Are you asking your clients about their liabilities? Looking only at one side of your clients' balance sheet may put their long-term goals at risk. Great asset allocation constructed to fit the clients' investment risk tolerance is only one part of the formula–your clients' level of debt (or leverage) and their capacity for risk is a huge part of the equation as well.
Today, more than at most other times in U.S. history, Americans are highly leveraged. Just look at these staggering facts:
- Personal bankruptcies are on the rise, according to the Administrative Office of the U.S. Courts. Approximately 2.1 million bankruptcy petitions were filed in 2005, 50% higher than the prior year and the most ever filed in any 12-month period.
- In June 2006, the U.S. personal savings rate was again negative, at -1.5%, according to the U.S. Department of Commerce's Bureau of Economic Analysis.
- American households' overall debt rose to a median 108% of income in 2004, up from 78% of income in 2001, according to the Federal Reserve Board's Survey of Consumer Finances.
- In 2005, for the first time, U.S. households borrowed more than $1 trillion. Before 2000, consumers had never borrowed more than $488 billion in one year, according to Federal Reserve statistics.
Overconfidence in Borrowing
Let's recall the way things were as recently as the late 1990s. If a corporate executive wanted to buy a vacation home that cost $2 million, she might borrow 90% of the purchase price based on her annual cash flow of $1 million and an investment portfolio worth $25 million.
Sounded okay, but there's a catch. The investment portfolio was heavily concentrated in one public company.
When the price of the collateral stock declined, the executive was required to make a margin call and had to liquidate assets in a depressed market. In so doing, she had to forgo any future rebound and appreciation of the stock. What might have been a temporary dip in value became a permanent destruction of her wealth, having a huge impact on her long-term goals.
In the late '90s, many investors suffered from exuberant overconfidence and thought that the stocks they purchased had nowhere to go but up. We now know this was not true. However, could history repeat itself if our clients suffer another case of overconfidence in residential real estate?
Let's look at the latest housing market data. Existing home sales rose to a nine-year high, but price appreciation was at an 11-year low, according to a June 2006 National Association of Realtors report. Inventories of existing homes were up 39% while sales were down 8.9% over the past year. Adding to the slower housing market is the ever-increasing range of loan choices available to borrowers. These include interest-only mortgages, longer average loan maturities, and "piggyback" mortgages, or second liens originated at the time of purchase. These choices allow borrowers to assume bigger mortgages than they otherwise could afford and take on greater risk. (See "ATM" sidebar)
Today's Opportunity
With the recent cooling in housing prices and interest rates on the rise, now is an excellent time for you to add value to your client relationships. Consider reviewing your clients' existing commitments and collateral, and to discuss with them their "personal maximum debt level."
Your clients' borrowing decisions should be made with the same kind of discipline applied to their investment strategy. It's important to distinguish between leverage that's beneficial from borrowing and exposure to outsized risk. To become wealthy, many of your clients took calculated risks along the way, but preserving wealth requires a much more balanced approach. Credit used wisely can be a potent tool for both building and sustaining wealth. You can play a key role in helping your clients to understand and embrace their "personal maximum debt level."
