I’m not sure whether to laugh or cry:
“A California man who has defaulted on nine homes and expects banks to foreclose on all of them, forcing him into bankruptcy, says he now considers it a mistake to have invested in the real estate market.”
It’s good that he now realizes it was a mistake.
The Story
The story goes that Shawn Forgaard was once a wealthy man. He received $800,000 from stock options in his software company. He began buying properties.
He was putting anywhere from 10% to 40% down. It wasn’t the down payment that caused him problems.
What sunk him is the type of loan. He was using negative amortization loans. That’s the type of loan with a balance that can actually grow from month to month.
A negative amortization loan doesn’t cause problems if the borrower pays the interest off each month. But if the borrow fails to pay the interest, the deficit gets added to the balance. The balance grows until the bank decides the loan is too risky and pulls the plug.
As with any investment strategy, buying property in this way is not “risky” unless the borrower doesn’t have the ability to make the monthly payments.
My guess is that Shawn had enough money in his bank account to pay the mortgages for a while. He was counting on being able to refinance after the value of his properties went up. He would be able to pull money out of each property and use it to continue to service the nine mortgages.
The value never went up. He wasn’t able to refinance, he ran out of money, he couldn’t make the payments, and kaboom!
If he had cash flow from another source, like his job or other investments, he may have been able to hold on long enough and make a killing when the market recovered. His strategy was very risky because it required the market to behave in a certain way and he didn’t have the funds to hold on when the market didn’t cooperate.
Long Term Capital Management
It reminds me of Long Term Capital Management (”LTCM”). LTCM was a company started by brilliant people that figured out a way to arbitrage government bonds. They borrowed incredible amounts of money and implemented their strategy. For three or four years they made tremendous returns. Then all hell broke loose.
The Asian financial crisis in 1997, along with other global financial events, led to tremendous losses for LTCM. To make a long story short, the Fed organized a bailout of LTCM on behalf of various creditors.
Bear Stearns declined to participate in the bailout. They must not believe in bailouts.
The Moral of the Story
Here’s the key point. By the time they got around to liquidating LTCM’s positions, the global financial crises had abated. Not only had LTCM’s positions recovered from their tremendous losses, they were actually liquidated at a profit!
As Jeremy Siegel indicates, if LTCM had not leveraged to the extent it did it may have had sufficient liquidity to weather the crisis and turn a profit despite the serious problems in the marketplace.
The Two Requirements for Successful Long-Term Investing
Here’s my short list of the requirements for successful long-term investing:
1) A winning long-term strategy
2) Sufficient liquidity to give your strategy time to weather any downturns.
Both Shawn Forgaard and LTCM obeyed the first rule but flunked the second.
