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Mortgages; The Misunderstood Financial Instrument February 12, 2008

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The next financial strategy is equity management of home equity. Or getting the largest mortgage you can afford in order to seperate home equity and put it to work for you. Now your alarm bells should be really ringing. Isn’t paying off your mortgage the #1 financial goal? Don’t people do all sorts of fancy things to get that mortgage paid off? But why?

No financial instrument has created more wealth for the middle class than mortgages. A bold statement but demonstrably true. Not stocks, not mutual funds, not annuities, nor bonds. But how can this be? How can debt create wealth? Very simply, mortgages allow for the middle class to purchase real estate, something they could not do without this financial instrument. Mortgages allow one to leverage their money into control of a larger asset. Mortgages are cheap money, made cheaper by the tax laws. This combination has allowed people to create more wealth in their homes than any other place.

The median amount of home equity in primary homes is $65,000 for all homeowners. The median total net worth for all families is $93,000. So, in short for Americans, much of their wealth is held inside their homes. So why if mortgages are so successful in building wealth for people are they in such a hurry to get rid of them? That is literally the million dollar question.

Unfortunately, people usually don’t understand how holding their wealth inside of their homes is a very risky position as well as a financially dumb place for holding their wealth. Now, you can’t argue that mortgages has allowed for the middle class to build more wealth than any other financial instrument. You are left with the emotional baggage of thinking all debt is bad. This is also demonstrably false.

So now we understand where the most wealth is for Americans, the question remains how to put that to work for you? See my post on equity management for details, but the bottom line is this strategy works because it takes a hidden asset (home equity) and puts it to work for you in a safe liquid environment. Most Americans (90%) have been unable to save more than a pittance anywhere outside of their homes. The success of this strategy is built on the fact people are successful (over 99% of conforming loans are paid back) in using mortgages to build wealth, while people are not successful in their other wealth building endeavors (ie retirement saving, stock ownership, mutual funds, etc.). Use what people are good at to build wealth…..what a concept!

Paradigm Shift III December 13, 2007

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How does a banker make money?  Well they borrow money from folks who put money into savings accounts and Certificates of Deposit or they borrow money from the government.  Then they loan that money out at a higher rate.  It is called arbitrage and is the basis for wealth creation for bankers over the last several thousand years.  Do banks incur risks?  Yes, their main risk is if people don’t pay them back what they owe.  Periodically, bankers forget about this risk and the result is disastrous.  Like in the 1980’s with the S & L’s lending money to real estate developers who just happen to be their buddies.  Or now, lending money to people who have a history of not paying their bills.  But the bankers do something else; they require collateral in most cases.  So, they reduce their risk this way.  They really don’t like to, but if forced they will foreclose and resell an asset to recoup as much of their money as possible.   But here is a key.  If bankers don’t think they can get their money from the asset, they will work with the borrower to avoid taking a loss.  Donald Trump tells the story of owing $100 million dollars and not being able to make his payments.  He told a room full of bankers he couldn’t pay them back.  What did they do?  They restructured his loan.  Did they take his yacht from him (yacht was his collateral)?  No.  Now here is the point.  It’s good to have a banker as a partner.  When they have a large amount of risk in the deal they will become very good partners, willing to work with you to insure that you become successful.

How do investors make money?  They buy assets.  These assets range from businesses to real estate to bonds.  Quite simply they put money to work for them.  Successful investors can create extreme wealth by infusing young businesses with capital (money).  For example Mitt Romney, Republican presidential candidate, and his company Bain Capital which turned 57 million dollars into 50 billion dollars.  The famous financier JP Morgan, along with being a banker also put together deals turning his bank into an equity investor creating tremendous wealth.

Now both of these ideas have been around for a long time.  Yet, they seemed to be reserved for only a special few.  But the new emerging paradigm is about extending these ideas to a larger percentage of the people.  Now on top of this is the fact the tax laws privilege business owners and investors.   

One of the biggest financial hoaxes is that you can achieve financial peace by being a consumer, either a spender or a saver (who saves so they can consume later in retirement).  Financial peace can only come from becoming an investor, using the arbitrage method of bankers, and using the power of leverage.  Now I know that most people view these ideas as extraordinarily risky.  But the financial truth is that they are far less risky than the risk most folks take every day with their finances. 

