The ideas from MIM2 continue to percolate more than a week later. My earlier reference of an article from today's LA Times got me thinking to a conversation I recently had with a friend, as well as the concept of matching one's risk to one's timeframe.
My friend is a guy I know from biz school, with an MBA in finance and a lot of practical experience. He and his wife just bought their first home. To do it, they had to take on three separate loans: A primary mortgage (adjustable - 3 year), a second mortgage (adjustable - 1 year) and a line of credit to finance some needed upgrades (also adjustable, don't recall the details).
When I discussed the risk of the situation, he acknowledged that there is admittedly risk to the Southern California market, but that he wasn't concerned because he plans to stay in the place for 5-10 years.
I asked him how he felt his risk matched up with his timeframe. He had no clue what I was talking about. I had to explain.
He's purchased an asset that he plans to keep for some time, and to a large degree justified the purchase by saying he doesn't feel the need to worry about short-term fluctuations. This isn't necessarily a bad thing, in itself.
But he's financed it with debt that is short-term risky. He plans to avoid the problem of a possible short-to-medium term drawdown by holding for the long term, but the nature of his debt is such that he could be forced out of the asset in the short term if interest rates don't go his way.
Like many people, he's been tempted to use short finance in order to increase his purchasing power for long assets. He'll excuse this by pointing out (correctly) that he couldn't afford the long assets if they had to finance across the expected period of ownership (say, with a loan that's fixed for 5-10 years at least).
What he's missing, and what will ultimately burn a lot of people is that the mismatch of the timeframe of debt-related risk and the timeframe of expected ownership means that more and more of the risk is not balanced against the assets. That additional risk is there, and whether they recognize it or not, it is borne by my friend and millions of other homeowners like them.
My friend says he's not worried. "All I need," he says, "is 3-5% of appreciation per year and in a couple of years I'll be able to get rid of that variable risk." In the meantime, the risk is on him.
-btc
Comments (1)
Terrific post. Understanding risk is so critical with the plethora of complex financing products. What your friend is doing is a "classic" carry trade. Borrow short and lend long. As long as he can come up with the loan payments if rates rise, he does not have to concern himself with the price of his house.
But if current trends continue those payments will get bigger. HELOC rates have gone from 4.5% to 6.75% in the past 2 years.
Posted by unter | August 29, 2005 10:46 PM