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Last week, I talked about how the current credit crises evolved.
This crisis is the result of mistakes made by the homeowner, the
mortgage company, the investment banks and the rating agencies. This
week, you'll see what caused the House of Cards to fall and will
learn how this example can keep you from making a financial mistake.
Leverage was used at each stage of the mortgage-chain. Leverage is
when money is borrowed so that additional investments can be made.
The idea is that more can be earned on the investment than has to be
paid in interest on the loan. So the homeowner borrows the full
value of the home, the investment banks borrow money so they can buy
more loans, etc. While leverage can increase returns, it also
exacerbates a decline.
For example, a popular concept these days is to borrow the equity
from your home and invest it in life insurance (one that I don't
agree with). Perhaps both spouses work and their income easily
covers the additional mortgage payment. The couple only sees the
potential profit and doesn't realize if things don't work out, this
transaction can be very costly to unwind.
Suppose one spouse loses their job and their income falls short of
covering the mortgage payment. Or maybe their mortgage payment
increases because of interest rates. Unless the spouse can find
another job, the couple will be faced with having to sell their home
quickly to pay back the mortgage company. If there are lots of other
people in the situation, all trying to sell their homes at the same
time, the value of a home is going to drop quickly.
Taking this example a step further, if home prices in general have
declined 20%, then those who had 20% equity in their home suddenly
have none. Now their home is only worth what they owe. Or, they may
have a home equity line of credit. The bank is going to reduce the
line of credit based on the decreased amount of equity.
That's basically what has occurred on a national scale at every
point in the mortgage-chain. If a portfolio of mortgages is used as
collateral and it's suddenly worth 50% less, the lender is going to
want their money.
What should we learn from this? First, examine why so many homes are
in foreclosure. Is it because the borrower wasn't informed about the
details of the loan? No, the bank or mortgage company provided lots
of fine print for homeowners to sign, explaining every aspect of
their loans, including how interest rates would increase payments in
the future.
Did banks or mortgage companies illegally provide mortgages to
consumers who weren't qualified? No, not really. Obviously, the
mortgage lenders wanted to sell as many mortgages as possible
because that's how they made money. It wasn't their job to protect
the borrower.
It's the same in the world of investing. You can't expect the one
selling you a product like a mutual fund or annuity to be the one to
watch out for your best interests. As a consumer, it is your
responsibility to do the research, read the fine print and
thoroughly understand any financial contract you sign. A financial
advisor isn't going to say to you, "Hey, this might not be the best
investment for you. Your money is going to be locked up for 15 years
and the only way you can tap it is by paying a big penalty. Besides,
you can earn even more using a balanced portfolio of quality
investments."
Believe it or not, a commission-based broker or agent is NOT legally
obligated to do what is in your best interest. They only have to
offer investments that are suitable. They don't have to make sure
you understand the fine print you sign. They don't have to go over
all the future consequences of your financial decisions. They don't
have to sort through all your investment options and find the one
that fits you perfectly. That's not their job!
Don't let fear or greed cause you to defy common sense when it comes
to investing. Do independent research, read and carefully parse the
fine print and if you can't understand it then you shouldn't buy the
investment. Don't let a smooth-talking advisor cause you to skip any
of these important steps.
Nationally-syndicated financial columnist and Certified Financial
Planner(R)
Jeffrey Voudrie provides personal, in-depth money management
services and advice to select private clients throughout the USA. |
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