prices.

Low teaser rates have enticed households into borrowing with adjustable rate mortgages. These individuals are now full exposed to increases in interest rates that are beyond the control of our government.

Do your own assessment of the environment

If you think there are problems with excessive borrowing, then you may want to limit your exposure to assets whose price depends on a continuous free flow of cheap credit.

Do a self-assessment

The beauty of this is that it costs you nothing but your time. Set personal objectives and priorities. Determine possible actions to be taken to improve your financial situation and you ability to prosper whether the economy is good, bad or anything in between.

Gauge the outcome of the do-nothing alternative

Keep in mind that taking no action is a decision. However, you should consider the likely consequences. The residents of New Orleans were always one levee break away from a calamity. How many pondered the consequences of a flood? Are you one bear market away from a calamity?

Identify specific actions that will make a difference

Good intentions are wonderful, but there is no substitute for identifying specific actions that will improve your financial situation.

Have a margin for error

Don’t plan like Candide for the best of all possible worlds. Consider the possibility of being in the “Outer Limits” (not in control).

Summary

The use of leverage in the economy has increased the potential impact of external shocks. With the advent of globalized trade and financial markets, it will be more difficult for our government to engineer a warm and fuzzy outcome for over indebted US households.

Tax proposals have been made that, if enacted, will raise the after tax cost of owning residential real estate. This will have a negative effect on prices.

Sound business practices should be applied to household financial management that will allow you to prosper, even in the face of an uneven economy or external shocks.