Now you might be thinking that you are an investor because you buy mutual funds inside your 401K.  Technically, you are and this is a good thing.  But I argue that becoming an investor is more about your state of mind, the way to see the world, than whether you own a microscopic piece of some corporations.  In short Wall Street has done a great job convincing us that investing in mutual funds is the way to riches (in order to retire), but behind this veil of propaganda is the reality that the only folks getting rich off of mutual funds is Wall Street.  I mean study after study has documented that 99% of mutual funds under perform the market over time (15 years or longer), that stock pickers are routinely beaten by darts thrown at a board (chance), and that you are best off finding a low expense index fund that will mimic the market.  In other words the best you can really hope for is average returns.  Yet, most people think that they can identify (buy) mutual funds that will turn them into automatic millionaires; or at least that is what the financial gurus are selling these days.  The facts tell a different story. Despite having been told to save and invest in mutual funds for a generation, despite having a good amount of folks retiring with a defined benefit retirement plan, despite living through the greatest economic expansion in the history of the world, less than 10% of folks retiring today are self sufficient.  Why?   Because they have the mindset of the consumer paradigm.  They shop.  They get caught up in the minutia of consuming, even to the point of consuming investments/retirement plans. 

These folks who consume investments are perhaps the saddest of the consumer paradigm, thinking they can save enough from their paychecks to retire wealthy by buying mutual funds.  Even the salesmen/financial planners are no longer arguing this is possible.  They now tell you that your goal should be to save enough to replace 60%-80% of your current income.  But of course they still tell you that you can beat the market with mutual funds, some arguing that you can get a return of 12% or more!  Here is another fact that should shock you.  Study after study has indicated that consumers of mutual funds’ total rate of return is approximately 10% below what the market returns! Why?  Because folks think like consumers, selling their mutual funds to change to the hottest funds of yesterday, cashing in their 401K’s to bid them over in times of trouble, and moving out of the market after a large drop in value.

Investors do not chase yesterday’s good investments.  They don’t panic when their investment dips.  Warren Buffet, perhaps the most successful investor ever, sums it up nicely: “You should invest like a Catholic marries-for life.”  The point that Warren Buffett has made succinctly is that you should do your homework on what you want to invest in, look for true value, and hold on to it for a long time until the fundamentals of the business don’t make sense anymore.  That is what being an investor is really about.

Bankers work a little differently, but ultimately it turns out to be the same viewpoint.  Their arbitrage strategy is based on taking money in at a fixed cost and putting it to work at a higher rate than their cost.  Now in all interest rate environments this works because interest rates move in tandem.  For example, in the early 1980’s bankers were issuing Certificate of Deposits that paid over 14% interest.  However, they were charging for their residential mortgages up to 18%.  Their commercial mortgages were over 25%.  Now you can get at Certificate of Deposit for 5% and a mortgage for 6% so the margin has gone down, but the strategy still applies.  The strategy works as long as no malfeasance occurs as when the Savings and Loans lent money to folks with no track record of commercial success or when some lenders lent money to individuals with bad credit.  But as long as you have accounted for the ability to be paid back on a loan the arbitrage strategy will create value and wealth.  If you don’t believe this, just take a look at any downtown center in the country and note the names on the large buildings.  Bet you they include bank names!

Now paradigm change is a very difficult thing to accomplish.  It takes much intellectual and emotional work.  You don’t accomplish this in a weekend seminar or by reading any single book.  For me, it took years of research, reading, thinking and yes mistakes to fully pull my financial viewpoint to the place it is now.

The question for your consideration is do you want to continue doing what hasn’t worked?  Or, are you ready to move forward in your understanding of financial principals?

Next blog on paradigm shift I will offer a suggestion on how to move forward.

  

Paradigm Shift II December 5, 2007

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You might be asking at this point, what this all means to my financial life?

First, we need to look at why you need to be concerned about this shift to the investor/banker paradigm.  The mortgage industry has suffered from bad press lately.  And it deserves the bad press it gets because consumers have been hurt by bad mortgage advice and Wall Street firms have also been hurt by lax underwriting standards. But the naked truth is that the mortgage industry labors under the assumptions of the consumer paradigm. Remember, the underlying assumptions from the consumer paradigm are competition for a limited amount of wealth, and the need to overcome someone else for the limited resources.  Hence the lenders set up a system that generally guarantees what is best for them is not best for their customers.  And of course the customers react by not trusting, or even worse, hating the mortgage company so much that they do things that are counter-productive to their wealth building.  This is in a nutshell what the consumer paradigm has come to for not just mortgages but for just about everything.

