Ponzi Investing & The Plankton Theory

By John Nicola CLU, CHFC, CFP

IN THIS ISSUE: Many people see housing as an investment and are willing to use leverage (mortgages) as a way to hopefully achieve a good return. But what if one took that money and invested it elsewhere? What if one used the same equity and leverage to own other investments? Could they get a higher rate of return than the person who invested in real estate? John Nicola looks at the impact of leverage not just on the housing market, but as an overall investment tool for getting better returns.

A little while ago I was reading a newsletter written by Paul McCulley who is a portfolio manager at PIMCO. He was opining on a prescient article written by his partner, Bill Gross, in 1980, on what could happen to the housing market in the early eighties.

For those of you who have insufficient grey hairs to remember this period of time, it was one of high inflation, a choppy stock market, rising interest rates, and most of all, a booming property market that had grown in value at something approaching twice the rate of inflation for several years. People were gaga over gold and oil prices had reached record highs the year before. In other words, there are at least a few similarities between then and now. (It was also the end of disco, as people discovered that walking in Nikes was a tad easier than platform shoes).

Essentially, McCulley was trying to connect Gross’ observations about the importance of plankton in the aquatic food chain with another theory developed by Hyman Minsky regarding different types of investment risks we seem to be willing to accept. The Plankton Theory states that if plankton die, the food supply for small fish disappears and they die as well (and so on until eventually even the whales succumb).

For Gross, this water-based theory is a metaphor for what occurs in housing when the first-time buyer is simply priced out of the market. What happened then (and arguably is occurring now) was that too many first-time buyers were drawn into a market they could not afford to be in. This created artificial demand which, in turn, elevated prices. Paradoxically, the new higher prices attracted even more buyers and speculators who feared they would be left on the sidelines as a financial wallflower forever doomed to a lifetime of renting and “paying someone else’s mortgage”. However, as you might guess, housing experienced a major correction that took many years from which to recover.

In 2007 it would be easy to say that the crisis in U.S. housing only exists with the low-income buyers who borrow egregious amounts of money that, in some cases, exceed the cost of the house which is already inflated. But if these buyers (some of whom are going into foreclosure) are lost (think plankton), then who will be the buyers for those moving into the next higher level of housing? As we move up to McMansions, there will eventually be a dearth of buyers up and down the food chain. Consider the following changes in the last couple of years to the U.S. housing market:

  • 69% of US Households own their own home – and this is a record. It has increased by over 5 million households in the last 12 years. Now, however, it is starting to decline.
  • A higher home ownership percentage also means fewer potential buyers in the future.
  • In 2006, U.S. Sub Prime and Alta A mortgages (higher risk mortgages) increased to 40% of all mortgages issued. To make matters worse, on average they were made a loan-tovalue ratio of 94%.
  • There are over 10 million homes in the U.S. in which the owner has less than 5% equity. To add even more financial pressure, 40% of all adjustable rate mortgages (ARMs) taken out between 2004 and 2006 were made to this same group of homeowners who have less than 5% equity. Almost all of these mortgages will reset at higher rates in 2007 and 2008, virtually guaranteeing an increase in foreclosures and housing inventories.

So what do these scary stats from the U.S. have to do with our idyllic neighbourhood in B.C.? Surely we are immune to the volatile U.S. market gyrations. Perhaps we are, but we would do well to also consider the following:

40-year mortgages are now available in Canada (thus ensuring that if you take this long to pay off your mortgage, you can use your CPP and OAS to help make the payments).

CMHC finances mortgages with 5% down. They have now decided to decrease that to 0% down (100% financing) and in certain cases they will make payments “interest only” for up to ten years. After all, why pay off the principal? That is so last generation thinking.

The US still counts for a huge percentage of our trade. Lumber prices have already dropped 30% in the last twelve months and other commodity prices are likely to follow. We will feel some heat from their slowdown.

