What Happened To The Dinosaurs?


January 2008
Vol 31 No 4

          Long time readers of the CommonWealth Letters will recognize the title line for this month’s letter.  I use it just about every time there is a major shift in the market, tax laws, or political scene.  All of these are going to manifest themselves during 2008.  Those who can adapt to these changes will prosper.  Those who either can’t or won’t change the things they do, and the way that they do them, will go the way of the dinosaurs, leaving only the fossil remains of past successes.
In the final analysis, your future is really up to you.  

          A few weeks ago, one of those traveling road shows once again migrated through Tampa with the same old tired message that had worked for the past ten years. You know the pitch:  “Buy my special Success System that enables you to buy with nothing down by placing multiple loans on a property, then selling it for far more than you paid to make instant riches.”  For only $99 augmented with merciless selling of very expensive future seminars and “Home Study” courses, anyone from any walk of life, regardless of initiative, specialized real estate knowledge or skill, resolve, money or credit could quit his or her job and reap a fortune without much effort at all.  All they needed was the cash to buy the sure-fire lesson materials.

          What’s pathetic about this scenario is that, in the prevailing market, the old dinosaur was sadly out of date; and so were those hopefuls who were being bilked of their remaining savings.  Neither seemed to understand that the world had changed and they were going to have to change with it.  Except for special situations that affect some local areas around the country, the appreciation of the past few years,   driven by investors and speculators who were able to finance their activities with low-cost easy loans, has gone with the wind.  It has been replaced.  

          Today, the overall real estate market is characterized by indifferent buyers, foreclosures, and bankruptcies that have triggered falling prices, failing mortgage companies, and the end to easy credit.  Does that mean we should all fold our tents and go home?  No.  But it does mean that there’s a different market paradigm that we’ll have to deal with.  Who will the next winners be?  The future will belong to those who can adapt to it.  They will be able not only to survive, but to prosper over the coming years.  Let me try to sketch out some of the critical changes that are coming and the way they can be dealt with.
THE ECONOMY:  Because we’re borrowing more and more money to finance the Iraq war, the dollar is now trading at historically low levels against foreign currencies. I recently saw this first hand on a recent visit to Canada.  The Canadian dollar hasn’t traded this high against the U.S. dollar since the Korean War, when we were busy creating money to support that war too. American products and services look like real bargains to Europeans, Arabs, and Asians.  Exporters are doing a booming business.  Those who rent vacation houses to Europeans are also doing well.  

          The rising world price of gold and gasoline denominated in U.S. dollars indicates that the world thinks the dollar is going to deflate even more.  They’re raising the price to offset its drop.  We’re going to pay more for just about everything we buy that is manufactured in another country.
          The combination of higher interest, higher taxes, insurance, products, and energy are going to pinch wage earners.  They are going to begin buying less.  Many of them are trying desperately to sell their homes in order to reduce debt.  They’ll elect to buy smaller, older houses in established neighborhoods.  This could auger well for fixer-uppers who take advantage of the foreclosure markets to buy low and sell low at today’s prices; and for those who create, buy, and sell mortgage Notes.
           In election year, politicians at every level are now expressing grave concern over loss of homes by those who mortgaged their appreciated equity to be able to refinance or add to the debt on their existing homes.  Last month the Wall Street Journal reported that a Federal Judge in Ohio threw a foreclosure suit out of court because the lender couldn’t prove it had any standing in the court.  

           Typically, individuals who bought or sold a Note and Mortgage would get an assignment and record it.  But FNMA, GNMA, major mortgage bankers, and investment companies that issue securities backed by mortgage Notes routinely buy and sell billions of dollars of these in blocks of $100,000,000 solely on the basis of their aggregated yields and terms.  They rarely bother to record assignments of them, nor can most of them even identify an individual Note or Mortgage.  

           When lenders go through a judicial foreclosure, the Note and Mortgage are extracted and turned over to the foreclosing entity, but there isn’t any “chain of title” to show how that entity came into possession of the Note and Mortgage.  Now the Judge says they can’t foreclose without showing the entire chain of assignments.  This has potentially disastrous ramifications and could turn the entire foreclosure and credit markets on their heads.  If an assignee can’t foreclose, why would he invest in a mortgage?  The real question is this:  How can the housing market recover without an active secondary market that will buy billions of dollars of loans, and without investors willing to invest money in mortgage-backed securities?  

