Thursday, June 2, 2011

Why Home Ownership Is Bad for You

When you think about it, a landlord transforming his apartments into condos, while keeping the condo maintenance business in exchange for a monthly fee, is like a bank securitizing its loan portfolio. The landlord is migrating from a highly capital intensive business renting apartments to a service business with low capital and high fees. The new business is less risky and has higher margins. Because it requires much less capital, the former landlord can often buy back from his unsuspecting partners their share of the properties and keep the maintenance business all to himself.

Hotel companies do this when they fold their properties into a REIT and keep the high margin hotel management business in a separate company without the risks of owning and maintaining the properties. The profits from running the hotel are the same but on a much lower capital base; which makes for fantastic returns on equity. The returns on the REIT could also be good but it is essentially a different business which profitability will depend on the leverage, the financing conditions of that leverage and on the appreciation of the property. It is a very risky and capital intensive business. Some owners can try to have their cake and eat it too by leveraging their properties to the maximum (instead of selling them) in order to reduce the capital invested; but then the business becomes very risky.

The bottom line is you can't have both low capital invested and low risk ... unless you sell the properties and keep the side business. And because, sometimes it is the side business which is responsible for most of the profits, who in their right mind would be stupid enough to keep the properties when you could have a profitable low risk side business which does not require much capital? On the other hand, it takes some people that have good reasons to buy the properties and let go of the profitable part of the business.

Getting where I am going? Banking is a very capital-intensive business where you can make tons of money only if you build sufficient leverage; but then you become risky. For banks, loans are like apartments. They require lots of capital and, unless they can leverage, banking is a rather unexciting business to be in. Yet there is real money to be made elsewhere with the fees (transaction fees, re-mortgaging fees, insurance fees, etc.). However, selling these products does not really require that the banks own the loans.

Once banks understood this, they quickly started to sell their loans portfolio in packages of loans, like apartment complexes transformed into condos; and, by the way, not just real estate loans, all sorts of loans! Once they were done selling their portfolio, like real estate developers, they tried building another loan inventory which they, again, sold when the loan warehouse was full and ready to be packaged and sold into "tranches" (the financial version of condos) to willing investors.

The problem was that there was only a limited amount of loans that the banks could make. The solution was then to create borrowers where none existed before. Who do you think suddenly had your best interest in mind? Who was selling you the American dream of owning a home? Yes, you know the answer: The banks with, unfortunately, the government as their accomplice. It is no wonder then that banks became your enthusiastic representatives and lobbied Washington hard to facilitate home ownership. They also lobbied hard to be able to sell you insurance. And when that did not happen quickly enough, some very honest banker merged City and Travelers; even if it was illegal ... until some very uninterested Treasury Secretary legalized the whole process ex-post.

And buy, did we? And not just homes! Cars, appliances, all kinds of goods and vacations and more; all on credit. Even those without any money were allowed to participate. This little detail did not really matter to the banks; they were going to sell these loans anyways. Keep them coming! Until all the warehouses (and there were more of them and they got bigger as the good times were rolling) got full; all at the same time. And what followed is now history: There was acid reflux. Or, rather, toxic waste reflux. It was time to call the plumber.

In Why I’d Rather Shoot Myself in the Head than Ever Own a Home Again, published last week in the Blog of Freakonomics, James Altucher explains why owning a home is not always such a good idea and opines that many of us may have bought one for the wrong reasons; just because ...

As it is a bit complicated to reproduce the article here (the format is tricky), you will have to click on the link above to read the article. It is worth the click!

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