The basic problem, of course, is that home ownership makes sense in the long run. In my opinion, housing works best when it is acquired as a lifestyle choice (expense) vs. as an investment. Over many years I have noticed that very few people die having spent all of the equity in their home. In fact, most people still have all of their housing equity intact and pass it on to their heirs. This means that their home not only does not add to their retirement income, it becomes part of their retirement lifestyle (property taxes, maintenance, etc.).

Therefore, from a cash flow perspective, housing is an expense. Investments are not simply assets that should rise in value, they are also able to generate cash flow that one can consume as an alternative to working.

There were two theories we wanted to look at in this newsletter. The second was put forward a few years ago by Hyman Minsky, in which he put investments into three categories.

In this case, the investment acquired generates more than sufficient cash flow to fund the debt used to acquire it and pay back the principal in a reasonable time frame.

These are investments which generate sufficient cash flow to service their debt, but not enough cash flow to repay the principal. These units will roll over debt rather than pay it off (and assume lenders will be willing to accommodate them).

These types of investments do not generate sufficient cash flow to pay even their interest expense so it is sometimes capitalized and the principal of the debt grows. The only way one can make money on these investments is to hope the price of the asset grows faster than the interest on the debt. This is also called “the last man standing in musical chairs” investment strategy.

So how does the plankton theory connect with Ponzi financing?

In B.C., many, if not most, first-time house buyers (plankton) are taking on significant debt and cash flow obligations just to get into the market (Ponzi financing). In many other markets around the world, this is beginning to unravel; yet we all know how good an investment housing has been for most of us over the years. And in any event we have to live somewhere, so why not put one’s savings into a home?

Unfortunately the combination of cheap or easy to obtain financing and a desire for home ownership over rent actually makes the situation worse for first-time buyers.

If more of them chose to save, invest, and rent, then the housing market would cool off quite rapidly and, in fact, prices might decline (as has occurred twice in Vancouver in the last 25 years – 1981-1987 and 1995-2001).

The question then becomes: if in the last ten years, one saved towards a home while renting, wouldn’t they be much further behind than if they had simply struggled to acquire their first home and then pay off the mortgage as best they could?

The answer: it depends. The reason that housing has generally performed well for individuals is because of the use of leverage. Let’s look at an example.

Assume one buys a starter condo for $300,000. Let’s further assume one saves 25% ($75,000) and then borrows a 75% ($225,000) mortgage amortized over 25 years. 10 years later we’ll assume the condo is worth $600,000 and the mortgage has been reduced to $150,000. Therefore our intrepid homeowner has seen his $75,000 equity grow to $450,000 tax free over 10 years..

Even though the price doubled from $300,000 to $600,000 over ten years (about 7% annualized return), the return on the down payment of $75,000 would have been 19.6% per year mainly because of the positive effects of leverage. So those who see my comments as nattering negativity can point to this simple example as to why getting into homeownership as soon as possible is the best option. Just imagine how great the return would have been with a 5% down payment (at zero down it is literally off the charts which must prove the age old maxim: if a little is good thing, a lot must be better).

The problem with this theory is that, as with most Ponzi financing structures, it ignores cash flow. Further, one needs to factor in the additional risk of The Plankton Theory. If buyers are priced out of the market, then those nice annual increases in price will not occur.

In Vancouver, for example, house prices have increased 7% annually for the last 25 years. Over the last ten years, however, there were two different housing markets. Between 1997 and 2001 the cumulative price increase was zero. Between 2001 and 2006, prices doubled (14% annually). While this does average to 7% annually, it does show that those increases can be very inconsistent.

So what occurs when we apply financing approaches used in home ownership with other assets? Let’s consider the story of Tom, Dick, and Harriet. 

