Understanding leverage – a double edged sword

Leverage is something that have made people very wealthy. In real estate, depending on the credit profile of the investor, the typical leverage is 5 to 1. If the investor has a good relationship with a bank, he/she need only place 10% down for a property, and the leverage is then 10 to 1.

When people say real estate is a good investment, I think they are confusing the leverage with the actual rate of return. Properties are not marked to market on a daily basis; there are no margin calls or calls for liquidation. Sometimes, the property assessor can evaluate the property – honestly or dishonestly –  for future investments. What other business can you hold an adjustable rate mortgage for 5 years, pay 10% and control a multi-million dollar property?

Life is good in the real estate market.

On the other hand, financial investments are marked daily; volatility is tracked for risk management purposes; and the margin – or leverage – allowed by the bank is only 2 to 1. There are opportunities in the stock market, but on an individual stock basis. Concentrating assets in a few stocks, with a margin account, can reap profits; but, there are risks.

Can you guess the type of leverage a hedge fund manager uses?

Depending on their relationship with the bank, the leverage can be extremely high; perhaps up to 50 to 1 or higher. For every million dollars the hedge fund manager places with his/her prime broker, the hedge fund can control up to 50 to 100 million in assets. To make matters worse, hedge funds will charge a 2 percent annual fee to manage your money, and take 20 percent on profits they make.

 

Leverage is a double edged sword; be careful when swinging it.

Non-qualified deferred compensation plans – an short description

There are a number of companies that need to compensate their highly compensated employees, and keep them for a period of time. If the company has a large number of employees, creating a defined benefit plan would be too costly; there are alternatives if owners are willing to bend.

Non-qualified deferred compensation plans are outside of the ERISA rules, and allow corporations to create deferred compensation plans for employees they want to keep – without compensating other employees. There are several basic factors you need to know: One, the corporation has to be a C-corp. An LLC or S will not work since any compensation would be post-tax dollars. Two, the assets are kept on the balance sheets of the corporation, and are taxed as a non-qualified expense. The corporation can take the deduction when the employee takes distribution. Three, the employee should be sure that the employer will survive the duration of the agreement.

Non-qualified deferred compensation (“NQDC”) are solid plans, and used by many large corporations. I will write more about it in coming articles.

 

Assume Nothing – Our Pension Crisis Is Looming

Calpers, a couple of years ago, lowered their assumptions rates from 7.5 to 7 percent. The assumption rate – in simple terms – is the rate which Calpers gauges their investment return on the pension funds. The funds, are paid out to present and future retirees.

In a perfect world, assumptions can be created; in reality, assumptions can create an enormous amount of damage.

In my opinion, I think this is why the Federal Reserve instituted its purchases of toxic assets  – to the tune of 4 trillion dollars – to avert an additional crisis. After the  2008 market crash, there were a number of private pensions that were imploding due to their investments. This signal was not ignored.

Which brings me to this point. What is going wrong?

In short, the answer is greed. Blame the brokerage firms and insurance companies for convincing people to switch out of bonds to equities and hedge funds. Pensions were created to secure the future income flow of retirees. This assumes that the underlying asset of the pension is stable; equities and hedge funds are not stable.

The only asset that should be the foundation of a pension should be US government bonds – in my humble opinion. But, to each their own. Which brings me back to Calpers.

Calpers and all of the other pensions funds are in deep trouble. The unfunded liabilities are enormous; I think Los Angeles, at the time of this writing, have unfunded pension liabilities of  9 billion alone. Multiply that by the number of cities and counties in California, and you have a major crisis.

The moral of the story is: don’t assume that everything will go your way.

 

 

The State of the Financial Markets

Don’t fight the Fed.

Or, don’t fight the global central banks.

Since the market crash of 2008, central banks have been instrumental in propping up the world economy through creative monetary policies. Japan has used monetary policies to keep their economy afloat since 1990. Even though their Debt to GDP is over 200%  – double the size of the US – they seem to be ok for now.

What could trigger the next crash?

Another Lehman Brothers, or a Puerto Rico type bankruptcy. The risk that US investors face are the high correlated assets created by the arbitrage of high frequency companies. Diversification of risk can be mitigated by these companies when another event occurs; they will cause most assets to go in one direction – and that is down.

If enough damage is created by these type of companies, legislation – although too late – will be implemented. The SEC or government agencies are always slow to act. The Bernie Madoff debacle is a perfect illustration of this incompetence.