Monday, May 3, 2010

Fixed Costs and the Housing Market

In 1987 the privately held company I worked for sold out to a much larger corporate competitor. I was in a mid-level position and required to own a certain level of stock. I voted against the acquisition. I thought I would have more opportunity with the smaller company where I had been promised a particular higher position a year hence.

Didn’t matter, the old guys (and it was almost entirely guys back then) had the shares and they voted their wallets and we sold out. (Oh, they officially called it a merger—they usually do—but when one side controls all the subsequent decisions, it’s a merger in name only.)

The good news was that I made a hefty profit on my stock, and didn’t have to maintain any level of ownership in the acquiring company. As a result I had some free cash.

Interest rates were high (in the 9-10% range), the stock market had been on a tear and one of my friends and I decided the best thing we could do with some of the money was pay off our mortgages. Not everyone agreed. We had another co-worker and friend who thought the best approach was to use the stock sale windfall to trade up in houses. He figured he'd use the money as a down payment, combine that with the profit he had in his house (the housing market was booming then) and get a really big, expensive house.

His analysis showed that he could afford the mortgage, with the additional down payment, it would only increase 25% from current levels, and with raises and expected bonuses he could cover the increase.

But, he didn’t think about (1) the additional real estate taxes (2) the increase in property insurance costs (3) additional maintenance costs that come with a bigger house, and (4) the house he wanted was farther away from work, so his commuting costs and time would both increase.

Lastly, he would have no cushion. If the business had a bad year and bonuses declined he was in trouble—and our business was cyclical.

During that whole time I joked with my finically conservative friend that if I took on that much risk, I couldn’t sleep. He said, if our other friend took on that much risk, he couldn’t sleep.

Given that, we sat our friend down and talked him out of his proposed house purchase. Back in 1987 our friend was “out there” on the risk frontier.

Twenty years later, huge portions of the United States shared his risk tolerance and we narrowly avoided a depression as a result.

~ Jim

No comments:

Post a Comment