In January of 1997 all three of them chose to acquire a $300,000 investment with 25% equity (savings) and 75% debt. Let’s further assume the following:

  • Tom bought a condo in Yaletown and rented it out. The rent started at 3% of the value of the condo (after expenses) and he received annual increases equal to CPI. All rent was applied to the debt and if it was not sufficient to cover interest costs, the debt increased (friendly banker). These rental assumptions were correct for most areas in B.C. for the last ten years.
  • Dick stayed with real estate, but chose to invest in a new real estate trust called Riocan and used the distributions in the same way Tom used the rent for the Condo.
  • Harriet did the same as Dick and Tom, but with shares of the Royal Bank.

After ten years, who has the most equity, the least debt, and the most cash flow from their investment decision? The table below shows the results and also shows the results with zero leverage, 50% leverage, and 90% leverage.

What can we learn from these somewhat surprising results?

  • Leverage dramatically increases annual returns in rising markets. However what the table does not show, is that at 90% financing Tom’s Yaletown condo was worth less than the total debt and his return was minus-100% cumulatively after four years. If he had sold prior to 2001, he would have lost all of his equity and more.
  • These numbers ignore trading costs and commissions, which are much higher for real estate than for marketable securities. When one adds property purchase tax, real estate commissions, and legal costs, it can add up to 5% or more of the gross investment and 20% of the down payment.
  •  In all three cases the underlying investment had a period of time when its value either dropped or remained flat for several years. Patience is always required when one uses leverage to acquire an asset.
  • Cash flows are far more reliable and predictable than market prices. Therefore, to make leverage work well, you need enough cash flow to fund both principal and interest on any debt used (Hedge, not Ponzi). In the above example, only Riocan qualifies if 75% financing is used. 
  • What makes the Royal Bank stock work much better than the condo, is the rate at which its profits and dividends increased when compared to rental incomes in Vancouver. The bank’s dividends have grown at a 14% rate vs. about 2% for rents after expenses.

How would this example look different if Tom had bought the condo to move into and not rented it out? Because Tom would no longer be paying rent, his return would be the same and now the gain would be tax-free. Pretty good, really. However not as good as if he had rented the condo and invested as Dick and Harriet had. Ten years later both of them can buy a much nicer condo than Tom would have owned.

Can we be accused of choosing outstanding equity investments in hindsight? Even if Tom had simply invested in the S& P TSX index he would have achieved the same 10% return as his condo assuming no leverage over the last ten years. The example above focuses on using leverage to acquire cash flow generating assets. This, in our opinion, is much less risky.

 It’s important to understand that leverage can be a very useful and simultaneously dangerous tool for allowing us to acquire the assets we want over a lifetime. There is no magic in borrowing to buy a home. One can achieve similar (and often better) returns with less hassle and more liquidity through many other assets (including dividend-paying stocks, income trusts, mortgages, and commercial real estate).

The key is to remember that the cash flow from the investment should always exceed the cost of any debt used by a reasonably wide margin.

 Let me end this with some comments for future/current first-time homebuyers.

  • Your ideal time to buy your first home is during a recession and/or when interest rates are rising (real estate is very sensitive to the cost of borrowing).
  • To improve cash flows, consider acquiring a starter home where you can create or rent out a suite to help pay your mortgage costs.
  • Sit with your advisor to potentially explore some alternative cash flow investments and see if using leverage to enhance returns can help your savings keep pace with, or even exceed, the returns typically generated from housing.
  • Renting is not wasting money. When you acquire a home, all of your interest, taxes, maintenance, and insurance premiums are the equivalent of rent. They do not make your home more valuable.

A home is and should be a personal lifestyle decision. The memories it provides for you and your family will usually be far more valuable than its future selling price (especially because you have to live somewhere).

The plankton theory suggests that when we remove the “little guy” from the housing market every home owner will eventually feel the pain. And Ponzi financing always ends badly. If an asset’s cash flow won’t support its own debt, then in order to make a profit, you have to find a buyer willing to pay more than you did. Eventually someone is the last person standing. Make sure it’s not you.