But on the fringes of the mortgage business are folks that have recognized the destruction of this way of doing business and have started to introduce different ways of doing business that break down the destructive cycle. In the finance world I call this the investor/banker paradigm.

The change it engenders for both the folks selling financial services and the folks on the consumer side is incredible.  But first a little explanation as to how to put the general ideas outlined in my first post to work.

There are three intellectual/emotional changes that need to occur:

1. We need to change our understanding of what is financially important from income to net wealth.  Let me give you a personal example of how this works.  A couple years ago I changed careers.  In that particular year I spent more money than I made to the tune of $30,000.  Now the old way of thinking is that you should never spend more than you make.  There are myriad of folks out there that ask you to track spending and compare it to how much you make.  They insist that if you spend more than what comes in you are on the way to financial ruin.  From the consumer paradigm this is a fact.  However, for me I didn’t care.  Why?  Because the proper metric to look at is net wealth.  Net wealth is the total worth of all your assets minus your debts.  In that year my net wealth went up $50,000.  Hmm, how could that be?  Well, I control some real estate that appreciated.  I control some stocks, bonds, and mutual funds that appreciated. So even though my income from work did not cover my expenses, the appreciation of my assets was so much that it drove my net worth up.  I will take that kind of year any day over a year that my income and expenses were evenly matched, yet my net wealth stayed the same.  Now the funny thing about net wealth is that you have a great deal of control over it, compared to income.  Income for most people is controlled by a boss, a company, geographic area, education, career choice, etc.  But you can design your assets any way you want to.  And this is what creates wealth.  From a practical view, you should always know what your net wealth is.  This should be a part of your daily regime, calculating net wealth in your head for the day.

2. The mental image of ownership should be replaced by control.  You don’t own your home,car,truck, etc. the bank does!  How many times have you heard that?  That is the consumer paradigm speaking loudly.  Are you in competition with your mortgage lender over your home? With the bank for your car?  Some people think so.  The reality is you control your home, your car, or any other item that someone loaned you money in order to purchase.  The lender doesn’t want it.  It is a royal pain for them to get it back.  They are in the business of selling money, not in selling distressed homes, or repossessed cars.  The truth is that the bankers of the world are your greatest asset, not your enemy (not that they think this way).  They make it possible to control assets without having the money to buy them outright.  By controlling assets you get the benefit if they appreciate.  You get the benefit of using them.  And you share the risk of this control with the lenders.  Personally, I care less whether I own assets, because I only want to control them so I can benefit from their appreciation and cash flow.  Now here is where the hard emotional work gets done.  The consumer paradigm has infused us with fear.  We fear losing things that we own.  But it is only things.  What makes a home?  Is it the brick, wood, cement, dry wall, and paint?  Or is it the people that live in the home?  I believe it is the people that make a home.  If a hurricane came and wiped out the structure I live in, I could easily find another one.  And it would become my home because my family would be there.  My job would be to replace an asset that I controlled.  It could be anywhere.  Fear of losing THINGS we own is what keeps most people from obtaining happiness and security.

3. Victimization and scarcity are the keystones of the consumer paradigm.  Currently there is much talk of mortgage companies who victimized consumers by putting them into bad loans.  People are going to lose their homes because of these sub-prime or variable rate or interest-only or option arm loans.  Earlier in the decade it was all those folks who got victimized by financial advisors who had their money in the stock market.  Every few years it is a new set of victims.  No discussion of why these “victims” knowingly entered into these mortgages.  Nor is there any discussion of who and what was really lost.  These “victims” are portrayed, somewhat accurately, as passive actors in life.  Bad things happen TO them.  They are blown by the winds of society to and fro.  This can only happen to folks working under the consumer paradigm.  Folks who have move beyond this are not victims because they understand there is no scarcity.  Human beings all have the capacity to act upon things, to control our destiny, to create wealth.  There is abundance out there for anyone to obtain.  Move beyond victimization and scarcity and you begin to see it, understand it, and make it possible.

Next blog post I will drill down to the core of the investor/banker paradigm.   