           This is happening right in the middle of an election year in which office seekers are trying to woo the electorate.  Politicians long ago learned that providing low cost multi-family low income housing would concentrate uninformed and grateful voters dependent upon government for shelter.  They’re even building homeless “shelters” to garner the votes of those unregistered potential voters sleeping under the bridges.  And they’re desperately trying to find a way to sneak as many low-paid illegal immigrants as possible onto the voter rolls by passing out I.D. cards and Drivers Licenses.  All they have to do to capture the loyalty of these voters was to take credit for providing almost free housing.       

            Now, the Sub-Prime fiasco is creating an entirely new political constituency comprised of those who earn plenty of money and live in middle class housing, but who spend more than they make.  In a typical situation, these consumers maxed out their multiple credit cards, then put some form of variable interest rate “Home Equity” loan on their homes. They used the proceeds to pay off their credit cards.  Now they are wailing to Congress that they need legislation to provide payment relief.  Politicians have proposed that all interest rate indexing and payments be frozen.  Further, that Sub-Prime loans with balloon payments be restructured so the balloon is effectively refinanced so no cash will be needed.

           Politicians don’t seem to realize that mortgage lenders borrow the money they lend.  In so many words, they borrow at one rate, sell their loans to an investor at another rate, and make billions of dollars in profit servicing these loans.  The entire mortgage banking system is based upon being able to sell packages of mortgages that have a predicted yield over their term.  The proposed political solutions to the credit problem, if made into law, will drive the final nail into the credit markets; and into any hope of an early housing recovery.

           Without housing, where will all these voters who can’t afford large down payments live?  In government housing.  This won’t be great housing, nor will it be high rise low income apartments.  These take too long to build.  On the other hand, there are all those fantastic FEMA trailer subdivisions just sitting empty.  Can you see a glowing opportunity for entrepreneurs who can buy and sell, or lease/Option, lower priced housing with a low down payment and with seller financing?  They could raise cash from another group of entrepreneurs who’ll make a secondary market in discounted seller carry-back paper.  Fanciful?  We’ve already sold a property by carrying the financing, then discounting the note to an investor for cash.

          It looks like the tax-holiday created in 1997 is almost over.  A lot of trial balloons are being kited by political candidates as to which of Bush’s tax reforms will be allowed to die, which will be changed, and which will be extended. You can forget about all the pre-election talk of a flat tax and lower rates.  No matter who wins in 2008, just about everyone believes that federal income taxes will rise for all but the lowest tax brackets once the new Administration and new Congress agree on whose ox gets gored.  

          One item of good news:  People who lose primary homes that don’t qualify for Section 121 tax exclusion won’t incur income tax for the debt relief they get when their property is foreclosed.  This doesn’t apply to secondary homes.  The unpaid loan balance is taxable to the borrowers.  

          The Dems have already tipped their hand viz a viz taxes.  They plan to increase them for many wage earners and small businesses.  They want to start taxing singles with AGIs above $15,000, and marrieds with AGIs above $30,000 at 35%.  Singles who’s AGIs are more than $150,000 and married who’s AGIs are more than $250,000 will pay 39.6% tax.  Capital gains will go as high as 19.6%.  Corporations are also slated for a tax increase with a flat 35% tax bracket and lots of fringe benefits will be taxed.  Unless you actually live on corporate premises, you can no longer receive lodging tax free as a condition of employment.      

          Owners of one-member LLCs are now liable for back unpaid payroll taxes when they elect to be taxed as a sole proprietorship.  In 2008, the first $102,000 of earned income will be taxed at 15.3% for FICA and Medicare taxes in addition to income taxes.  This includes single member non-corporate LLC’s and Managing Member’s income, but doesn’t apply to income distributions of multi-member LLCs, or one-member LLCs that elect to be taxed as corporations.  It’s fairly easy to change a single member LLC taxed as a sole proprietorship to a dual member LLC taxed as a partnership by having it owned by an individual and a Trust.  If you have a corporation, it could replace the Trust or the individual as the named manager.  This would eliminate payroll taxes on earned income since corporations aren’t employees, nor do they “earn” income; they make profit.
          For those whose combined income and capital gains leaves them in the 15% tax bracket or lower, there will be no capital gains tax in 2008.  Before you get all excited about passing on assets to your kids to sell, the kid has to be over 19.  For corporate owners in high tax brackets, taking more dividends taxed at 15% and less salary taxed at your rate will also mean less FICA and Medicare taxes.  The corporation can’t deduct the dividends, so do the math to figure out what’s best.      

