07 Sep A RISKY TALE: TOO GOOD TO BE TRUE
There’s a company that once advertised in local magazines in Maryland what they called the 1% solution. Of course they don’t do it any more since I suspect they are broke as are their clients. Nevertheless, I loved the way it sounded. Imagine a 1% solution. I want one. We all want one. Even if you have no idea what it means you just want to call them up and ask for one of those solutions. Heck why not a few 1% solutions. I called them up to see what was behind the advertisement and what I found made me angry. It made me angry because in the investment advisory business the 1% solution would for the vast majority of investors be a prohibited practice because it can cause significant financial harm yet in this business, the mortgage business, it was not just allowed, it was unsupervised, unregulated and the 1% solution advocate was even permitted to advertise this potential financial bomb. When it is all said and done and history is written on the real estate bubble, the main cause will be the total lack of supervision of the mortgage industry. The 1% solution is just one of the culprits.
So what is the 1% solution? The 1% solution is nothing more than using the existing equity in your home to buy even more real estate. The 1% stands for the initial rate of return that you get on the money that you borrow. Of course the real rate of return is much higher but the theory is that by the time the rate goes up you will have made so much money on the appreciation of the new properties that you’ve purchased that you will be way ahead of the game. It’s a good theory and makes the purveyor of the 1% solution a lot of money but when real estate prices go down or stop going up, as they invariably do, you will be left holding the bag on properties you can’t afford and depending on how much you borrowed and how much you purchased the 1% solution turns into the 1% nightmare as you hire an attorney to help you through bankruptcy procedures or simply walk away from your real estate purchase.
What made me angry about this practice? The anger stems from the fact that the purveyors of this potential disaster are not responsible for their actions. They reap all the rewards from the fees they generate from selling mortgages or loans but none of the risk when the market turns against their client. What they are essentially selling is no different than what a brokerage firm can provide through the use of borrowing or margin in order to purchase more securities than you otherwise could afford. In many cases the degree of borrowing they were espousing would fall outside the range of what a brokerage account would even consider too risky and into the realm of a futures account. Yet there it was, completely unregulated.
The 1% solution was bad business. It was bad for the people that were sold a false promise. It was bad for their neighbors that had to suffer the false illusions of property prices that were unsustainable. It was bad for the country since we are all suffering from some version of the 1% solution and the effect it has had on housing prices and the availability of credit. The 1% solution existed and still exists in an unregulated manner because it deals with real estate yet the exact same business practice is regulated if the borrower was intending to purchase securities instead of real estate. It’s insane.
The securities business is regulated and if an advisor recommended an unsuitable investment such as the 1% solution you can be certain there would be legal consequences if or when the portfolio dwindles to almost nothing. Like my investment advisor mentors explained many years ago, “Don’t ever buy stocks on margin, 17 out of every 20 years you do great and you think you are on top of the world. The other 3 years you lose almost all your money and your clients leave you.” The same or some version of the same holds true for the 1% solution. It should come with a warning. I’m not saying that the securities industry needs less regulation when it comes to the relationship between an advisor and their client. I am saying that the mortgage industry needs more regulation and advertisements such as the 1% solution must come with a buyer beware sticker attached to them. I am sure that when the credit and real estate disaster plays out that smarter regulation will make sure we don’t repeat the sins of the last few years.
Since the purpose of my tales is not to focus or comment on the present but to teach lessons that are timeless let me tell you what investors must learn from this period of easy credit and rising real estate prices. The lesson is, if it sounds too good to be true, it is. Don’t be a victim. Spend time to analyze what can go wrong. In the case of the 1% solution it was clear that you were holding a live grenade.
Let’s turn our attention away from the mortgage and real estate industry to hedge funds, brokerage firms and banks. This triumvirate of trading doom played the role of co-conspirators in the credit debacle that we are mired in as of this writing. These people made a lot of money taking risks with other people’s money they would probably never take with their own. I say this because I assume they weren’t stupid and understood the risks associated with too much leverage. For example numerous hedge funds have recently gone bankrupt not because they purchased lousy investments but because they purchased investments using too much borrowed money. Let me explain.
If you are managing a hedge fund and you have one million dollars to invest and you invest it in a portfolio of risky bonds that pay an average of 8%, you might collect performance fees of $16,000 for the year. However, if you borrow an additional one million dollars at a cost of 5% per year and invest it at 8% per year you make an additional 3% per year on the borrowed money. What this means to the hedge fund manager is that for every one million dollars they can borrow they put an additional $6,000 in performance fees in their pocket every year. Their income increases from $16,000 to $22,000 by just borrowing one million dollars and investing it in risky bonds.
Using the age-old Wall Street adage of anything that’s worth doing is worth overdoing they decided to borrow thirty million. When things were clicking on all cylinders the hedge fund managers were making 3% per year on the $30 million that they borrowed or an additional $900,000 per year by using extreme leverage or uncontrolled borrowing. Compared to not using any leverage this represented an additional $180,000 in performance fees to these fund managers. To contradict Gordon Gecko, in this case greed was not good, unless you were a hedge fund manager. They were playing a losing game and the losers were their clients and the American people. Not to pick on hedge funds alone. As we can see from the losses suffered by banks and brokerage firms they too were participants in this game of over-leverage.
The end result of this unregulated greed is that the individuals at hedge funds, banks and brokerage firms made lots of money for a short period of time at the expense of others. A term that I have heard often to describe this is that these individuals found a way to privatize gain while socializing risk. What this means is that they reaped the benefits of the compensation they derived by participating in a game that was doomed to fail while others are now paying the price for this excess. I don’t know what the future holds in terms of future regulation and it is an area that is outside my expertise. However, what is certain is that future regulation must find a way to prevent perfectly ordinary people such as mortgage brokers, hedge fund managers, bank and brokerage employees from doing perfectly ordinary things and by using extraordinary leverage make extraordinary compensation. Extraordinary compensation must be reserved for the extraordinary.
From the perspective of the investor this tale is simple. It describes a world of the recent past and lets you see that if something is too good to be true then it probably is too good to be true. The investor can learn that leverage takes a very simple and profitable concept or method of doing business and exacerbates it. When making investments of any kind the investor should be intimately aware of the amount of borrowing or risk in the investment. Don’t get fooled. Once again, if it’s too good to be true it is.