Caution: Main Street Wealth Moving To Wall Street - 12/10/2004 - Mortgage Loan Refinance Debt Equity

Caution: Main Street Wealth Moving To Wall Street
by Broderick Perkins

Perhaps they are getting bad advice from securities brokers and their firms.

How bad can it be?

Spending from housing wealth takes only a year or so to reach 80 percent of its long-run wealth effect, compared with nearly five years for the same effect from stock market investments, according to "Housing Wealth Effects," produced by the Joint Center for Housing Studies at Harvard University and Macroeconomic Advisers, LCC.

While Freddie Mac recently reported in its quarterly Conventional Mortgage Home Price Index that home values increased by an annualized rate of almost 16 percent in the third quarter of 2004, up from 9.9 percent in the second quarter, the Dow Jones Industrial Average has been stuck in the 10,000 neighborhood for nearly half a decade and other stock market indices have likewise floundered.

For all the bubble talk, the housing market right now is like bedrock. Comparatively speaking, the stock market is, well, sedimentary clay.

For the typical small investor whose primary wealth is in his or her home, diversifying that wealth with investments in a few balanced stocks, bonds, mutual funds and other securities may be well advised, but taking most or all of the equity from a windfall to buy something that's already blown over -- or over blown -- can be inherently risky and more than a little stupid.

Nevertheless, a growing number of homeowners appear to be taking that risk.

A Federal Reserve Board study found that during the most recent period it checked -- 2001 through the first half of 2002 -- 11 percent of the total funds from mortgage refinancings were used for stock market and other financial investments, up from less than two percent during a 1998 to 1999 period.

The average amount of cashed-out home equity individuals used for investments also increased substantially -- from "relatively small amounts" in the 1998-to-1999 period to more than $24,000 in 2001 to 2002.

What's surprising is that the average amount used for investments was greater than nearly all other categories, including home improvements.

One of the reasons for the current real estate boom is the migration of investments from the stock market to real estate. That's especially true among those who turned the "sudden wealth effect" of the dot com era into real estate and later, others who survived relatively unscathed from the largely technology-driven stock market collapse less than a half decade ago.

How quickly some forget.

Here's a reminder.

Most personal finance advisors, real estate experts and related professions advise, before your home is an investment vehicle it's your shelter -- both from the elements and from taxes -- and you should avoid financial behavior that threatens the roof over your head.

The best use of borrowed equity is always capital improvements -- home improvements, education, perhaps new business financing -- loans that have a good potential to generate a return. More conservative advisers say the equity is for emergencies only, to see you through tough times. Otherwise, leave it alone and you have a better chance of retiring mortgage-free on a fixed-income.

Too often that's not happening.

For the third time this year the National Association Of Securities Dealers sternly advised its members not to lead homeowners astray on this matter.

"Many homeowners have become wealthier -- at least on paper -- because of escalating home values. And more of them than ever before are tapping into their increased home equity to purchase securities," said NASD Vice Chairman Mary L. Schapiro.

"But turning equity into cash to make financial investments isn't an appropriate strategy for many investors. That strategy poses significant and unique risks, and failure to understand those risks could cost them their biggest asset -- their home," she added.

NASD recommended in its latest alert yesterday that firms have a fiduciary duty to go beyond factors typically considered when gauging an investor's tolerance for risk.

It said regulated firms should consider the amount of equity a homeowner has available, how much is being liquefied for investments, how the investor will meet his or her increased mortgage obligations, the burden of the terms on the loan obtained to buy securities, the investor's risk tolerance based on the amount being invested and the investor's overall debt burden and sustainability of the value of the investor's home. The latter consideration has been the subject of much debate by economists, real estate analysts and related experts.

While the housing market feels like bedrock today, some studies point to a real estate market bubble that could burst, causing home prices to plummet leaving homeowners with more mortgage than home value. Homeowners who've also traded much of their equity for stocks that likewise tank will double their financial trouble.

Homeowners should heed the same advice NASD is giving its members.

In March, NASD issued an Investor Alert, "Betting the Ranch: Risking Your Home to Buy Securities." Two months later it issued the related Investor Alert "100% Mortgages: The Low Down on No Money Down," associated with pledging securities in lieu of a mortgage down payment -- a questionable holdover habit popular during the stock market's technology-driven hey day.

In its most recent notice to members, NASD made the following point:

Members should use industry-sanctioned "best principles" for disclosing relevant risks and conflicts, including:

 

• Unlike other potential lenders, the recommending firm has an interest in having the proceeds of the loan used for investments that may generate commissions, mark-ups or fees for the firm.

   

• The recommending firm or its affiliate may earn fees in connection with originating and/or servicing the loan.

   

• The impact of liquefied home equity on the ability to refinance a home mortgage, and the possibility that a change in home value could result in negative equity in the home.

NASD also warned investors:

 

• You may lose your home if the return on the investment is not sufficient to cover the cost of the new mortgage or line of credit.

   

• Pay close attention to potential conflicts of interest, including a broker's interest in generating commissions or fees on investments from the cash proceeds of a refinancing or home equity line of credit. The firm has an interest in generating compensation for itself or an affiliate for originating and/or servicing the new mortgage or line of credit.

   

• Cashing out home equity may undermine your home's built-in asset diversification benefits -- the ability to send your children to college and private schools and seed money for a well-planned start-up business, second home or value-enhancing home improvement.

For the small investor, some of the best advise is to invest close to home.