          Why spend so much time on proposed tax changes that haven’t been passed into law?  Many laws, including a lot of tax breaks will expire in the next two years unless they are extended.  Clearly, there will be a debate on which laws to let die, and which to extend.  When it comes to fiscal and monetary policy and responsibility, there is little to choose between the two major parties.  

          Republicans aren’t exactly fiscally responsible. They don’t raise taxes, but they're bent on borrowing America into insolvency in an attempt to pay for their “guns and butter” policies.  The last three Republican administrations, comprised of the Reagan and all Bush Administrations, created half of all national debt that America has accumulated since 1796; including all war-time debt. Despite this, as long as the world will continue to lend us money by buying U.S. Treasury Bonds, America will enjoy the highest living standard on the planet; based on borrowed money instead of productivity.  

          Instead of running up the national debt, the Democrats prefer taxing wage earners who work to earn a living.  They seem to resent the small businesses that provide 85% of the jobs in America; and seem to be willing to do anything to create more government dependents.  Taxing profit is a pretty good way to accomplish this.



          The key to dealing with projected changes in your market is to ask yourself exactly how they are going to affect you today; and adapt what you do to deal with them. Write down your answers to the following questions:  

How much further will house prices drop?  When do you think the bottom will come?  Why then? Will house prices ever return to their 2005 levels?  Why?  Will “burned” investors and speculators ever return to the market?  Will lenders ever offer “No Doc” and “100% loans” again? When? How many houses sold in your area last year? How many months of unsold inventory remains.  How many houses have been on the market for over 1 year?  How many houses sit vacant either foreclosed, or awaiting foreclosure?  How many distressed builders, investors, lenders, home owners, and landlords are there in your area?  Is there any way you can make money with short sales and foreclosures without cash or credit? How? will you make more money; waiting for things to change, or by changing yourself?  How much is your unsold, stagnant inventory costing you each month?  How will you make money if you can’t sell to Sub-Prime borrowers? How much longer can you wait for qualified buyers to return to the market? How will you survive, pay your bills, and make money until the market returns?  What will you do with houses that cost you more to hold than you can afford to pay? If you sit idly by doing nothing, how will you recover all the time and money you will have lost? Who will profit most in the next two years; landlords, investors, lenders, or speculators?  Which of these are you? What’s the best thing you could do today to exploit this slow real estate market?    

          Following each of your answers to the above questions, write down the first thing you can think of to make money or to improve your position.  When you consider what others in your area are confronting, can you see opportunity to make money? Put things into perspective:  If there is a 10-month supply of “For Sale” inventory in your area, and there are 10,000 houses for sale; that means that 1000 houses per month are being sold.  Ask yourself if the reason you aren’t selling your houses is that you aren’t trying as hard as the other 1000 sellers per month.  Or be honest, is it that you aren’t willing to adapt to the new market realities?
          Don’t become a victim of self-doubt.  Despite all the reasons why those who buy/fix/sell houses say nobody can make money today, I know one guy who continues to close the sale of about one house a week.  How?  He focused on price ranges in the bottom 40% of his market — between $110,000 and $135,000 — that can still be sold to buyers with 650 FICO scores with “seller assisted” financing.  

          If there are no institutional loans available in your area, find a capable mortgage broker with contacts in other markets and see if he can find a loan for you.  Don’t overlook IRA Custodians, local Pension Plan Trustees, investors, Qualified Exchange Intermediaries, and local business people who have money to invest for profitable short term transactions.  Offer to pay them more than their current investments earn for the use of their funds on a short term basis.  If you have an active foreclosure market in your area, get an IRA Custodian (or the Trustee of a self-directed IRA Trust), or your Qualified Exchange Intermediary to attend foreclosure sales and auctions with you to bid on properties using their funds.

          In order to offset pending tax code changes, if earned income is going to be taxed at higher levels, stop earning income and start generating your income from rents, interest, dividends, and capital gains; all of which are not earned income. If capital gains are going to be taxed at higher rates, make tax-free exchanging you new mode of operation.  If you can’t find investors willing to lend their money, start up an exchange group where people can swap equities with only a minimal amount of cash or credit.  Invite Brokers to join so they can put their listings into the pot.  Most importantly, do something starting right now.

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