Paradigm Shift; Consumer v. Investor/Banker December 3, 2007

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I make it a habit to read extensively about a host of subjects.  Currently, there is a major shift in human understanding of subjects ranging from science, spirituality, finance, politics, to social relationships.  This paradigm shift is going on right under our noses, mostly unnoticed, and mostly uncommented on by the mass media.  For those that like to hang out at book stores, you have definitely noticed it.  Just walk the aisles of any subject in any bookstore; you will come across titles talking about this amazing change.  Want proof of this happening?  Up until last year General Motors, was insisting that American consumers would never base their car buying decisions on gas mileage.  Now, they are marketing their “green” cars.  Whether their cars are actually “green” or not is irrelevant to the fact that they are now telling us that American consumers want good gas mileage and lower polluting cars by the way they are marketing.  Now this paradigm shift has been in the works for a while, at least since the first hybrid car was introduced, but GM (and many of you) didn’t notice this shift until recently. http://www.youtube.com/watch?v=luopS-xmQYI

I have decided to spend some blog time talking about the paradigm shift going on in the finance world.  This is the first of a series of posts to address this issue.For the better part of the19th and 20th Centuries citizens of the western world were taught to become consumers.  This was a major change from what had existed before, self reliance.  No longer did we build our own homes, make our own soap, kill/grow our own food.  With the advent of credit, we disconnected our purchases from our cash reserves.  Let’s not fool ourselves into thinking that credit did not drive the success of our capitalistic system, which we all benefited from.  So that evil (according to the bible) of credit did much to benefit our society, but it also played into developing our consumer mindset.This consumer paradigm, or way of thinking, developed two sides; the saver mentality and the purchaser mentality.  Now most people think that there is some moral superiority to being a saver rather than a purchaser, but it is really just two sides of the same coin.  One side, the saver, is able to put off into the future their consumerism, while the other side, the purchaser is incurring the cost of immediate gratification.  No doubt, one is better off in the long run by being a saver over a purchaser, but both labor under a dying way of thinking.The emerging paradigm is the investor/banker paradigm.  This paradigm was brought to the attention of millions most recently with the Kiyosaki, Rich Dad, Poor Dad series, but it has been emerging for quite a long time.  Now there has been some critique on the veracity of Kiyoski’s original book, but it is really irrelevant to the message it articulates.  The message in this and many other books is one of moving from a consumer paradigm to an investor/banker paradigm.  Now, this is important to understand.  We are changing our way of thinking as a society whether you personally change or not.  Like General Motors, you can deny what is happening for a good amount of time, but eventually you will have to change your way of being to match the new reality.What does this investor/banker way of thinking require of us?  Simply we will need to understand our lives and our goals in fundamentally different ways.  This can only happen through an educational/emotional process. 

Let me outline what this process might entail.

Here are some of the mindsets that enable the consumer way of being:

1. The conscious or unconscious belief that money and material wealth is our primary directive;

2. The conscious or unconscious belief that we exist in a zero sum game, that our success is predicated on overcoming someone or something else;

3. The conscious or unconscious belief that material things have intrinsic value;

4. The conscious or unconscious belief that there is a limited supply of wealth that must be competed for; and

5. The conscious or unconscious belief that time and money have a direct relationship.

Compare this to the ideas that animate the investor/banker way of thinking.

1. Happiness for us, our family, and our community, is the primary directive;

2. Success is predicated on positive relationships with others;

3. Only people have intrinsic value;

4. There is unlimited opportunity and prosperity available for all; and

5. Time and money have only indirect relationships.

Now the truth is that many of us will deny that we engage in the consumer mindset.  But if we really are truthful with ourselves then we will recognize how deeply we are beholden to the consumer way of thinking.  The investor/banking way of thinking should not sound foreign to us.  That is because these ideas have been around for a long time, but we only give lip service to them.  Our job is to do the academic/emotional work of engaging these ideas and making them work on an unconscious level, just as the consumer ideas do for us currently.

The next post will delve into the why’s and how’s of moving to this new paradigm. 

Hello world! October 1, 2007

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Hello. I have been fortunate to combine my two professional interests, finance (B.S. Florida State Univ.) and social science (Ph.D. Brandeis Univ.), into my work as a Wealth Coach. This blog is dedicated to creating knowledgeable consumers who with a better understanding of wealth creation, finance, and money will be able to build a better future for themselves and their families. I believe the current state of financial/retirement planning is really about what Wall Street and the Lenders want individuals to do, as opposed to what the evidence demonstrates works for folks. Hope you find the ideas and information useful, educational, and entertaining.  If you find this blog unique and interesting please go to my wealth coaching web site: www.shaferwealthacademy.com.